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Forces Driving the Credit Crunch

Companies / Credit Crisis 2008 Sep 06, 2008 - 02:30 AM GMT

By: Money_and_Markets

Companies

Best Financial Markets Analysis ArticleMike Larson writes: The credit crunch. We all know it's here, and that it's impacting virtually every corner of the financial markets. But a lot of investors don't really understand how a crunch really works ... why it's so insidious ... and why the Feds' efforts to ease the logjam have been largely ineffective.

So let me try to get at the heart of the matter today. It boils down to two key forces ...


Force #1: Many lenders lack the DESIRE to lend.

Commercial and investment bankers aren't a brave bunch, by and large. They move like a herd.

When one bank or lender comes up with a new loan product that generates volume and profits, others quickly pile in and copy it.

When one lender gets more aggressive with its qualification standards, it doesn't take long for others to jump in and do the same thing.

When a fad takes over in the investment community — whether it's a love affair with risky residential mortgage-backed securities or the creation of newfangled debt instruments (CDOs, CLOs, and so on) — it sweeps through the industry like wildfire.

And when it all goes kerflooey? The bankers scurry back into their holes and hibernate.

That's exactly what is happening now. I've talked about the Fed's Senior Loan Officer Opinion Survey on Bank Lending Practices before, but the numbers bear repeating. After all, they show that the DESIRE to lend just isn't there ...

  • A net of roughly two-thirds of the banks surveyed said they were tightening standards on prime mortgages; 84.4% said they were cracking down on nontraditional financing; and 85.7% said they were tightening up on subprime loans. These figures are off the charts — by far the highest the Fed has ever found in the 18 years it has conducted its survey.
  • The tightening trend has spilled over into commercial real estate, where almost 81% of those polled said they were tightening standards. That's another record!
  • Two-thirds of respondents were tightening standards on credit card borrowers, more than double the level of just three months earlier, and the highest ever. Auto loans? Personal loans? Same story there — record-high tightening readings.

But that's not all. Another major contributing factor to the crunch is clear ...

Force #2: Banks that want to lend don't have the CAPACITY to do so.

Banks are required to maintain a minimum cushion of capital. Think of it as the last line of defense against bad loans and other problems. It also serves as a base upon which banks can build a book of loans and other assets.

When capital levels are healthy, banks have a huge capacity to lend. But when capital is being eroded — say, by the charging off of a huge pile of bad debts — banks have to react by cutting back on new lending.

Don't just take my word for it. Get a load of the comments out this week from the president of the Federal Reserve Bank of Boston, Eric Rosengren. I've highlighted a few key passages:

Eric Rosengren, Federal Reserve Bank of Boston
Eric Rosengren, Federal Reserve Bank of Boston

"We see that mounting losses at financial institutions, and an increasing reluctance among investors to invest new capital while the economic outlook is unclear, are forcing financial institutions to 'shrink their balance sheets .'

"Allow me to explain that notion for the non-bankers here today. Recall that a loan is counted as an asset on a bank's balance sheet. Banks hold capital in part as a reserve against the possibility that a loan will default. Thus banks attempt to maintain a reasonable ratio of capital to assets.

If a bank experiences a reduction in the value of its capital or an increase in its assets (for example as credit lines that were extended in better times are tapped), the bank must take steps to shrink the asset side of its balance sheet in order to restore its desired capital-to-asset ratio .

"In other words, the bank becomes more restrictive in its lending. This shrinkage in lending entails tighter underwriting standards, wider interest rate margins, and reduced credit availability."

In normal times, banks can replenish capital by generating and retaining earnings over time. That's the slow way. Or they can go out and sell common shares, preferred shares, or so-called hybrid securities that have characteristics of both equity and debt. That's the fast way.

But if investors don't want that kind of paper, lenders have to pay through the nose to raise money. Some institutions can be shut out of the market entirely. That's exactly what is happening now. The welcoming arms that banks and brokers found in 2007 and early 2008 have been replaced with cold shoulders.

Why? Potential investors can see the writing on the wall. They know that profits across the banking industry plunged 86.5% to just $5 billion in the second quarter, according to the FDIC. They know that we're going to see a big wave of bank failures in the next 12-24 months. And they don't want to get swept up in it.

More importantly, the sovereign wealth funds in Dubai, Singapore, and elsewhere ... and other private investors ... have seen their prior investments in U.S. banks sink dramatically in value. So they're increasingly reluctant to throw good money after bad.

Or as the Fed's Rosengren said:

"An alternative is to raise more capital, but this can be quite difficult in times like these, when investors are wary of putting more money into some seemingly fragile financial institutions. Witness the reliance, particularly by some large, well-known institutions, on foreign sources of capital like the sovereign wealth funds in recent months."

How This Is Bleeding Over to the Real Economy ...

If this were all just a financial crisis, you could arguably avoid the pain by just staying away from bank and broker stocks. But that is no longer the case!

The credit crisis that began in housing ... and then infected the financial sector ... is now spreading throughout the economy.

Credit is becoming harder and more costly to obtain across the board. That is making it more difficult for consumers to boost spending, and for businesses to borrow and invest in their operations. This is having a real, measurable, and severe impact on the overall economy.

Heck, the Federal Reserve's latest "Beige Book" report on the economy — just like the FDIC's QBP — read like a horror novel. A few excerpts ...

  • Consumer spending was reported to be slow in most Districts, with purchasing concentrated on necessary items and retrenchment in discretionary spending.
  • Reports from the twelve Federal Reserve Districts indicate that the pace of economic activity has been slow in most Districts. Many described business conditions as "weak," "soft," or "subdued."
  • Residential real estate conditions weakened or remained soft in all Districts, except Kansas City, which reported a modest increase in sales since the last report.
  • Commercial real estate activity moved down or remained weak in all Districts except Dallas. Boston, New York, Philadelphia, Atlanta, and Chicago reported signs of softening demand for commercial real estate, including declining leasing activity, rising vacancies, and decreasing construction.

So as far as I'm concerned, the downside risk to the economy and the stock market far outweighs the potential for upside moves. So stay defensive. Pare your market exposure. And consider using inverse ETFs and put options as potential profit vehicles unless and until the credit crunch abates.

Until next time,

Mike

P.S. Want to share your thoughts on the credit crunch — or any other investment topic — with our entire Money and Markets audience? Then check out the Editor-For-A-Day contest that we're running right now!

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