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Five Things You Need to Know: The Credit Crunch, What's Next?


We know we're in a "Credit Crunch," how do we get out of it?


Kevin Depew's Five Things You Need to Know to stay ahead of the pack on Wall Street:

It's hard not to feel shot by both sides this morning.

"I do not think that the headwinds have diminished," Gary Stern, the president of the Federal Reserve Bank of Minneapolis, told the Financial Times. "If anything, I think that they are picking up a little steam."

Meanwhile, in a separate Financial Times article, the International Monetary Fund warned credit growth in the US could fall further as a result of ongoing financial system stress.

The New York Times got in on the action as well, noting that banks are curtailing loans to American businesses, "depriving even healthy companies of money for expansion and hiring."

Scanning the Times piece caught the following:

"credit tightening"

"scarcity of credit"

"access is restrained"

"struggle to secure finance"

"loan growth slowing"

"back to basics"

"new era of caution"

Welcome to the reality of the ongoing Credit Crunch. This is stage two; the Main Street impact from the unwinding of the Wall Street debt bubble.

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.

Under ordinary circumstances, the market (and sometimes the Federal Reserve) can induce a decline in 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.

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 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.

As long as credit expansion and demand for credit continues at an accelerating pace, the appearance of prosperity continues as asset prices increase.

The "accelerating pace" aspect is critical. It is the key to maintaining the boom.

As Michael Darda, chief economist for MKM Partners told the Times today, "Access to capital and credit is essential to growth. If that access is restrained or blocked, the economic system takes a hit."

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 credit has increasingly been used to mask weak economic growth.

Since the early 1990s, 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.

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 money was then overinvested and misallocated by investors in ventures and houses.

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. 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 Crunch"?

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 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," 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) in order to raise capital to repay loans. This pressures asset prices.

We then have a situation where the fear of not having money (U.S. dollars) to pay down debt spreads. This deepens further 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.

5. What Next?

So what happens next? If we are in a "Credit Crunch," how do we get out of it?

The Fed can make even more credit available; a monetary response. This may temporarily relieve tight credit conditions among financial institutions, but so far, despite an array of special lending programs, the creation of weird acronyms and the opening of access to the Fed's discount window to broker-dealers, the monetary response has been weak, largely because of the size and impact of the housing inflation and the leverage involved.

When monetary policy is insufficient to stop the credit crunch, government can step in and create any number of mechanisms to essentially bailout lenders and borrowers; a fiscal response. We are seeing this happen now with Fannie Mae (FNM) and Freddie Mac (FRE).

Markets are too large for any central bank or group of central banks to control for long. And ironically, the more they act to try and prop up or even slow the decline in asset prices, the larger the market becomes. By targeting asset prices and attempting to "manage the economy" the Fed ironically creates the conditions for a market that is too large for it to control. As a result, crashes, unwindings of speculative bubbles, become more devastating, and affect far more people in the real economy.

What happens on the other side of that is what we need to be concerned with now. One consequence of the Credit Crunch will be new, sweeping increases in the balance sheet of the government. This will likely take the form of 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.

In some weird, perverted sense, this couldn't happen at a better time, something we first noted over a year ago in Five Things (May 9, 2007, Number Four: The Return of Public Works Projects). Our view, at that time, was a report released by the Urban Land Institute and Ernst & Young projecting a U.S. deficit of $1.6 trillion through 2010 for basic infrastructure repairs and maintenance. We viewed that shortfall as "good" news.

How could a $1.6 trillion shortfall in infrastructure spending possible be "good' news? Easy.

During economic depressions caused by mal-investment and magnified by intervention and perversion of the normal business cycle, the ensuing widespread layoffs create vast societal upheaval as displaced workers and former homeowners turn desperate in order to feed their families and get by.

Fortunately, all this deteriorating infrastructure is perfect for government-paid public works projects.

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