Tentacles of The Credit Beast III

Posted by jeff

Tue Mar 10th, 2009 09:14 AM

tentacles1.jpgThis financial crisis has been like an AIDs virus attacking the machinery that usually protects the system. That machinery is the creation of credit. It is being attacked the way acquired immune deficiency syndrome attacks the body's defenses by using the immune system itself to hide and multiply. When you think further about the analogy, one is an amazing piece of viral evolution and the other is an amazing piece of market evolution. Both lay bare weaknesses in the systems they have infected. The former crisis was only forestalled by instituting safer practices and the same will be the case for this one. Let's hope the patient can survive long enough for the safe practices to be instituted. One wrinkle with the financial crisis is that safe practices when instituted all at the same time can make the crisis worse rather than better.

To wit, in this morning's Wall Street Journal, Meredith Whitney, of Oppenheimer banking analysis fame, and now proprietor of an eponymous consulting firm, writes that credit card debt is the next credit crunch. You can find the gist of her piece here. Whitney's contention is that credit card companies are pulling back from lending all at once and are in fact threatening the availability of consumer credit even to those who deserve it. The credit card companies have found that their tried and true FICO scores failed them, when highly rated borrowers got underwater on their mortgages. They are therefore now limiting credit in hard hit zip codes. Whitney's contention is that revolving credit is used as a cash flow management tool, citing the statistic that 90% of credit-card users revolve a balance at least once a year and over 45% of credit card users revolve every month (I am amazed that the second number is that high). I would argue that for 45% it's not a cash flow management tool, but rather a way of maintaining higher consumption through a larger balance sheet for some period of time. As I have discussed previously on Urban Digs in my piece Regulator Revenge: There's a New Sheriff in Town, after the crimes have all been committed regulators wake up and put strong deterrents in place, that usually cause the collapse of the bubble which incited the fraudulent activity to be even worse. The same apparently goes for unfair lending, where according to Whitney, new provisions of the Unfair and Deceptive Acts or Practices (UDAP) regulations, which would restrict credit card providers ability to raise rates on customers, will likely result in no credit being offered at all.

Whitney makes a good point here about not having the medicine kill the patient. In keeping with this, up and down the economy we have seen officials tread lightly on things like allowing banks to stay open, despite severe losses, as they recognize that causing a panic on top of a crisis is self-defeating. However, moral hazards seem to be running very high and my personal feeling is that tacitly saying to 45% of the population that it's okay to carry revolving debt all year long, is a bad practice. Furthermore we need to all recognize that this unsustainable behavior, won't be sustained long-term no matter how many dollars are printed by Uncle Sam. The Deleveraging Will Be Televised. What do Urban Dig's readers think? It will be a delicate balance to not choke off the economy, by limiting credit, while trying to reform the unsustainable practices that got us here. Going back to 2006 ain't gonna happen, neither should it.

We need a lot more transparency in order to understand how to carry out the delicate work of fixing what is broken, without making matters worse. We still don't seem to be getting it. The Federal Home Loan Bank of Seattle has apparently failed to meet certain regulatory capital ratios at month's end due to writedowns on mortgage backed securities (MBS). I have highlited the risks to the Federal Home Loan Banking system before, but it does not seem like any significant steps are going to be taken by regulators at the present time. Interestingly, the Seattle Home Loan Bank took a $304.2 million write-down on the MBS paper, but said it only expects to have an actual loss of $12 million over the life of the loans. Yet the accounting language trigger for the write-down is if the drop in value is deemed "other than temporary". Come on guys let's get it straight, this paper is either going to go bad or it's not, pick one and conduct yourselves accordingly. This needs to happen up and down the system and hopefully the banking stress tests will give the markets some confidence here. Although I'm not sure I want to wager on that with how it has been handled to date.

Apparently however, another over-leveraged and likely under-regulated part of the system is coming under increased pressure as the tide of leverage goes out. There is no turning this tide, people are not dumb and if they didn't know before, they know now that they shouldn't depend on their bonuses to maintain their basic standard of living, that they shouldn't carry outrageous revolving debt to boost their living standard and speculation on housing prices is an easy way to go bankrupt. The economy must and will shrink to meet this lower level of leverage and activity. Only from that new equilibrium level can we move forward. In the meantime, I agree that the government must keep the patient on life support, but let's not encourage any new risky behavior.

For New York city residential real estate, the question is: Despite working in the notoriously cyclical business that is Wall Street and being ingrained in risk management culture, how many of our brethren engaged in the risky behaviors cited above? If many did, the risk to all will be greater. What are your thoughts?

Add a comment

18 comments

CAPTCHA Image