Wednesday, February 10, 2010

The unequal credit crunch

  • by Martin Hutchinson
  • February 08, 2010

When the banking system imploded in September 2008, commentators immediately feared that the result would be a credit crunch, leading to a major downturn in GDP and rise in unemployment. The U.S. government, however, deployed all its resources to ensure that housing did not suffer the credit crunch it deserved, while taking its own borrowing to unprecedented heights. The result of course has been a credit crunch, hitting especially hard the sector of the economy that is almost entirely the victim rather than the beneficiary of government programs – small business.

The Federal Reserve Bank's Senior Loan Officer Survey, which appeared February 1, demonstrates this fairly clearly. Loan officers reported that the outlook for delinquencies and charge-offs was considerably worse for small and medium-sized firms than for other businesses. At first sight, their other observation – that demand for loans from small firms was well down – would appear to indicate there was no problem. However, you should consider in this case what "demand" means. If your local bank has tightened lending standards sharply for small business, as they have, and if it believes small business loans are exceptionally likely to default, then as a small business owner, what do you think your chances are of getting the loan you need? Unless you have pictures of your bank manager in flagrante delicto, not too high – and probably not even if you have such pictures, such are the lowered moral standards of our times!

Given that getting a loan is likely to be pretty well impossible, most small businessmen, not being fools, won't bother asking for it – after all, the way credit scores work, applying for credit unsuccessfully itself lowers your credit rating. That will cause a dearth of small businessmen walking in through the door of the bank asking for loans. The "senior loan officer" will then sit smugly and report that there appears to be little "demand" by small business for loans but that, oddly enough, all the small businessmen in his neighborhood (being unable to get the finance they need) are going belly-up. He will then profitably deploy the bank's resources into government guaranteed home mortgage debt, mixed with a few Treasurys, which, thanks to Ben Bernanke's ultra-low short term interest rates, will give him a nice profit.

You can see this in action in another Fed report, the Assets and Liabilities of Commercial Banks in the United States (H8). Since December 2008, bank credit has declined about 4%, an acceptable figure in a year when the banks have been deleveraging. However, within that total, the statistics are not so pretty. Treasury and agency securities (included in "bank credit") are up 18%, with mortgage-backed securities up about 2% and non-MBS (presumably mostly direct Treasury bonds) up 23%. Other securities, corporate bonds and such, are also up 5%.

Loans and leases, the non-securities part of "bank credit," were down 8%. However, real estate loans, half of that total, are down only 1%. Of the real estate loans, home mortgages (presumably mostly again government guaranteed) were up 3%, home equity loans (mostly utterly economically unproductive credit card refinancings, I suspect) were up 1% and commercial real estate was down 6%. Credit card lending is down 15% (some of it having been refinanced through second mortgages), but other consumer lending was up 2%.

Finally, we come to commercial and industrial loans, in many ways the main purpose of the banks' existence, now that security of deposits is rendered nugatory by the FDIC guarantee. Even in December 2008, these represented only 17% of "bank credit." However, since then, their total has declined by 19%, more than any other major category of loan, and they now represent only 13% of bank credit.

These are the loans to small businesses – along with a few loans to leveraged buyouts, a market that is still open and must absorb some of the total. They represent only a small part of commercial banks' business, and their level is shrinking rapidly. Banks have too many other profitable things to do with their money, in particular lending it to government and to government guaranteed mortgages, both at high long-term rates that yield a handsome spread over short-term funding costs. All the jawboning of banks to increase small business lending has been completely ineffectual; they are reducing it as fast as they can, because in risk/reward terms, there are more attractive things to do with the money. Needless to say, since small businesses cannot get financing, they tend to fail, increasing their perceived risk.

Thus "crowding out" of small business, the economists' main worry about large government budget deficits, is most certainly happening. Government is spending more money than it takes in, so small businesses can't get finance and go bust instead. If that creates jobs, I'm a Dutchman. The most fruitful source of new employment is small new businesses that are in fields not yet tapped by the big behemoths. By suppressing small businesses while preserving large businesses, the Obama administration is suppressing the creativity of the U.S. economy, which is the only thing that economically justifies U.S. living standards being higher than China's.

Given President Obama's 2011 budget, the prognostication for the next couple of years is thus a gloomy one. However much money Ben Bernanke prints, it will simply go into asset price inflation or old-fashioned consumer price inflation. This is already apparently helping the housing market, which brings some benefit since the loss of wealth to both sides from foreclosures and mortgage defaults is very real indeed. However, if stabilization in the housing market is bought at the cost of entrenching substantial or even high inflation in the U.S. economy, the price is too high. Meanwhile, Bernanke or no Bernanke, the huge budget deficits will reduce still further the finance available for small businesses and increase still further the percentage of U.S. jobs that have been lost forever to cheaper Asian competitors.

The solution is a simple one, and it is not even all that painful. Short-term interest rates must be increased forthwith to the 5% to 6% level, at which they are above the current and impending rate of inflation. At the same time, fiscal discipline must be restored, both directly in public spending and through closing down the housing finance behemoths Fannie Mae, Freddie Mac and the FHA. Huge amounts of current public spending are either wasteful or outright harmful – the gigantic subsidies to "green" fuel technologies, based on a global warming theory that now seems to have been almost entirely a scam, are examples of the latter since they divert valuable private sector resources and people from more useful, wealth-generating activities.

The short-term pain from a renewed housing downturn will be finite; with those moderate interest rates, the equilibrium price level for housing is only some 10% to 15% below current levels, and financing will be readily available on "jumbo" mortgage terms, which will quickly reduce towards "conforming" levels as government guaranteed paper ceases to be available. While the foreclosures will be worse than on the current track, the housing pain will be bearable and the wasteful diversion of resources into housing reduced.

However, the real benefit of removing monetary and fiscal stimulus will come in the banks' attitude to their local small businesses. They will no longer be able to make money from investing in Treasurys because short-term rates will be as high as long-term rates. Mortgages and mortgage bonds, as well as being only modestly profitable, will now carry a degree of risk. Local small businesses, where the lending officer is aware of the businessman's competence and integrity through the community network, will become the most attractive way to make relatively secure lending returns at an attractive level. The word will soon get out through the community that small business loans are again available. At that point, "demand" for small business loans will magically reappear, and small business bankruptcies will equally magically decline to more normal levels.

The U.S. economy will then recover and move onto a more innovative growth track that supports U.S. living standards – which is what the "stimulus" was supposed to be about, wasn't it?

The Bears Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005). Details can be found on the Web site

Views are as of February 8, 2010, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.

Gross Domestic Product (GDP) is a broad gauge of the economy that measures the retail value of goods and services produced in a country.

Federated Equity Management Company of Pennsylvania

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