Greenspan Any onset of increased investor caution elevates risk

http://www.socalbubble.com/ Interest Only – Creative Financing or Harbinger of Deflation? On November 28, 2005, In Uncategorized, By Chuck Ponzi.The economists over at Elliott Wave have a great write up about deflation and what causes deflation in a piece titled “What is Deflation and What Causes it to Occur?” All deflationary periods were marked with the following conditions: (a) All were set off by a deflation of excess credit. This was the one factor in common. (b) Sometimes the excess-of-credit situation seemed to last years before the bubble broke. (c) Some outside event, such as a major failure, brought the thing to a head, but the signs were visible many months, and in some cases years, in advance. (d) None was ever quite like the last, so that the public was always fooled thereby. (e) Some panics occurred under great government surpluses of revenue (1837, for instance) and some under great government deficits. (f) Credit is credit, whether non-self-liquidating or self-liquidating. (g) Deflation of non-self-liquidating credit usually produces the greater slumps. From the article: “Self-liquidating credit is a loan that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan – for business start-up or expansion, for example – generates the financial return that makes repayment possible. The full transaction adds value to the economy.” Credit lent against homes are most definitely non-self-liquidating credit. Unless, you count the opportunity cost of renting as a form of liquidation – however this requires there to be some relationship of rents to monthly payments; something that can’t be said of current market. The relationship of these nonproductive asset backed loans to productive asset backed loans, it would seem is at its peak historically. Reading this type of semi doom-and-gloom scholarly article makes me think about the many types of financing recently available to the public masses and what impact they might have. It takes a bit of economic sense to understand a risk premium. A risk premium is an additional amount that a lender expects to compensate them for additional risk. If risk is considered great either a high risk premium is attached or sometimes a transaction cannot take place. We currently have some of the lowest risk premiums in history; interest rates on non-productive assets are at historical lows. Typically, a lender requires that at some point, principal on the note must be paid back. Interest only loans are an exception to this. Why? And, why have they become popular now? It’s easy to see why a borrower would want to take on one of these loans; why pay for something now if I can pay later. But, what’s more interesting is why are they so popular for lenders? Human beings are a fickle bunch. Each one wanting to do something different than the other. Like watching an ant, it runs to and fro, sometimes lost, sometimes productive, but always unpredictable. But, take a step back, and the anthill is an extremely efficient, coordinated jumble of activity. A very predictable bunch. Human financial systems are similar. Each borrower is very unpredictable, but bundle a few thousand together and they suddenly become more predictable; hence the popularity of Mortgage Backed Security Bonds (MBS’s). BUT… and you knew this was coming… you need to take even a step back to see what is going on in the macro environment. Who has all of this money, and why are they lending it at such low rates. A flat yield curve would signal that lenders see little reason require a larger risk premium for longer-term loans because they expect long-term rates to be about where they are far into the future. How often is the bond market right? Well, that’s for you to decide. Greenspan has even named it a conundrum. So, this brings me to the title of my post. How could interest only loans signal possible deflation in the future? We already know that low-interest rates can be a signal, but what about creative financing? Interest only loans cannot be self-liquidating in the short run. When they switch to a liquidating (fully amortized) loan, the payments jump substantially because they do 2 things at once: 1, they begin fully amortizing 2, they adjust to prevailing interest rates. One would expect that people faced with these issues would simply replace the shorter amortizing period with a longer amortizing period at the same rate. Or, they would attempt to liquidate the loan by selling. Since interest-only loans are not self-liquidating in the short run, the bond market is signalling that for the medium-term, interest rates and returns will be low, or that investors are extremely risk-averse to the stock market. The investors feel justified that any possible deflation is offset by the Fed’s moderate inflationary policy, or at least an attempt to prevent deflation. So, MBS investors have signalled that for the medium term (3 to 10 years), that they would rather take their chances with low interest rates AND non-liquidating debt. Will this truly end as Greenspan has put it? I will leave you with one of his most famous statements on the subject: “But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.“