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No Vacancy: A Debt Crisis Primer


Banks clamp down on lending.

Over the weekend I was asked at dinner by some non-financial friends to explain what was happening in the credit markets. I offered the following story and I share it with the Minyanville community today with the hope that it may help you better explain what's happening around us to your family and friends.

Right out of college, one of my cousins managed the front desk for a major hotel in Chicago. At the holidays she always had colorful stories to share about when the hotel was oversold and customers were turned away, or worse evicted from their needed rooms.

But she was also quick to point out that overbooking was a necessity to hotels, along with airlines and rental car companies. Cancellations carried little to no penalty and were thus generally very predictable.

Except when they weren't.

Now hold that thought. While the analogy is not perfect, I think it is very helpful to think of a bank as a building with lots of rooms -- and the rooms hold loans.

In the old days, banks were like apartment buildings. A new borrower moved in, and when his loan was repaid after a few months or years, the borrower moved out. In good times, there was demand for more rooms, and additional wings were built. And in bad times, when people couldn't pay their rent, they were evicted (written off) and rooms went empty. And in really bad times, the building was sold in foreclosure (receivership) to a new owner. And for hundreds of years that is how banking worked.

Then along came securitization, and with it, banks converted themselves from apartment buildings to hotels. And rather than staying for years, borrowers started to stay for only a few months, then only a few weeks, and in some cases only a few days or even hours.

In some cases borrowers moved into apartment buildings owned by someone else and in other cases they moved into "franchisee" apartments (SIVs etc.) operated, but not owned by the bank. Sometimes too, whole families moved out, while at other times, families left stray cats and dogs, that either couldn't or wouldn't leave on their own (subordinate pieces in securitizations).

Because of the frequent turnover in rooms, banks had to become much better at managing occupancy. Some chose to tear down wings (bought back stock), while others began to offer lower and lower rates to attract additional clients.

But beginning last year, as the market for securitized products peaked, occupancy began to rise. Loans which had previously stayed on balance sheets one night started to check in for a week. And the banks' initial response was to slow their stock buybacks to keep more rooms open, figuring that the problem was temporary.

But it wasn't. And not only were some loans staying a week, but some a month. And an increasing number weren't paying their bills. Further, those operated but not owned SIV "franchisees" the banks created were being closed down and loans that the bank thought were gone for good were reappearing at the check-in desk demanding a room.

To deal with the problem, banks started to raise the room rate, hoping to slow the pace of new loan arrivals. They also demanded for more security, asking those willing to pay a higher price for more cash or collateral up front.

The regulators, seeing that the hotels were charging more to new customers, lowered the cost of electricity (interest rates) and drove over some of the leftover Hurricane Katrina RV's (the TAF) hoping to create both more demand and supply for rooms.

But even that wasn't enough. And with more clients not paying their bills, the banks had to shut down more floors of the hotel, which brings us to today.

Now we are to the point where to deal with this problem, banks have begun to evict "comped" customers from their rooms. You know, those folks who were using the room for free in exchange for their dining or convention business – folks like municipalities, who never paid directly for their room (auction remarketing), but who paid big underwriting fees.

Also, looking at what is happening with Carlyle and Thornburg (TMA), banks are also demanding that those pay-by-the-hour borrowers (uncommitted overnight REPO) leave, and leave now.

But beyond the closing of more and more floors of the hotel (due to capital and earnings issues) the bigger problem that the banks are facing is that more and more long time paying customers (committed revolving credit borrowers) are showing up at the front desk saying "I have paid you a commitment fee for years to have a guaranteed room when I needed it. And I need a room now. Give me my keys!"

Now admittedly some, like Clear Channel (CCU), have been walked to another hotel, thanks to "Mac" the bouncer (Material Adverse Change). But most others, such as Countrywide (CFC) and Sprint (S), have been quickly shown a room, and some, given their size, have even taken very large suites.

But to be clear, with every passing day, as risk aversion rises in the capital markets, more and more borrowers are showing up to the door. At at the same time, with more existing clients not paying their bills, and the hotel's lenders cutting off credit, more and more wings are being closed.

On Friday, $100 billion worth of more Hurricane Katrina RV's were driven in by the regulators from Louisiana. And, next week, if all goes as planned, the cost of electricity (interest rates) will go down some more. And maybe, just maybe, this will help balance the supply and demand of rooms.

But to those without a pre-paid reservation, I would caution you that there may not be a room. And even to those with reservations, I would remind you that "Mac" the bouncer will certainly look you over very carefully before letting you upstairs.

Finally, and to all, I would remind you that, even with the caravan of RV's streaming into the parking lot, there are far more reservations (committed and uncommitted credit lines) than available rooms.

While I sincerely do not wish for it, I am increasingly afraid that before too long the "No Vacancy" sign may ultimately be lit up for the night.
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