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Monday, February 04, 2008


american banking lights the way to further deflation

the argument for continuing deflation -- a credit contraction manifested in a collapse of asset and durable goods prices vis-a-vis lower-order goods and commodities -- got a major boost over the last week as far as i can tell. via calculated risk, banks in the united states have begun to defend themselves by shutting off consumer credit lines and tightening standards in areas of heavy exposure.

About 80 percent of domestic banks reported tightening their lending standards on commercial real estate loans over the past three months, a notable increase from the October survey. The net fraction of domestic banks reporting tighter lending standards on these loans was the highest since this question was introduced in 1990.

In the January survey, significant numbers of domestic respondents reported that they had tightened their lending standards on prime, nontraditional, and subprime residential mortgages over the past three months; the remaining respondents noted that their lending standards had remained basically unchanged.

the historic proportion of the bank retrenchment is picked up on by paul krugman and the orange county register as well. commercial originations have already declined sharply in response, coming on the heels of the repricing and contraction of the commercial paper market and all non-conforming residential lending. some color is provided elsewhere in the report.

On balance, the responses indicate that large majorities of domestic and foreign banks expect a deterioration in loan quality in 2008. Regarding loans to businesses, between about 75 percent and 85 percent of domestic and foreign banks expect a deterioration in the quality of their (business) and commercial real estate loan portfolios. About 15 percent of domestic and 20 percent of foreign respondents expect a substantial deterioration in the quality of their commercial real estate portfolios. Concerning residential real estate loans, between about 70 percent and 80 percent of domestic respondents expect the quality of their prime, nontraditional, and subprime residential mortgage loans, as well as of their revolving home equity loans, to deteriorate in 2008. Finally, about 70 percent of domestic respondents expect a deterioration in the quality of both credit card and other consumer loans.

that is, deterioration isn't really widely anticipated yet by banks in CRE lending -- but standards are flying up and originations are crashing anyway. that's what capital hoarding looks like, and heady CRE valuations are unlikely to withstand the tempering of credit in spite of the projections of loan officers.

in any case, it's not a moment too soon for the banks and their investors and certainly too late for many to mitigate some very severe damage on both the residential and commercial lending fronts.

what remains to be seen is how far the contraction of credit has to run before surviving banks start feeling secure enough to return to domestic lending. a big part of the answer to that question will be written in china, but the american government will clearly do whatever it can to keep the debt bubble inflated for as long as possible and prevent markets from clearing efficiently. removing the incentive of the banks to aggressively write off their relevant exposures and drive weaker banks out of business could keep domestic lending crippled for years.

i suspect, however, as many do, that much of the liquidity being forced through the financial system will find its way not into underperforming and overleveraged asset classes like housing or domestic consumer loans but instead to the best recent performers with good forward prospects -- emerging markets and higher-quality domestic and multinational corporate lending. many sick american corporations have been kept alive by easy money and will now fail, but there are larger companies around which are balance sheet trim and in fighting shape, ready to capitalize on foreign market profitability even as domestic volumes decline -- and they probably present the banks' best hopes at generating much-needed income with new lending.

back in the states, though, that reorientation has the potential to encourage deflationary bleeding for years to come as housing valuations wither back to the mean or below, credit remains hard to get, and consumers begin to try to reduce debt loads. it may not mean the bubble economy endgame straightaway in global terms, but the american malaise is likely to become a common topic. for all their sound and fury, the federal reserve seems poorly equipped to counter systemic banking insolvency -- and the likelihood of a treasury-underwritten recapitalization of banks in an election year would seem to me to be nearly nil. as banks batten down the hatches heading into a difficult cycle, further deflation would seem to be the watchword.

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