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Asset Deflation Driving Move Toward Recession


With home foreclosures rising, we are seeing higher and higher loss severity among financial institutions.

The following is the latest missive from Minyan Peter, author of such recent popular articles as Bank Earnings Post Mortem and A Closer Look At Mastercard's Earnings.

A quick pre-Thanksgiving quiz: Kryptonite is to Superman as ______ is to banks?

The answer: asset deflation.

While many people think of banks as making unsecured loans, the vast majority of bank lending is secured by something: real estate, commodities, securities, receivables, equipment, etc. And so long as there is some level of appreciation in the underlying asset, both the borrower and the bank benefit from the increase in "equity" in the underlying asset.

As we have seen over the past seven years, price appreciation in housing created significant equity, yet as that equity grew, banks assisted homeowners in monetizing it through home equity loans and other mortgage refinancing, which enabled consumers to make a variety of purchases.

Fast-forward to today, and we are clearly on the other side of price appreciation. We are now coping with asset deflation, particularly in assets that were leveraged and re-leveraged at higher and higher valuations. For many homeowners and their mortgage lenders, equity is quickly becoming a thing of the past. And, with home foreclosures rising, we are seeing higher and higher loss severity among financial institutions.

In looking over prior economic cycles, credit issues were largely contained to one or two market segments – commercial real estate, high yield debt, etc. One of the reasons I remain bearish on financial institution stocks (even with their more than 20% declines) is that I believe practices followed by banks in mortgages were followed across substantially all other loan categories. From 2001 to 2007, no matter where you look, loan to value requirements (along with covenants) were stretched about as far they could be.

With the economy slowing and consumers pulling back on small and large purchases alike, I expect we will continue to see asset deflation in the United States. And, as a result of tighter lending restrictions in both Europe (due to the impact of America's housing problems on major European banks) and in Asia and the Middle East (to curb domestic inflation), we will see asset deflation across all categories, including commodities.

As we are seeing in the market today, actions by global central banks to lower interest rates may help slow the pace of asset deflation, but ultimately as the impact of asset deflation on each loan category flows through to income statements and balance sheets of financial institutions across the globe, lending will slow further, ultimately bringing with it a recession in the West and significantly slower growth in Asia.

Minyan Peter has positions in SKF, DUG, SMN.
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No positions in stocks mentioned.
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