Manhattan Monthly - September 2009

Manhattan College Economics Professor Authors New Book on America’s Credit Crisis

Collateral Damaged: The Marketing of Consumer Debt to America

By Charles Geisst

Lending money has always been he second oldest profession and not always the most admired. No other business practice has been as thoroughly criticized for more than two thousand years. Presidents, finance ministers, popes, kings, and saints have labeled interest as a process that drains the life out of the economy, impeding progress at every turn. Historically, lenders have all shared a common trait in the eyes of their critics. Their purpose was to “beggar-thy-neighbor” by charging high rates of interest on loans.

For centuries, antilending feelings were so strong that Dante placed money lenders in the inferno along with inhabitants of Sodom. Scores of writers from the early church fathers to Shakespeare and Adam Smith spoke out against them, calling for an end to their evil ways. Smith actually favored regulating the hateful practice, and the Bard wrote famously about the pound of flesh as recompense for Shylock’s services.

In a remarkable turnaround, today’s lenders are not considered to be exploiting their neighbors but providing them with loans at a so-called market rate. The only true crooks today are those who covertly charge extortionate rates and use strong-arm tactics to make the borrower pay. When debt was something to be considered gingerly, rates of 30 percent were considered usurious. In today’s markets, where the odious term “debt” has been replaced by the more complimentary sounding “credit,” the borrower who is considered a credit risk is charged high rates of interest to compensate the lender.

A thousand years ago, lending was subject to strict restrictions far removed from today’s world. When the lord of a manor lent a peasant two bushels of wheat and demanded two and half bushels in return, the transaction was considered ordinary and lawful business. But when a moneylender demanded 25 percent on a cash loan, the interest was considered extortionate even though it was the same as the lord’s percentage rate. If the peasant could not repay, there were ordinary legal remedies against him and the lender was protected. But the moneylender was in a more precarious position. Charging interest on cash loans was the province of the idle rich or minority groups in Europe, and moneylenders had to be careful because their activities, begrudgingly accepted as necessary in Europe, had little redress. Shylock did not win his case. Lenders could never be assured of protection under the law.

During the Renaissance and Reformation, debt became a more practical, commercial affair. The Italians made a good living from banking and became the best examples of the new leisure class that lent money while avoiding what was known as real work. The great banking houses became the first examples of making a living by investing in intangibles. When the modern banking houses of Rothschild and Baring were founded in the late eighteenth century, they capitalized on a tradition built by the Lombard bankers before them. It was now possible for heads of state to borrow money discreetly rather than hock the crown jewels for urgently needed cash.

For over a thousand years, the distaste for usury and interest remained in place. Ideas about indebtedness and interest then began to change in the early nineteenth century. Developments in the United States would prove crucial to the acceptance of debt in the twentieth century, especially with the long history of bias that had become deeply ingrained in Western European and American practice. The British perpetual war loans, incurred after the defeat of Napoleon, changed the perception of large-scale government borrowings. And the passing of bankruptcy laws in the early nineteenth century began the slow trend toward the general acceptance of debt as a necessary sin that could be remedied. Another subtle change was that usury was defined as excessive interest, not simply interest itself.

After surviving as a prohibition for years, the charging of interest underwent a profound change after World War II. A dramatic increase in population provided for easier credit for the masses, especially in the United States, and a relaxed attitude toward indebtedness in general. A subtle shift occurred. What previously had been known as the more onerous term “debt” now took on a positive note. Those in debt were referred to as having “received” credit. The newer version of the old concept made it more palatable to be in debt because now the borrower was being extended credit, as if being given a gift. Personal and corporate indebtedness grew to levels never anticipated fifty years before.

In the contemporary world, the debate still rages about usury but without the moral overtones. The levels of personal and corporate indebtedness in the United States have risen to historic highs. In the recent financial crisis, it finally has been admitted that the precipitous asset value drops were the result of the deleveraging of financial assets by borrowers. Although some originally believed that these levels of indebtedness were sustainable, the change of a severe depression or recession caused by rising interest rates became more likely as the economic cycle shifted toward rising energy prices and slow economic growth, conditions similar to those last witnessed in the 1930s and 1970s.

The amount of debt financing began humbly but grew to be very large within twenty years. In the 1950s and 1960s, borrowing still was considered somewhat risky, depending on the income of the borrower. But when in the early 1950s Franco Modigliani and Merton Miller published their now famous hypothesis that a firm’s debt levels were coincidental to its ability to make money, the old prohibitions began to crumble at the corporate level. The door now was open to higher levels of leverage in the United States. A revolution had begun. Corporate indebtedness increased, and the short-term commercial paper market grew rapidly. With it, consumer credit also exploded because the resurgent commercial paper was used to fund banks’ activities in creating credit card debt, a uniquely American innovation from the start.

This credit revolution, beginning after World War II, took hold faster in the United States than in other industrialized countries. The general acceptance of credit cards and extensive corporate credit facilities helped fuel the world’s largest consumer-driven economy and enabled it to maintain its premier position as the world’s economic engine. America quickly was on its way to becoming a buy-now-pay-later society rather than the save-now-buy-later society it had been before the war. As a result, consumer and corporate indebtedness reached historic levels. Personal levels of indebtedness also became a factor when setting the course of monetary policy. Indebtedness now was an integral part of climbing the economic ladder.

The sheer size of the indebtedness acquired on corporate balance sheets eventually required a market where interest rate risks and currency risks could be laid off. As a result, the swap market was born in the 1980s. Institutional investors and corporations could exchange cash flows based on different types of interest rates. Most did this for hedging purposes, but others did it simply for speculation. Regardless of the intent, swaps proved that debt finally had become fungible and marketable. This marked another turning point in the history of debt. If the concepts had been around four hundred years earlier, Portia would not have had to intervene at the debt trial of Antonio in The Merchant Venice. All she would have had to do was swap the onerous debt owed to Shylock for something based instead on Antonio’s future cash flows. If that did not work, then that pound of flesh could have been securitized, sliced into tranches and sold to other investors.

These new markets, especially the swap market, have made the wholesale trading of debt routine. Most of the old prohibitions against incurring debt were swept aside in favor of increased levels of leverage that could be traded in a secondary market, much like stocks or foreign exchange. As a result, credit became easier to obtain than at any time in history. Easy money found its way into the retail sector as consumption continued to be more important than indebtedness in driving the economy. With interest rates deregulated since the mid-1980s, trading debt-related derivatives was possible and quickly grew to become the fastest growing financial market ever witnessed.

The recent developments in the mortgage industry could not have been possible with securitization. The ability to bundle residential mortgage loans and other forms of indebtedness and use them as collateral for bond borrowing allowed banks to keep their balance sheets clear of many previously created loans and to continue generating credit. The original type of securitization, applied by Fannie Mae, Ginnie Mae and Freddie Mac in the 1970s, became a standard tool for repackaging mortgages and consumer debt for eventual sale to bondholders. After 2001, the technique became so widespread that the value of the collateral was overlooked in favor of creating even more debt-backed securities, leading to the credit market crisis beginning in 2007. Securitization became the favorite way to fund subprime mortgages and other forms of debt, planting the seeds for the economic crisis that followed.