How Low Interest Rates
Contributed to the Credit Crisis

By ETHAN PENNER

"What inning are we in?" How many times have we all heard that inane question asked and answered in the credit-driven downturn that we've been suffering through for over a year now?

We've heard many answers from financial industry and government leaders, such as "the worst is behind us," or "we'll not need to raise any further capital" -- only to learn in short order that our leaders really did not have the ability to make the market bend to their will.

Corbis

To understand exactly what is happening, one needs to properly understand what occurred in the late stages of the prior cycle. Interest rates had been driven to historical lows in the U.S. and throughout the world. The cause of this can be debated. However, it is clear that economic globalization, with the migration of jobs to low-wage nations, had a profound impact on inflation, and thus on interest rates.

In general, low interest rates are beneficial, as the low cost of capital encourages business borrowing for research and development, capital investment or expansion initiatives, which lead to job growth. Low interest rates also reduce the cost of homeownership, and, in fact, the cost of servicing any debt at all, thereby freeing up capital for more productive uses.

The flip side of a low-interest rate environment is that it reduces the absolute level of returns that are available to investors. This has significant implications for the massive wave of baby boomers, which holds many billions of dollars in retirement savings, either through direct investment or through managed pension-fund systems.

It is estimated by those in the pension-fund world that in order to meet the retirement needs of those baby boomers, their investments will need to yield a minimum of 8% per annum. When their money was set aside with this yield target in mind, rates on U.S. Treasuries hovered at high levels. However, in our most recent low-rate period, with U.S. Treasuries yielding 4% and below, achieving 8% became quite a challenge. The threat of not achieving it became both real and quite frightening for those whose retirement livelihood depends upon their pensions.

With a large portion of pension-fund asset allocations directed toward fixed-income investments that were yielding closer to 4%, the pressure to achieve an overall 8% on their portfolios drove investment managers to allocate large pools of capital to the strategies that promised higher returns. Even beyond the pension investment world, the global investor base had become comfortable in the last cycle with the notion that achieving an annual 20% or greater yield was possible. Thus huge amounts of investment capital migrated to funds promising lofty returns, and fund managers were pressured to advertise a 20% targeted yield or risk not attracting any capital.

It can be argued that it was the low interest-rate environment that actually fueled the huge boom in the hedge-fund and private-equity world that we've witnessed in the past decade. A major flaw in all this was that targeted returns became disconnected from the risk-free U.S. Treasury yield benchmark, to which all investments are implicitly pegged.

There is a direct relationship between returns and risk. If a five-year U.S. Treasury bond is yielding 8%, as it once did, a five-year corporate AAA-rated bond must provide a yield higher than 8% for it to be attractive to an investor, given its increased credit risk. And, further out on the risk spectrum, a five-year investment in a closed-end private equity fund must provide a much higher yield still -- perhaps as high as 20%.

If, however, the yield on the five-year Treasury bond falls to 3%, then the competitive market is set up such that yields on the more risky assets move down in relation, and a AAA-rated, five-year corporate bond will surely no longer be available at a yield above 8%. By extension, the yields available/achievable by the private equity fund, without taking heightened risk, must also fall to a number far below 20%.

Yet, in a low-rate environment, investors still insisted on this high yield target, and, in competing for capital, investment managers strived to achieve it -- mostly through the use of increased leverage or the acquisition of assets with greater risk profiles.

The system became burdened with the need to produce high returns, with many investors chasing that magic 20%, in spite of the fact that the yield targets had little to do with the realities of the low-rate environment.

The preferred formula for manufacturing high returns in a low-rate environment is actually quite simple: utilize large amounts of leverage. If, for example, you can buy an asset that produces a cash-flow yield of 6.5%, and leverage that 9:1 at a cost of borrowing of 5%, you've achieved your 20% target. This use of excessive leverage to capitalize upon low rates, and the easy availability of credit, began in the period after 9/11. Policy makers moved assertively to counteract the potentially devastating effect that tragedy might have had on our economy.

As investors scoured the market for assets with yields of 6.5%, the competition drove prices higher and yields lower. Investors started to buy assets with yields of 5%-5.5%, just barely above the cost of debt. They would justify the price by either borrowing still more or by creating a pro forma budget that reflected a plan for increasing revenues in time to levels that would achieve and surpass that 6.5% level, and that would ultimately produce the magic 20%.

The risk became that those ambitious growth goals would not be met -- and the buyer of the asset would be stuck with an overpriced and overleveraged investment, and a suboptimal yield.

