Financial Fuss (2) - Credit Squeeze

There is now less credit available. Americans have been poor savers for a long time and have relied on people in other nations to make up the short fall. I suspect that foreigners are now not so keen on that role. Worse still, some of the money that used to be available for lending has been wiped out by “write downs” and losses by various banks. The collapse of leverage has also reduced the amount of credit available.

In a normal world, declining availability of credit would not be a problem. Interest rates would rise to ration the available credit to the most efficient users. However, the Fed is holding interest rates down at a level where demand exceeds supply. This makes it seem like there is a shortage.

When supply declines, some of those who would previously have received credit miss out. Marginal businesses will find credit more difficult to obtain. Homebuyers with only a small deposit will find a mortgage more difficult to obtain. This happens as banks become more careful about allocating credit. However, credit is still available for good businesses. Statistics show that commercial and industrial loans by commercial banks are still at very high levels.

The Economic Situation (2) - Credit Blow Out

During the last decade there has been a tremendous expansion in credit all round the world. This started when the US Federal Reserve cut interest rates when the Dotcom bubble crashed in 2001. Since then a huge surplus of money has been slushing around the world distorting markets everywhere.

The growth in money was exacerbated by a whole lot of new banking tricks developed by banks in the United States and copied all round the world. These included securitisation of mortgages and moving debt into off-balance sheet subsidiaries. Cheap money was available to everyone everywhere, including many who could not afford to pay the money back.

This flood of easy money had several effects:

1. Cheap money created the housing boom. All round the world house prices rocketed upward as banks provided huge mortgages to anyone who asked and some who didn't.
2. Easy credit fuelled a consumption boom. Consumers used their credit card to purchase more and more consumer goods, particularly electronics. This boom was exacerbated by a wealth effect, as rising house prices made homeowners feel like they were better off. Cheap imports from China also kicked the consumption boom along.
3. Cheap money enabled people to buy cars than they could afford.
4. Low interest rates make many marginal business investments viable, causing capital investment to become distorted.

Superleverage

The problems faced by the US economy were mostly caused by “easy credit”, so they will not be resolved be resolved by more “easy credit”.

Sub-prime borrowers have bought houses that they cannot afford with borrowed money. Borrowing more money is not the solution to their problem. The only solution for those who cannot hang on where they are would be to sell up and move to housing that they can afford.

Easy credit has allowed US consumers to spend a large on their credit cards. If they have bought SUVS and LCD TVs that they cannot afford, they really need to learn to live with in their means. Easy credit will only encourage more unwise behaviour.

Easy credit allowed Investment Banks to wrap up mortgages into collateralized debt obligations (CDOs) and sell them to investors all round the world. The problem with these CDOs is that borrowers are defaulting on the mortgages and no one knows who is carrying the risks. Easy credit will not solve this problem. The only solution is for the investment banks is to unwind some of the links and decide who owes what to whom and establish who will bear the loss. May the bankers who have earned million dollar bonuses will bear some of the pain.

Easy credit has allowed hedge funds and others to undertake leveraged buy outs (LBOs) of large listed companies. If some of them have paid too much, more easy credit. They will just have to take their losses on the chin and the price for being in what has been a profitable.

Easy credit has allowed bond insurers like Ambac and MBIA to provide credit insurance way beyond the value of their capital. Insurers should be able to make good decisions about the size of risk. If they have been getting risk wrong, easy credit will just reward their mistakes. Taking their losses might be better education.

Easy credit has allowed business to expand without increasing their equity. They have been able to get the benefits without paying the price, but reality is now catching up. More easy credit will not strengthen their balance sheets.

George Soros says that the “era of superleverage” is coming to and end. He is probably right. Easy credit has allowed households, businesses and bankers to be heavily leveraged, without understanding the risk, but this is not the way of blessing.

You will lend to many nations but will borrow from none. The LORD will make you the head, not the tail. If you pay attention to the commands of the LORD your God that I give you this day and carefully follow them, you will always be at the top, never at the bottom (Deut 28:12-13).

Providing easy credit is like providing “another drink” to an alcoholic. It does not help them to get off the wagon. Banker Ben is the disease of the US economy, not the cure.

Of course, "Will it work?" is the wrong question (positive economics). The really important question is, "Is it morally right? (the normative issue). I will answer that question tomorrow.