Peak Credit & What That May Mean

Posted by urbandigs

Mon Aug 4th, 2008 12:46 PM

A: Peak credit, sounds like I hit my limit on my credit cards! I guess its kind of true. For owners of home equity lines of credit, you may have noticed a decrease in your available credit line recently. Why is that? Because credit has peaked, and is now contracting! As banks work to repair their toxic balance sheets, capital must be raised and cash hoarded; that means less lending for us consumers. Peak credit, the idea that our system of borrow now & pay later has reached its pinnacle, is a scary notion. So lets figure out just how out of whack we actually went, before discussing what credit deflation may bring in our future.

Yves Smith, of NakedCapitalism, was one of the panelists with me on the Inman Bull vs Bear debate a few weeks ago. I recall her mention of total credit debt as a percentage of GDP, but didn't really think much about it until I got back from San Francisco. Looking back at the video of the debate, Yves stated on the panel:

(5:56 into the video) - "...right now we got a level of debt to GDP which is OUT of proportion, way out of proportion, right now debt to GDP is 350%...never been that high, the highest it was at the depth of the depression was 260%, and its only went above that level since basically 2000, we had a parabolic increase in debt to GDP, but this is at a level that is just not sustainable in the long term, so the question is...what's going to make this break?"
Interesting stuff. Below is a chart (courtesy of Austrianenginomics.com) that visually shows you what our total credit market debt is as a percentage of our GDP. Look closely and you will realize something very interesting when comparing the two spikes (the first starting after the Great Depression & the second from the past few decades as our economy was driven by debt & credit):
The use of debt in the 1930s was a direct response to the Great Depression! We used debt to get us out of the depression. Recently, we used debt for an entirely different reason: TO SUSTAIN ECONOMIC GROWTH! My two questions are, who are we going to borrow from this time to get out of this mess + how are we going to service our current levels of debt?
total-credit-debt-percentage-gdp.jpg

Yea, thats right. That huge runup that you are looking at above is the amount of debt that we have taken on to fund our growth for the past few decades. This is giving the term 'peak credit' a whole new meaning isn't it!

When you hear Mish discuss peak credit and credit deflation, now you know what he is talking about:
Peak credit has been reached. That final wave of consumer recklessness created the exact conditions required for its own destruction. The housing bubble orgy was the last hurrah. It is not coming back and there will be no bigger bubble to replace it. Consumers and banks have both been burnt, and attitudes have changed.

Some choose to call what is happening "credit deflation". In this regard "credit" is an unnecessary label. Deflation is about the contraction in money supply and credit. The conditions now are very similar to what happened in 1929. The primary difference is that prices of many goods and services (notably energy and food) have been rising.
So where does this leave us? Unfortunately, we are far from finding out as we are only in the beginning phases of credit deflation and credit destruction. The system that has drained every ounce of umph from available credit, is in fact, broken. That is why you are not seeing lending rates fall with the 325 basis points of fed easing seen thus far, and instead, seeing tightening lending standards implemented. It's a new world of tighter credit and higher costs of credit. For now, we still need to let the process unwind, delever, re-price risk, or whatever you want to call it.

That is what worries me. How bright is our economic future when the credit system is deflating, the cost of credit is rising, and we already took on huge loads of debt? Lets face it, we have been a society built on credit, and now:

a) credit is contracting
b) the cost of debt is rising

Unfortunately, I wonder how much more debt we can afford to take on for future stimulus and to bail out troubled institutions that are too intertwined to our financial system to allow to fail. On the consumer side, credit is not being dispersed the way you would hope; those that need credit, can't get it, while those that don't need it continue to get new offers via snail mail. Looking ahead, I see three endings to this story:

1) we continue to service the debt as rates rise
2) we pay off the debt
3) we default on the debt

Its hard to imagine the US defaulting on our debts, but its also hard to imagine that Fannie Mae and Freddie Mac may be nationalized by this time next year! The key element here are the foreigners holding massive amounts of dollar based assets; our debt. I would expect the bond market to be hit at some point, as treasury prices fall and yields surge; especially if foreigners slow down purchases of our debt or decide to dump some of their holdings in. The next big bubble to burst could very well be the bond market resulting in double digit treasury yields. This is not a new argument, but to me, is probably closer than some people would like to admit.

Back to peak credit, I think we have seen it. How we adapt is anyone's guess. One thing is for sure, is that the credit platform that we have gotten used to for the past few decades, has vastly changed, and psychology with it. There comes a time when we will have to pay off our debts, and like with our pesky credit card bills, paying off debt is no where near as fun as spending it!

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