Sunday, August 17, 2008
In our debt-based economy, new credit is the source of new money. Without ever more money (meaning credit) to fuel ever more spending, our economy will contract. Which is why I keep a close eye on credit. The stories below tell a very different tale from the recent stock market action.
In this type of economy, nothing is more important than the continuation of ever more borrowing in ever larger amounts. If this falters for any reason, extreme financial instability would be the expected outcome, especially given the extreme degree of leverage in the financial system, which we would experience as collapsing financial institutions and rising levels of default. The three main sources of demand for new borrowing are consumers, businesses, and the government. I will examine each below, along with some other evidence to make the case that our financial crisis is not over; in fact, it has hardly begun. This means that the recent perplexing actions in the dollar and the stock market very likely represent one of the largest head-fakes of all time.
We are all familiar with the fact that US residential real estate activity is basically down 33% from its all-time peak. This represents roughly 2 million homes that will not be sold this year, compared to 2005. Among other things, this includes 2 million fewer mortgages, sales commissions, inspections, title searches, and municipal transfer fees paid. The ripple effect extends to everything from granite countertop sales, to lumber prices, to furniture. Assuming that the average house sale resulted in a net increase of borrowing of $100,000 (= the size of a new loan on a newly purchased house when compared to the old one), that results in a direct borrowing hit of 2,000,000 times $100,000, or $200 billion. Add in the ripple effects, and we are talking another few hundred billion in lost activity.
Further, Mortgage Equity Withdrawal, the practice of “extracting wealth” from a house, peaked at $682 billion in 2006, and will be lucky to break $200 billion this year, which will represent a loss of nearly $500 billion/yr from the peak and some $275 billion from last year. Taken together, residential real estate is already off some $500 billion in consumer borrowing from last year. The question lurks: What will fill in that gap? Business borrowing? Even higher levels of government borrowing?
And here’s the mystery: For “money” to show up in the banking system, borrowing has to happen somewhere. Our indirect evidence that something is amiss rests in this chart of MZM, or Money of Zero Maturity, which is the next best descriptor of total money that we have left since the Fed stopped publishing M3 over a year ago. As you can see in the first chart below, MZM has been growing quite smartly throughout 2008, and you really have to squint at the very end of the chart to detect a slight abatement in the growth. There’s a little wiggle right at the end of the line.
If this is not clear enough, then we can switch to the second chart, which shows the change in the money supply from a year ago. That is, if the chart reads “$1,000 billion” (which = $1 trillion), it means that over the past 12 months, $1 trillion of new money was somehow created in the banking system.
This second chart of MZM shows a couple of interesting points. Note that in 1989, MZM went briefly negative, and we then entered a pretty nasty “double dip” recessionary period. Alan Greenspan got chewed out by Bush-the-First for “costing him the election,” because Greenspan failed to act quickly enough to remedy that situation. When money supply declines, it means credit is not expanding, and this quickly leads to economic pain and dislocation in our must-always-be-expanding system.
The second time that Alan was faced with MZM heading into negative territory was in 1995 (marked on the graph), and this time he was ready. Unfortunately, he did something really exceptional to “goose” the creation of new money/credit – he effectively eliminated bank reserves.
In theory a bank is limited in the amount of credit it can create by the so-called “fractional reserve” ratio, which is usually related to be 10%. But since MZM stands at 8,700 billion dollars and bank reserves currently stand at only $43 billion dollars we can easily determine that bank reserves are, in reality, only 0.5% of liabilities, not 10.0%. This means that instead of creating $900,000 out of every $100,000 held in reserve, banks have created something closer to $20,000,000.
While this is all very interesting, the really important questions are, “How exactly has money grown by more than a trillion dollars over the past year?” and “Who exactly has been borrowing all that new money into existence?”
Here’s where the story gets difficult, because we cannot easily identify these sources of borrowing in the news. For instance, one factor normally required for money/credit to continue expanding at a fast pace is that bank lending must remain easy and loose. As this next article makes clear, over this past year, banks have been making it harder, not easier, for borrowers.
