The Credit Crunch Explained

No doubt you have heard the phrase "credit crunch" numerous times during the last few weeks in relation to the problems in the secondary mortgage market and the resulting volatility in the stock market. Warren Buffett has repeatedly stated that he was baffled by the waves of liquidity sloshing around the world and warned of the risk of a seize-up in the credit markets. Buffett, of course, is right, as many debt investors are finding out with unforgiving speed. What puzzles me is how investors could ignore the plainly obvious for so long.

The primary innovation of the secondary mortgage market is that risk of default is borne by investors who are many steps removed from borrowers. Traditionally, home mortgages were kept by the local bank. If a borrower defaulted, it was the bank that suffered. Therefore, the bank had the incentive to only make loans to creditworthy borrowers. Today, with an active secondary mortgage market, lenders are able to "securitize" or sell their customers' loans to investors. This, in turn, frees up the lender's capital to make more loans. However, the danger is that there are no longer any "gate keepers" along the securitization pathway who have an incentive to shut the door on uneconomic loans.

As a result, mortgage lenders continued to extend loans to ever-more-marginal borrowers because there was a ready party in the secondary market willing pay a fancy price for those loans. At best, the debt-rating agencies relied on false information provided by borrowers, which caused them to incorrectly rate packages of mortgage loans. At worst, the agencies perhaps compromised their institutional integrity to earn the resulting fee that came along with an adequate debt rating. The hedge fund managers, who levered up to purchase the mortgage-backed securities, were simply hoping to make it to Dec. 31 and collect a hefty, nonrefundable incentive fee. The parties left holding the bag, the investors who ultimately owned the mortgage-backed securities, were too blinded in their quest for yield to ask if the extra 200 basis points of income was really worth the risk.

Once the underlying mortgages began performing poorly, the prices of the mortgage-backed securities declined. These securities often served as collateral for hedge funds' margin loans, so as prices declined, brokers demanded more collateral. If the fund was unable to meet the margin call, the securities would be involuntarily liquidated, leading to further price declines that sent more funds head-first into the vicious margin call cycle. After a few high-profile fund disasters, skittish investors began to withdraw capital from all funds with mortgage exposure leading to more liquidations and driving down prices even further. You can see how this story ends. Could it have ended any differently considering starting conditions described above?

The tightening of credit certainly causes many problems in the short term, but this too shall pass. Markets correct by destroying misallocated capital, and we're certainly witnessing that now. Yes, it's not fun to experience short-term volatility, but what is happening in the credit markets is unlikely to affect our Growth Portfolio holdings in the long run. I'm sure five years from now Wall Street will have a different crisis to worry about. Hopefully by that time, our holdings will be worth substantially more because we were right about what really matters: the underlying economics of the businesses we own.

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