Wednesday, October 7, 2009

Debt-Market Paralysis Deepens Credit Drought

Good to see MSM media covering a topic I covered over a month ago.

So I'll do a reprint plus add in my nifty chart of the financial system.

This is similar to Paul Krugman's chart found here.

Here is the re-post in italics. Below I will add some notes from the NY Times post.

I was on the Federal Reserve website checking out the major holders of debt in the United States historically. Both charts that I created show basically the same data. The first though shows the difference in the amount of debt over time, though it is nominal terms not real terms. The second just illustrates more lucidly the amount allocated to each type of provider. There were no data from earlier, but we can generalize that the banking system in the Great Depression looked a lot more like the 1943 data than the 2003's data points.

So it is obvious that the financial system has evolved, not in the Victorian sense that evolution necessarily means for the better, just that it has mutated. Securitized pools which do not exist in the data until the end of the 1980's come to make up over 30% of debt extended in its halycon days of 2003. A securitized pool is a pool of debt instruments for instance mortgages, or credit card debt, or automobile debt, or just general loans. These are sold to investors, usually pension funds, mutual funds, etc. The idea is that these instruments should be safe but yield more than comparable government bonds or AAA corporate bonds. These pools also allow the end borrower to borrow more cheaply than had investors not bid up the price they would pay for these structures.

The reason to make the distinction between the two eras or even to look back at how the debt market has evolved is that the response of the players should be different as well. When a bank in the 1920s and 1930s funded itself via deposits and then constructed a loan portfolio of assets it was subject to a risk of concentration. The first part of the concentration risk was that since there was no FDIC the deposits were not insured, so if all the people of the town came asking for their money at the same time there would not be enough cash in the vault to meet their claims. The second risk that stems from the first, was that if the financial system was in dire enough shape for people to be asking for their cash deposits back it meant that the economic system was in arrears as well with unemployment sure to follow. Thus, the loan portfolio (mortgages, small business loans) concentrated in the area in which the bank was would probably not pay back all the cash flows it was expected to generate. These are the reasons that the social safety net was constructed with unemployment insurance and deposit insurance.

So, what can be expected of the banks to do now? Well, banks will keep on doing what they have been doing. Making loans where it is profitable to do so and winding down bad loans. It is instead the securitized pools that worry me. Some of those pools were brought back onto the originating banks balance sheets, which then ties up their regulatory capital, thus decreasing their lending. Now a securitized deal cannot even be done without a guarantee from the Federal Government backing it. If we lop off the 25% of debt structure of the United States it will be hard to recover back to normal and "normal earnings and revenues." It's what PIMCO has been saying for awhile now that a new normal may be in store.

I echo thoughts from Mr Krugman. When you have a business model that relies upon investors who then rely upon rating agencies there has to be a lot of trust. When a bank makes a loan either student, credit card, mortgage, it knows its customer, or at least tries to understand it. When the loan is extended through securitization the role of the bank know falls upon the investors. Since there are multitudes of underlying mortgages or loans that make up the pool the investors rely upon the originator to have made honest assessments and to diversify the holdings. Secondly, the investor relied upon the rating agencies to act as a safeguard in reviewing these same pools to ensure they were well diversified and that they were actual assets to back up the loans. During the boom neither of these ideas were true for the banks or the rating agencies. Of course, this market is now dead.

Now as I see it there is a two fold crisis. On the one hand there is no trust, so no one wishes to lend. [The decrease in securities lending and also bank lending] On the second hand no one wishes to borrow either. People do not want to borrow to purchase a home that may continue to lose value. They do not want to borrow to obtain a MBA that will have no job offer at the end of their two year commitment. There has to be an outside stimulus of aggregate demand to shift resources from the defunct housing market to the now unemployment dole to the next engine of growth.

In my state of mind, the weakening dollar is a good thing. It will stimulate export growth and also retard imports. It will make the creation of renewable energy devices, fresh water desalinization created here rather than China. It will be our next bubble to invest in!!!

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