As the market became more frenzied and prices continued to escalate in this competition to find yield, opportunistic buyers stepped in to buy an asset, almost without regard for its ability to create a suitable yield. They figured that someone flush with capital and in need of assets would buy it from them shortly at a quick-flip profit. These asset flippers, or traders, employed very little equity, and were granted large amounts of leverage for their activity, which had proved to be quite brilliant for a time.

Ultimately, as is always the case, there comes a time when someone rears his or her head and questions the sanity of a deal, and by implication, the entire market. At that moment, when everyone is fully invested and market participants have become most complacent about risk-management concerns, everything turns and the party ends abruptly. And thus begins the reversing of the leverage-driven run-up in asset values, with valuations ultimately returning to a level that is sensible and not predicated upon either excessive leverage or pro forma assumptions that everything will work out just perfectly.

Today, the pendulum has clearly swung very hard. Credit availability and cost have moved from one extreme to the other. In time, credit spreads will moderate, as lenders, whoever they will be in the next cycle, motivated by the need to earn revenue, will begin competing for good credits once again. Sadly, the benefits of this reduction in spread will more than likely be offset by an increase in the levels of real rates as the signs of inflation continue to appear.

In the meantime, we are still in the midst of what some analysts have dubbed "The Big Unwind," during which our system unwinds the excessive leverage of the past half-decade. We will likely see asset levels continue to adjust lower in order to come into alignment with today's more conservative lending environment and produce yields that would attract investment capital. There is no silver bullet that government or the financial community can shoot to bring this to a quick end.

Mr. Penner, a pioneer in real estate finance, is an executive managing director and member of the executive committee with CB Richard Ellis Investors.

'Our Country Is the Best'

Assorted TV commentators keep opining that the Olympics are all about the brotherhood of man, rather than national ambition or patriotism. But don't tell that to the fanatically nationalist Chinese -- or to Kobe Bryant, the NBA star who is playing with Team USA in Beijing.

AP

In an interview Friday on NBC, the world's most famous basketball player told Chris Collinsworth how he got "goosebumps" when he received his Olympics uniform. "I actually just looked at it for a while. I just held it there and I laid it across my bed and I just stared at it for a few minutes; just because as a kid growing up this is the ultimate, ultimate in basketball." The Los Angeles Laker went on to call the U.S. "the greatest country in the world. It has given us so many great opportunities, and it's just a sense of pride that you have; that you say, 'You know what? Our country is the best.'"

Mr. Collinsworth seemed either startled or impressed by such sentiment, and asked, "Is that a cool thing to say in this day and age? That you love your country, and that you're fighting for the red, white and blue? It seems sort of like a day gone by."

To which Mr. Bryant replied: "No, it's a cool thing for me to say. I feel great about it, and I'm not ashamed to say it. I mean, this is a tremendous honor."

Cynics will claim that this is merely about marketing, with Mr. Bryant hoping to use the Games to burnish his public image. On the other hand, he and his rich teammates on the basketball squad are giving up their offseason to play for nothing save possible medals. Mr. Bryant has also been an enthusiastic spectator for other U.S. Olympians, waving the Stars and Stripes at various events.

To the kind of Americans who consider themselves primarily "citizens of the world," nationalism at the Olympics is déclassé, even embarrassing. We're with Kobe.

Mexico Pays the Price of Prohibition

With the world fixated on Vladimir Putin's expansionist exploits in Georgia, a different sort of assault against a democracy south of the U.S. border is getting scant attention. But it is equally alarming.

Mexico is engaged in a life-or-death struggle against organized crime. Last week six more law enforcement officials were killed in the line of duty battling the country's drug cartels. This brings the death toll in President Felipe Calderón's blitz against organized crime to 4,909 since Dec. 1, 2006.

Americas columnist Mary O'Grady tells Kelsey Hubbard how the U.S. War on Drugs and the demand for narcotics is taking its toll on Mexico. (Aug. 18)

A number of the dead have been gangsters but they also include journalists, politicians, judges, police and military, and civilians. For perspective on how violent Mexico has become, consider that the total number of Americans killed in Iraq since March 2003 is 4,142.

Kidnapping and armed robbery numbers have also soared. In Tijuana, a kidnapping epidemic has provoked an exodus of upper-middle-class families across the U.S. border in search of safety.

As this column has pointed out many times, one reason that security has so deteriorated in the past decade is the demand in the U.S. for illegal narcotics, and the U.S. government's crackdown on the Caribbean trafficking route. Mexican cartels have risen up to serve the U.S. market, and their earnings have made them rich and well-armed.

