Credit crisis: What comes next?


A very insightful article from Minyanville.com about the causes of the credit crisis that we are in and what is awaiting us ahead.

Minyanville.com. August 21, 2009.

Five Things: What Comes Next?

“Unseasonable mirth always turns to sorrow.”
– Cervantes, “Don Quixote”

As the ongoing debt crisis continues, we have transitioned from Stage One, the initial Wall Street impact of debt-deleveraging, to Stage Two, the Main Street impact, and are now well into Stage Three, the coordinated Fiscal and Monetary response to the debt crisis. The question, then, is what comes next?

Before we get to the What Next? question, let’s revisit the basics of what is happening and what it means. To listen to pundits and politicians, we are experiencing a “credit crunch,” with the primary driver being, according to conventional wisdom, a risk aversion on the part of lenders.

For example, the Financial Times recently reported on a study from the credit-scoring firm, FICO, that banks reduced access to revolving loans such as credit cards and home equity lines of credit for about one in five US borrowers in the six months up to April of this year. Moreover, the FICO study said, banks not only cut credit lines for a larger share of US consumers than they had in the previous six months, they also became more aggressive in their cuts.

This sounds very much like a classic “credit crunch.” But our crisis extends deeper and well beyond these small symptoms, and that’s what is important to understand. First, let’s discus what a “credit crunch” is, and then we’ll look at how our situation differs and what that means as we transition to the most critical and perhaps misunderstood stage of the crisis.

1. What is a “Credit Crunch”?

The simple answer is that a “credit crunch” is a general decline in the the supply of, and demand for, credit. The second part of that equation – demand for credit – is crucial, but we’ll get to that momentarily. First, let’s look at the basic mechanics of a “credit crunch.”

Under certain circumstances, the market (or on occasion the Federal Reserve) can induce a decline in the supply of credit (or at least a decline in the growth rate of the supply of credit) by raising interest rates. This makes money more expensive for borrowers, and as a result slows the growth and demand for available credit. This is what a central bank attempts to do when the growth of inflation exceeds their “comfort level.”

But a credit crunch occurs when banks become more risk averse – less willing to lend – even though interest rates may remain the same, and in extreme cases, even though interest rates may go lower.

This risk aversion on the part of lenders makes it more difficult for even the most credit-worthy borrowers to obtain money at reasonable terms. In effect, interest rates – the cost of money – can become infinitely high for many borrowers. As a result, it becomes difficult to fund projects and investments, which can slow economic growth, which in turn can make lenders even more unwilling to lend; a vicious cycle of economic pain.

2. Why does credit growth matter in the first place?

Because in our fiat-based monetary system, economic growth is dependent upon credit expansion.

What does that mean? And why is it a problem?

First, a “fiat-based monetary system” is simply the name economists give to an economic system where money is created through fractional reserve banking techniques. Fractional reserve banking is the practice of issuing more money than a bank holds in cash reserves. So, in a fiat-based monetary system, if risk appetites are supportive – that is, if borrowers are willing to take on debt – then credit expansion can feed into normal risk-seeking behavior, and if excessive can foster unsustainable booms; dot.coms, housing, certain commodities.

As long as credit expansion and demand for credit continues at an accelerating pace, the appearance of prosperity continues as asset prices increase. But there are two sides to this credit coin; access to credit is one side, but demand is the other. And the demand for credit is the side the central bank has the least amount of control over. A central bank can make credit available, but there must be a demand for it or it’s like throwing a party where no one shows up.

In our economy, as we have seen, the “accelerating pace” aspect is critical, for it is the key to maintaining the boom. All we need to do is look at the monetary aggregates and we can easily see that the acceleration aspect is what has gone missing, and worse, that the demand side is what is largely responsible for that, even as bank lending growth itself has slowed.

3. What do we mean by “credit expansion,” anyway?

First, credit is not in and of itself necessarily a bad thing. Capitalism thrives on the productive use of credit. But what has transpired over the past decade is that credit has increasingly been used as a substitute for weak economic growth.

Essentially, new money was created by the banking system and offered at artificially low interest rates and, later, to borrowers with increasingly low credit quality. By offering willing borrowers money at artificially low rates, this encouraged increased time preferences among economic actors, which is to say that investment horizons were lengthened and risk tolerances were widened.

This is how debt was pyramided to such an extent that one small setback, in subprime borrowing for example, resulted in such a widespread problem, problems which quickly spread to other supposedly safe credit risks. And as this continues, we are seeing that prime loans now account for more than half of the seriously delinquent mortgage loans according to the most recent Mortgage Bankers Association. (Hat tip to Calculated Risk for pointing this out.)

In hindsight, once the herd has dispersed, it always seems as if these investors were simply dumb. After all, who could now believe that an “undertaking of great advantage; but nobody to know what it is” could be a reasonable investment? Probably, no one today. However at the time, during the South Sea Bubble of 1720, quite a few investors figured just such a company made really good economic sense. Seriously.

4. How, then, did we transition from credit expansion to a credit crisis?

Because credit expansion distorts capital investments and spending by creating the “illusion” of prosperity, when the time comes to pay back what is borrowed investors and lenders discover that they have misallocated their capital. This leads to losses because the only way to turn a misallocation of capital into a gain is to sell it at a higher price to someone who still believes it will go up in the future.

