Charlie Munger on the state of credit in 2006...

Now you have the problems of the macro scene. Let’s take credit expansion. Consumer credit has expanded to levels that nobody’s ever seen before. All of these credit cards and all of these algorithms… people [meaning lenders] really want that particular customer that’s just crazy enough to overspend but not so crazy that he goes bankrupt. [Laughter] They have computer algorithms to identify these people – they seek them out with clever marketing techniques. I always say it’s like having serfs when you finally get them. They while away at their job and you’re the lord of the manor and at the end of the month they send you [the money they make]. They’ve gotten so rich that [the lenders] keep surfing for more serfs with ever more liberal credit, and so forth. That is the world of consumer credit.   

Now you get into mortgage credit. Again, to the people in this room, this is a new world. Warren sold that house in Laguna that he’d owned for many years. He asked the buyer how much he’d borrowed for the $3.5 million or whatever the house cost, and he said 100%. He got an 80% loan and then got an equity line and with a little manipulation, he could borrow 100%. Now you have all these mortgages that say that if it’s inconvenient to pay the interest, it’s no big deal, just add it to the principal and you can get to it later. [Laughter] You not only don’t have to pay the principal, you don’t have to pay the interest! Of course, with this arrangement, you can buy a lovely spread.

And the accountants let people write mortgages like that and let you accrue substantially all of the income even though the credit risk has obviously gone up. And they do that because they can’t see any difference in the credit losses yet. That is not the way I would do accounting – but a lot that I see is not the way I would do accounting.

It was quite logical for people to gamble that with interest rates going down, housing prices would go up. And if you really took advantage of the low interest rates and really laid it on and took on a lot of leverage, I think that was very clever and you could even argue it was totally sound. People did it big time and made enormous amounts of money – unbelievable amounts of money. The rest of us were really dumb. It was a very logical thing to do if you stop to think about it: as interest rates were sure to go down, the value of property was sure to go up. The rest of us were stupid. It looked risky, but really wasn’t. It was a pretty smart thing for these people to do.

Whether it’s smart to continue it now from our present level is a very interesting question. I would think no. There are many instances of collapse after liberal mortgage lending. England had a tremendous collapse maybe 10 or 15 years ago.

Let’s talk about commercial lending to real estate developers. A good friend of mine just invested in a very intelligent real estate development project, with a good developer. The total development is going to cost $140 million. And guess how much non-recourse equity the developer put up? $8 million! I don’t care how promising the real estate market is – if you leverage something that much, there could be a lot of pain for the real estate lenders.

We are in a weird period. I think it’s extra dangerous because it’s worked so marvelously well for everybody who did these loony things in the past.