The victims of last week's killing spree include the deputy police chief of the state of Michoacan and one of his men, a detective in the state of Chihuahua, and a deputy police chief in the state of Quintana Roo. As of July, 449 police and military officers have died in the Calderón offensive, further underscoring the price Mexico is paying for the U.S. "war on drugs." But the costs go well beyond the loss of life.

AP

Doctors hold banners during a demonstration against a recent wave of crimes and kidnappings in Tijuana, Mexico.

In a developed country like the U.S., prohibition takes a toll on the rule of law but does not overwhelm it. In Mexico, where a newly revived democracy is trying to reform institutions after 70 years of autocratic governance under the Institutional Revolutionary Party (PRI), the corrupting influence of drug profits is far more pernicious.

According to Attorney General Eduardo Medina Mora, part of the explanation for the kidnapping surge can be traced to the success of the government's squeeze on the drug runners. He told me in February that he expected the pressure to produce a fragmentation of the cartels, turf wars and an increase in other criminal activities to replace shrinking profits in drug trafficking.

If true, the kidnapping spree might be a sign that Mr. Medina Mora's strategy is working. But when federal investigators recently fingered Mexico City police in the kidnapping and murder of 14-year-old Fernando Martí, the son of a wealthy entrepreneur, Mr. Medina Mora's theory lost some credibility. Rather than being the work of demoralized criminals, kidnapping, in the capital anyway, appears to be just one business run by a well-oiled machine with institutional links.

Ricardo Medina, a leading Mexican opinion writer and the editor of El Economista, the country's top financial daily, told me on Thursday the case shows that "independent of the shooting war on drugs there is the problem of institutions being infiltrated by criminals and corrupted."

Even captured criminals often go free, Mr. Medina says, and all branches of government share responsibility for this crisis of impunity. It is true that judges can be intimidated or bribed. But it is also true, for example, that under Mexican law kidnapping is not a federal crime, and therefore must be handled by local authorities. Often victims do not want to press charges because there is a perception that the local police and local governments are in on it.

That perception has been strengthened in the Martí case, but the problem of impunity is hardly new. As Mr. Medina wrote in El Economista on Friday, "impunity is in view of everyone, day after day. We all see it even to the point of smiling ironically or shrugging our shoulders."

Why hasn't this problem been tackled? One possible explanation in Mexico City is that the district police and the rest of the district's bureaucracy represent an important constituency for the ruling Revolutionary Democratic Party (PRD). If the PRD's base prefers the status quo, there is a high political cost to challenging it.

Drug profits going to organized crime only complicate the matter. Writing in the latest issue of the Milken Institute Review, former U.S. foreign service officer Laurence Kerr takes a page out of U.S. history. "America has been in Mexico's shoes: flush with the bounty of illegal liquor sales, organized crime thoroughly penetrated the U.S. justice system during Prohibition. As long as Americans willingly bury Mexican drug traffickers in greenbacks, progress in constraining the trade is likely to be limited." Regrettably, Mexico's institutional reform will also be limited and the death toll will keep climbing.

Banana Republic Behavior, Cont.

Last time we checked on Ecuador, the South American country was making itself notorious for a multibillion dollar legal shakedown of Chevron on bogus pollution charges. Now its President (and Hugo Chávez wannabe) Rafael Correa is lobbying the U.S. to renew Ecuador's preferential trade treatment, which is set to expire at the end of the year. What's Quichua for chutzpah?

We happen to support renewal of those preferences, granted under the 2002 Andean Trade Promotion and Drug Eradication Act. Ecuador is not (yet) Venezuela, and to the extent that trade preferences promote free-market political forces, so much the better. Then again, Mr. Correa's own behavior is the biggest political threat to those preferences. Since coming to power last year, Mr. Correa has threatened to default on Ecuador's debt, harassed the press, ejected numerous opposition leaders from congress, and rewritten the constitution to concentrate power in his hands.

Mr. Correa has also refused to renew a military basing agreement with the U.S. -- never mind that the U.S. soldiers there are involved in the kind of drug eradication that motivated the U.S. trade preferences in the first place. In March, the Colombian military raided a base run by the FARC in Ecuador and seized documents indicating close ties between the terrorist group and Mr. Correa's government, including FARC donations to his Presidential campaign. Mr. Correa dismissed the information, though Interpol has confirmed the documents as genuine.

Given his behavior, it's not surprising the country has the second-lowest rate of foreign direct investment in Latin America as a share of GDP, according to the Latin Business Chronicle. Mr. Correa seems to think a public relations campaign in the U.S. will ease his troubles here. He'd impress more Americans if he obeyed the law at home and abroad.