This loss of capital creates a cycle of risk aversion; lenders suddenly find they are not being repaid, say, by subprime borrowers who are defaulting on their mortgages. These lenders in turn – remember this is a fractional banking system – find that because they used the repayment of these loans as collateral for loans they took out to malinvest based on the false signals the economy was sending, suddenly discover they are unable to repay some of their debts. The lender’s lender is in the same boat, as is the lender’s lender’s lender. So, what do these lenders do? They “de-lever.” In other words, they sell whatever they can – whatever is still liquid (say, U.S. stocks, for example, or commodities) in order to raise capital to repay loans. This pressures asset prices further.

We then have a situation where the fear of not having money (U.S. dollars) to pay down debt spreads. This further deepens risk aversion. Time preferences shrink. Lenders in many cases cannot, or are no longer willing to, extend credit beyond the very short term, for they fear not being repaid. During past crises, on a superficial level, because debt on the broad consumer level had not yet been pyramided to the extent it has been over the past 25 years, credit demand was still prevalent even as lending institutions temporarily entered periods of risk aversion. In fact, that underlying demand for credit is what made those periods temporary. On a deeper level, a major positive social mood trend, which was supportive of risk-taking and increasing risk appetites, was what created the conditions necessary for credit expansion. Unfortunately, that trend in social mood has changed, and no amount of central bank tinkering or exogenous force can reinstall it.

5. What Comes Next?

When this debt crisis entered the second stage last fall, where the impact on Main Street began to intensify, there was a very predictable kickback to Wall Street that I wrote about, one in the form of sluggish consumer spending, lower economic activity and a deceleration in credit demand and risk appetites. We are now well into Stage Three, the coordinated fiscal and monetary response.

The Fed is trying to make still more credit available; a monetary response. This response is designed to relieve tight credit conditions among financial institutions, but so far, despite an array of special lending programs created over the past year, the response has been weak, largely because of the size of the housing market, the speed of the housing deflation and the leverage involved.

When monetary policy is insufficient to stop the credit crunch, the government can step in and create any number of mechanisms to essentially bailout lenders and borrowers; a direct fiscal response, which we have already seen with both banks and automakers and various other institutions, from Fannie Mae (FNM) and Freddie Mac (FRE) to American International Group (AIG).

The next step for the Federal Reserve in terms of monetary policy was to begin a series of short-term interest rate cuts, which have proven insufficient to kickstart credit demand (with the psychology of deflation now beginning to firmly take hold). Subsequently, the Fed had little choice but to adopt the quantitative easing policy the Bank of Japan used when the typical path of monetary expansion – reductions in target short-term interest rates – failed to increase the money supply.

There are still more weapons left in the Fed arsenal, however. A recent paper from RBC Capital Markets we linked to on Minyanville’s Daily Feed discusses these possibilities. Stock investors and traders should be aware of what these policies are, because we will almost certainly see them utilized later this year and into 2010.

On the fiscal side, one consequence of the debt crisis will be new, sweeping regulations for financial institutions, which we are already seeing, as well as massive increases in the balance sheet of the government. The regulatory changes, some of which are already being kicked around in Washington, will further impinge the earnings ability for banks and financials, and so while the market last fall and winter was focused on which banks will survive the crisis, the shift now is from fear of failure to questions about how the surviving banks will be able to make money under a stricter regulatory environment.

Meanwhile, other fiscal policy is focused on increases in public works projects targeting infrastructure, as well as increases in military spending and other government programs to help Americans deal with the transition from boom to bust and back again.

So, what comes next? There are a few important things to keep in mind.

This debt deflation and deleveraging among institutions and consumers will play out over a long period of time, almost in slow motion. There will be many meaningless policy announcements and adjustments. Market pundits and economists will cycle wildly between forecasting the bottom of the economy to predicting the complete destruction of our financial infrastructure.

Without a doubt, it will be difficult to remain unemotional and objective as this unfolds, and we must realize that even now, just when it looks like it’s over, in many respects it’s really only beginning. But whenever I see people describing how “unique” this debt crisis is, or how “unprecedented” it is, I think about this:

“If silver and coin constitute wealth, will increasing the quantity of [them] result in prosperity? In the case of a single family… yes. But if we consider the entire empire then nothing could be further from the truth. The greater the quantity of silver and coin, the more expensive grain and cloth become and the greater is the dearth that ensues. Thus, in earlier ages, rulers feared that future generations would want not for [money] but rather for grain and cloth.”
– Xu Guanqi, The Omnibus of Husbandry

That’s as true today as it was when it was written… nearly 400 years ago. And yet, here we are today, centuries later, with all our sophisticated computer modeling, quantitative strategies and innovative financial engineering, still trying to turn finite resources into infinite prosperity. We’re the Don Quixote’s of finance, tilting at imaginary windmills. At a point, you almost have to laugh. If I were a betting man, and I am, my wager is that this quest will pause for a time, but it isn’t going to end anytime soon.

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One Comment

  1. Posted August 27, 2009 at 9:30 am | Permalink

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    Sorry… forgot to say great post – can’t wait to read your next one!


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