When Fools Rush In, The Joke's on Them

An idea for a morality play: capture the madness of an era when investors, entranced by new technology, a novel set of economic assumptions and an all-powerful Federal Reserve, lost their heads, blew an exuberant bubble and suffered a painful bust.

Sure, it may be late for a chronicle of the zany dotcom 1990s. But this template can easily be adapted to the financial trend that has defined this decade—and that may have come to a close this week. It is, in a way, the Henny Youngman Economy. Lenders pleaded: "Take my money ... please!"

In recent months, harbingers of the end of the credit bubble have been popping up like shoots of yellow forsythia. The spring brought rising subprime delinquency rates and the ensuing failures of subprime lenders. In July, leveraged hedge funds tanked, and several massive corporate-debt offerings were shelved. This month, mortgage rates for borrowers with good credit have spiked, and credit-card giant Capital One Financial jacked up interest rates, citing "business and economic factors." The coup de grâce came on Tuesday, when Federal Reserve chairman Ben Bernanke dryly declared that he was in no mood to cut interest rates.

In the past six years, since Alan Greenspan's Federal Reserve slashed short-term interest rates after 9/11, and U.S. auto companies rolled out zero percent financing, cheap money evolved from a privilege extended only to the ultrarich into a near-constitutional right.

"Credit" derives from the Latin root credo, meaning "I believe." ("Subprime" comes from the Latin root sub primo, meaning "foreclosures in southern California.") And this credit boom rested on the staunch belief in three pillars of faith, all of which, coincidentally, underlay the 1990s boom.

Pillar #1. Technology, by ironing risk out of the system, obviates the business cycle and makes it safe to invest or lend at any level. In the new lending economy, the technology was securitization—the process through which loans are packaged and sold to investors.

Pillar #2. Asset prices continually rise. Banks were willing to lend 100 percent of the purchase price (and customers were willing to take on adjustable-rate mortgages that reset at higher rates after two years) because they knew a perpetually rising real-estate market would bail out even the most-leveraged borrowers.

Pillar #3. In a pinch, the Federal Reserve would step in with a well-timed interest-rate cut, just as it did after various 1990s crises, flooding the system with cheap money.

Cue Mr. Youngman. As low rates proliferated, lenders fell over themselves to stuff cash in customers' pockets. And ultimately the lenders jumped the shark. Ninety-five percent loans gave way to no-money-down mortgages to buy preconstruction condos in Miami. Subprime loans morphed into low-doc loans, no-doc loans and, the ne plus ultra, NINJA loans: no income, no job, no assets. In this age of promiscuous credit, the overriding sentiment was trust, but don't verify.

Bankers proved similarly accommodating to corporations, especially to private-equity firms. Historically, most bank loans came loaded with covenants—early-warning systems that stipulate that the borrower has to keep spending to a certain level. But starting in 2005, Wall Street banks, eager to supply credit to hungry private-equity firms, began extending "covenant-lite" loans—debt blissfully free of such requirements. In May 2007, according to Goldman Sachs, such loans accounted for 15 percent of bank debt.

It all worked fantastically well—borrowers got their money, bankers collected their fees, investors harvested interest payments. But this year, one by one, the pillars underlying the Henny Youngman Economy crumbled. The securitization of subprime mortgages had the perverse effect of tethering more investors around the globe to the same crumbling assets. Home prices fell nationwide for the first time in a generation, down 2 percent between June 2006 and March 2007, according to the Case-Shiller Index. And Alan Greenspan's replacement, Bernanke, revealed himself to be more concerned with the prospects of inflation than with the prospect of unemployment among hedge-fund managers.

Chagrined lenders have been gripped by the sudden realization that debt can, and does, go bad. So just as rapidly as they rushed to lower standards, mortgage companies—the ones that remain solvent—and lenders of all types are rushing to tighten them. Credit, the fuel that powers the economy, is becoming more scarce and expensive. Somewhere, in the great borscht belt in the sky, Henny Youngman is hoisting his violin.