Credit squeeze getting worse, banks say (emphasis mine)
Aug 11 – MarketWatch
Despite all the aggressive moves by the Fed in the past year to ease the flow of credit to the economy, a record percentage of banks were making it more difficult for borrowers in the three months ending in July, the Fed said in its quarterly senior loan officer survey of 52 major banks.
A majority of banks tightened their rules for granting loans to businesses and consumers. The survey shows little appetite at banks to lend for home mortgages, credit cards, home equity loans, commercial real estate loans, or commercial and industrial loans.
No bank in the survey eased credit terms for any type of loan in the past three months, and only one bank said it anticipated easing standards for consumers in the next 12 months.
C&I loans: 58% of banks tightened standards for commercial and industrial loans to large and medium firms, while 65% tightened for small firms.
Commercial real estate: 81% tightened standards, while 50% said demand was weakening.
Residential mortgages: A record 74% of banks said they tightened standards for prime mortgages, while 53% said they saw reduced demand. For subprime mortgages, 86% tightened standards, with the number of banks who offer such loans declining to 14% of banks from about 30% two years ago. For nontraditional mortgages, 84% tightened standards while 63% reported reduced demand.
Consumer credit: A record 36% of banks reported less willingness to extend consumer installment loans; only 2% were more willing. Eighty percent tightened standards on home-equity lines of credit. For credit cards, 67% tightened standards, mostly by refusing new loans to consumers without good credit.
Read this sentence again because it is truly unprecedented: “No bank in the survey eased credit terms for any type of loan in the past three months.”
NO BANK. As in ‘none.’ Zero. For any type of loan. This survey makes it clear that banks have tightened right across the board, in every segment of lending, often by RECORD AMOUNTS.
Now, it gets really tricky to understand how the money supply is reported to be close to a trillion dollars just this year while bank lending has dropped off by record amounts.
Here’s another example of a former source of lending that has experience a quite dramatic drop-off in volume over the first half of the year:
Aug 11 – Washington Post
In the District [of Columbia], $1.4 billion worth of office space traded hands in the first six months of the year, a 61 percent drop from the $3.6 billion sold by mid-2007, according to Real Capital Analytics of New York. The drop-off was even more pronounced in Northern Virginia, where building sales plummeted 87 percent, to $914 million from $6.8 billion a year ago.
“The commercial real estate game doesn’t work without debt, and it is very hard to come by these days on attractive terms,” said Dan Fasulo, research director for Real Capital.
Other cities have faired similarly. Manhattan, the nation’s biggest office market, saw a 59 percent drop, to $6.4 billion from $15.5 billion. Deal volume fell 60 percent in Los Angeles, to $1.84 billion from $4.65 billion. Chicago had a 23 percent drop, to $1.7 billion from $2.2 billion.
In major cities on both coasts and in the Midwest, office space deals fell anywhere from 23% to 87%. The deals fell through because debt could not be arranged and the game doesn’t work without debt. No debt = no money. No money = bad economy.
So where is all the money coming from?
Is it coming from overseas borrowing? Nope, not if this next article is accurate.
Aug 11 – Time
For banks across Europe, as for their U.S. counterparts, 2008 is proving painfully difficult. Globally, banks could write down as much as $450 billion more over the next three to four years, according to research from Deutsche Bank. Lenders, it says, are short of funds equivalent to 4% of their balance sheets, with those in Ireland, Spain and Britain finding fund-raising particularly tricky.
Even the banks are having a hard time raising money for their own balance sheets, which means they are certainly not lending it out to businesses and consumers.
Here’s one possible explanation for the continued increase in corporate borrowing: This link goes to a radio interview between a Bloomberg host and Mr. Goldman, who is a lively and clear orator. I really like the way Mr. Goldman makes clear that the so-called “credit crisis” is no such thing…yet. The credit crisis has not yet arrived, because major banks are contractually obligated to provide lines of credit to companies that are busy drawing those lines down. The credit crisis erupts when those loans are due to be renewed. He claims that banks do not have the balance sheets they need to extend that credit, and, therefore, the worst effects remain in front of us.
The bottom line: I do not have a great explanation for the mechanism that is creating the large reported increases in the money stock. At this point, my strong inclination is to go with the media reports of the actual situations out in the real world. They may be anecdotal, but they seem more accurate than the opaque reporting of the Federal Reserve or government.