A Tidal Wave of Credit Expansion?

Most of my posts over the past few weeks have been centered around the idea of this public credit finding its way to market and the implications for inflation, borrowing costs, and the stock market. I have tried to think about how the money will move out of the financial institutions and into the hands of consumers and corporations. One of the commentators on CNBC spoke about a tidal wave of credit that is coming in the next 6-18 months, but will it arrive?

Now I am trying to turn the picture around in order to answer this question. Let's assume that the banks stabilize and trust returns for the most part - we finally reach the point where banks are willing to start lending. Here are some of my thoughts.

1. Ultimately the banks won't be as aggressive as before. Just because they are sitting on capital it doesn't mean that they will lend it out, especially when they can deposit it with the Fed and earn interest on those deposits risk free. Tighter lending standards will probably also be a crucial strategy in luring depositors who may have fled their previous bank out of fear.
2. Consumers will be less credit worthy. Their homes will be worth significantly less, more of them will be out of work. Many will also have accumulated even more debt in the downturn through credit cards. There will also be a lot of people forced into bankruptcy and those people will find it especially hard to get credit (I forget the time frame, I believe it's about 7 years).
3. Businesses in general will be less leveraged and likely hold significantly less debt. Their bond covenants may also get stricter and with depressed equity values it may make it hard for companies to issue debt. Let's say for example that a company has to maintain a debt/equity ratio of 0.5. In other words, at most 1/3rd of a company's financing can come through debt, with the other 2/3rds made up of equity. In the new lower leveraged economy we may find bond covenants requiring lower D/E ratios and with the equity component depressed due to marked down asset values, we may find that it's very hard for companies to roll over debt or to issue new debt. In fact, we may see companies being forced to sell off assets to raise capital to buy some of its existing debt back in order to lower their ratios.
4. After watching Iceland's downfall, governments may be forced to maintain more appropriate levels of debt, especially after the current liquidity injections have worsened the balance sheets of some of the major trading countries. The U.S in particular will be raising capital at very bad rates at the long end of the yield curve. This may deter healthier countries from issuing debt at very expensive levels.

Summary

Governments can pump as much money as they want into the banking system, but ultimately the banks are responsible for that money. Direct capital injections gets around that problem, but it still doesn't force the banks to lend in a risky environment. The days of reckless lending are behind us and that will likely hinder the credit explosion that many market participants are expecting. One possible way that governments in the old economy may have dealt with that, would be by creating a GSE to lend out at below market rates. Looking forward, people are going to be far more hesitant as they know that the risks such institutions take on are ultimately on the shoulders of all the citizens in the country.

Disclosure: none

Comments

[1worldcurrency:]

The tidal wave will be inflation, coupled with interest rates FINALLY allowed to breathe. Either that or continued deflation of house prices, with more underwater.

Many will drown under either scenario.

2008 Oct 16 04:31 AM

[Mr.G:]

good article - I dont think there will be a huge wave of credit expansion -
and it is quite obvious that the consumer is the start of the food chain not the banks - If he is healthy, (which he isnt . he is the root cause of the problem ) -the banks will be healthy. -he(the consumer) needs discretionary income and breathing room in order for this to all turnaround and even if the banks are fully armed with cash they will find less and less consumers willing or able to accept it as they struggle to make it happen today -The bailout money could have done any number of things to help out consumers and banks at the same time -Instead of paying the debts of the banks they should have paid the debts of the consumer (the banks would have been the beneficiary anyway) - but it would have given some discretionary income to consumers

2008 Oct 16 05:07 AM

[Steven Hansen:]

unless something changes there will be no inflation. there will be no money flow. there will be little lending.

there has been nothing done to repair the economy. it is cooling as we speak. inflation will happen when the economy re-energizes in the next decade.

2008 Oct 16 06:15 AM

[DaveW:]

talk to the hand (sorry, I have a pre-teen daughter),
agree, inflation worries came crashing down in the last few months. Deflation over a long stretch of time is of much greater concern. As to the avalanche, this is a hard one to predict. If risk appetite returns to equities, I'm betting it will return to the banks, and once one lemming goes they will all go (mostly). A consensus of opinions predicts a bear rally in the coming 3-6 months, I wonder if it will be enough of a head-fake to get the lemmings to jump?

2008 Oct 16 09:29 AM

[Mark Wallace:]

The situation we presently face is far more dire than is commonly believed. For more than a quarter of a century, credit has been continuously expanded to boost economic activity. We've been living in a credit bubble for so long that it seems normal, but it is not. This system cannot exist in a steady state and, like a Ponzi game, must continually expand to maintain itself. Now, for the first time, credit expansion is dramatically slowing, and the entire system is beginning to go into reverse. This is highly contractionary in terms of economic activity. A negative feedback loop is developing that will choke the life out of the economy. To gain an appreciation of the potential downside, ask yourself this question: what would my house sell for if people had to pay cash for it (because no loans were available)?

2008 Dec 11 10:39 PM

[Jeff Benson:]

I like that comparison of a creditless society....what would someone pay for my house if no loans were available? Similarly, I agree with the comment by Mr. G that the government should have stabilized the consumer instead of the bank, but it's is hard to leverage the stabilizing dollars as it's been done with the banks. I am also struggling to imagine an economy with a huge pile of debt and non-performing loans that are (all of the sudden) nationalized by a government sponsored aggregator bank. What then? That is a massive opening of balance sheet considering that the state sponsored bank will likely be leveraged to the hilt, but unfortunately not in the likes of Lehman Bros. What then? Credit floods the markets for home buyers, new retailers, consumers, and auto loans? Would you be the first to grab that falling knife? No. I'm hopeful that the bank balance sheet forgiveness translates into a new era of financing meaningful capital endeavors. Alternative energy, tech development, Nationwide Wi-Max, brownfield development, more effective air travel, national security, heath improvements, public transportation systems that are worth a shit, trade improvements, trade partner regulations that promote well being, etc. It kind of sucks to see that a "quarter century" of credit expansion has been spent on inflated home improvement and overpriced German sports cars. We've overpriced assets that fundamentally don't have long lasting value. You would think that the nation's bankers would be smarter than squandering mass credit on non-performing assets. But, they are about to get a second chance. I hope the strings attached this time force the money to be spent on truly valuable assets.

Jan 20 03:52 PM