Five Things You Need to Know: Credit Crunch Puts the Heat on the Street; Main Street
Kevin Depew's Five Things You Need to Know to stay ahead of the pack on Wall Street:
We ran across an interesting brief in BusinessWeek, "Your Lifestyle May Hurt Your Credit," over the weekend that takes a look at a little-know lawsuit making its way through the Atlanta, GA court systems.
The suit, filed by the Federal Trade Commission against CompuCredit (CCRT), claims, among other things, that CompuCredit didn't properly disclose that it monitored consumer spending patterns and cut credit lines if consumers used their cards at certain places.
Among the places the company monitored, according to article: tire and retreading shops, massage parlors, bars, billiard halls, and marriage counseling offices.
The suit illustrates some of the credit scoring practices beyond simply payment history and FICO scores that are incrasingly being used to score consumers, something we mentioned on Friday in Five Things (Number 4).
On a related note, the New York Times on Saturday ran with a piece noting that Washington Mutual (WM), HSBC Holdings (HSBC), Target (TGT) and Wells Fargo (WFC) have collectively cut credit card lines by $15 billion over the past three months. The article went on to outline what could have been mistaken as a positive note: "Over all, the amount of available credit for the industry appears to be about flat, with the three biggest issuers — Bank of America (BAC), JPMorgan Chase (JPM) and Citigroup (C) — slightly increasing their overall credit lines. But, as we shall see, flat credit is not enough; we need credit growth.
Before we take a look at why credit growth is so critical, let's first outline some basics about this credit crucnh, what it is, and what it means going forward.
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.
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, by "fiat-based monetary system" we are not criticizing the economic system in the United States. This is just the name of an economic system where money is created through fractional reserve banking techniques.
Fractional what? Say again?
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. This is why so many market commentators are insistent that the Fed try and "stimulate" additional appetite for credit by lowering rates. It is also why the Federal Reserve, and more recently the European Central Bank, have backed away from "Hawkish" statements of late. The U.S. economy, and by extension the global economy, is not prepared for central bank activities that slow the growth of credit.
3. What is credit expansion, anyway?
Credit expansion occurs when new money is created by the banking system and offered at artificially low interest rates, or to borrowers with low credit quality.
We know this creates "malinvestments," but how?
By offering willing borrowers money at artificially low rates, this encourages increased time preferences among economic actors, which is to say that investment horizons are lengthened and risk tolerances are widened. It also creates the "illusion" of rising asset values. In the simplest terms, the demand for money outstrips the supply. This money is then overinvested and misallocated by investors in, say, dot.com ventures, or houses.
In hindsight, it always seems these investors were dumb. After all, who could now believe that an "undertaking of great advantave; 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, do 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 then 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.
Also, the government can step in and create any number of mechanisms to essentially bailout borrowers; a fiscal response.
Most likely we will see a combination of the two - a combined monetary and fiscal response. That will most likely delay a deflationary credit collapse, but it won't address two key issues; consumer time preference and risk aversion.
If consumer risk aversion becomes entrenched then we will see a long-term shift in market leadership away from financials and consumer discretionary-dependent sectors, and toward consumer staples and sectors with less exposure to consumer purchasing decisions.
And what about time preferences? 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. Think about it. If people begin to suspect that asset prices won't really be allowed to go down, what is the rational response to that? It's to increase the size of the bet.
So 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.
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A decision against CompuCredit is likely going to make credit more expensive and less available to all.
As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth -- not of existing wealth, but of wealth as it is currently produced -- to provide men with buying power equal to the amount of goods and services offered by the nation s economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.
That is what happened to us in the twenties. We sustained high levels of employment in that period with the aid of an exceptional expansion of debt outside of the banking system. This debt was provided by the large growth of business savings as well as savings by individuals, particularly in the upper-income groups where taxes were relatively low. Private debt outside of the banking system increased about fifty per cent. This debt, which was at high interest rates, largely took the form of mortgage debt on housing, office, and hotel structures, consumer installment debt, brokers' loans, and foreign debt. The stimulation to spending by debt-creation of this sort was short-lived and could not be counted on to sustain high levels of employment for long periods of time. Had there been a better distribution of the current income from the national product -- in other words, had there been less savings by business and the higher-income groups and more income in the lower groups -- we should have had far greater stability in our economy. Had the six billion dollars, for instance, that were loaned by corporations and wealthy individuals for stock-market speculation been distributed to the public as lower prices or higher wages and with less profits to the corporations and the well-to-do, it would have prevented or greatly moderated the economic collapse that began at the end of 1929.
The time came when there were no more poker chips to be loaned on credit. Debtors thereupon were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality underconsumption when judged in terms of the real world instead of the money world. This, in turn, brought about a fall in prices and employment.
Unemployment further decreased the consumption of goods, which further increased unemployment, thus closing the circle in a continuing decline of prices. Earnings began to disappear, requiring economies of all kinds in the wages, salaries, and time of those employed. And thus again the vicious circle of deflation was closed until one third of the entire working population was unemployed, with our national income reduced by fifty per cent, and with the aggregate debt burden greater than ever before, not in dollars, but measured by current values and income that represented the ability to pay. Fixed charges, such as taxes, railroad and other utility rates, insurance and interest charges, clung close to the 1929 level and required such a portion of the national income to meet them that the amount left for consumption of goods was not sufficient to support the population.
This then, was my reading of what brought on the depression."
Shouldn't we be calling for their heads instead?
I want to sink my teeth into the oil bubble theory but I can't seem to get there. I get the deflation theory and have been there since 2005 but I need some help on some info.
The first significant bubble was the Tulip bubble . . . no one really need tulips to function.
The second one was Mississippi Bubble which as far as I can ascertain was a financial speculation bubble.
Third; The South Sea Bubble which was much the same as the Mississippi Bubble.
Next comes the Roaring Twenties which was much like the previous ones in that it was created by financial speculation.
Then the Japanese bubble which was fueled by loose monetary policy and rather confusing way of doing business.
Then comes the bubble in tech stocks which were basically financial instruments but the actual stuff tech companies consume and sell was in fact deflating and still does.
Then comes the Credit bubble which was a financial bubble.
Then comes the Real-estate bubble which was fueled by the Credit bubble which was essentially a financial bubble.
Then comes the Oil bubble which is something most people actually need.
Save for the Oil bubble they all have one thing in common; they were engineered by financial speculators.
So is the oil bubble a function of financial speculation much like the electricity shortage was in California in the late '90s?
There still seems to be an electricity supply problem in California.
If if oil deflates as the dollar rises wouldn't oil deflate less than all other hard assets and there fore outperform?
If the Tech companies can thrive in an environment where their products are constantly deflating can't emerging economies thrive in an environment where oil inflates?
Wouldn't starting from a smaller infrastructure where new energy efficient technology can be applied offset the cost of rising oil give emerging economies an advantage?
And wouldn't that support demand?
And wouldn't that compromise supply?
The world didn't come to a screeching halt when Japan stepped off a cliff and it won't when the US and Eurozone does either.
As far as I can tell the human race has never stopped evolving and presently that evolution is fueled by oil consumption.
Previously it was driven by expansion and wars . . .
Fiat money is doomed when a central bank is worried about recession when inflation is growing. I vote for Gold Standard!
I've read reports that oil "should be" about $100 a barrel (as priced in gold). There's a lot of speculation in oil and there's thinking that's increased the price by $30-$40 a barrel.
