The Fed is Causing a Continuing Credit Crunch

There can be no real recovery without the private sector, and credit is collapsing for consumers and business. These two charts show the businesses are not able to borrow and consumers are not able to get credit. On the consumer side, overall credit is declining at 5%/yr and revolving credit (credit cards) is declining even faster at 8%.  Business loans are down 12% yearly, and in the last three months a frightening drop of 19% annualized for total loans and a 28% annualized in commercial loans. This means the credit crunch is accelerating. 

One of my investments is living this nightmare. Their sales will triple this year in a bad market for retail products, but they have a difficult time getting a line of credit even when backed by real assets - receivables - and have to pay an effective rate of 15%. 

The public looks at the extremely low Treasury interest rates & deposit interest rates, and presumes that businesses can borrow close to them. Instead, normal everyday commercial credit is run up to usurious levels. And almost everyone knows someone who has faced seemingly rapid and arbitrary increases in credit card rates to a stunning 28%. New accounting rules which are supposed to enhance transparency may make consumer credit even harder to get. 

The reason for the worsening crisis is the way the Fed has handled the situation, as described the Run on the Dollar post: by burying the toxic debt inside the Fed, they have postponed the day of reckoning for the banks but have not cured it. 

You can see in the chart how much the Fed has buried, inside their Maiden Lane vehicle and using the TALF program. Total bank reserves have hit an all time high.A huge chunk of it (70%) are "non borrowed reserves" which as best as I can figure from the Fed's gobbleygook are the reserves burined int he Fed. They are not being used for active lending. 

This postponement has consequence. The banks have apparently taken their reprieve and used it to speculate in bonds and equities - the current Obama Hope Rally. Yet they are still tightening credit and pulling back on lending because the buried reserves lock up lending capacity. After all, at some point the Fed will swap them back! And then the banks will have a much harder time avoiding insolvency, since these assets will have to be marked down due to their lack of liquidity and the underlying distress of the assets lent against (primarily real estate). 

So far the Fed has postponed the necessary write-downs of the first phase of the crisis - primarily subprime and alt A mortgages to people of questionable credit who have since defaulted at very high rates. 

In the next two years the second phase will hit: optionARMs, HELOCs (home equity lines of credit) and commercial REITS, mortgages to borrowers of decent credit. The optionARMs and HELOCs are destined to reset to much higher rates. They were typically designed as a five-year balloon, with the expectation that they would get refinanced within that period. Since real estate values have dropped, this is now a fantasy, since many of these homes are underwater - the mortgage is more than the equity value. 

The expectation of course had been for continuing appreciation. HELOCs in particular are distressing, since they were taken out by people of good credit as second or sometimes third mortgages with every intent and capability of covering the payments and repaying the loans. Yet all around them the subprime and no-money-down mortgages drove up the price of housing, both inflating the size of the optionARMs and seducing homeowners into HELOCs. 

In effect we began using our homes as ATM machines, withdrawing to buy SUVs, HDTVs and vacation property. The MEWs or mortgage equity withdrawals drove the rising GDP during the Greenspan Bubble. This chart shows how different GDP would have looked without MEWs. 

The chart below it shows how the home ATM has run dry. 

With MEWs we borrowed beyond our means and spent it on stuff that pulled in future GDP to the present, meaning GDP that would have happened anyway after we earned more to afford it was pulled forward by a debt binge. Just as the mortgages that funded the MEWs have to be repaid or written off, the unearned GDP will have to be given back in the form of lower GDP or actual drops in GDP over the next five years. 

The piper has to be paid. 

This is what makes this situation so different from a normal recession. Normally when we get ahead of ourselves we have borrowed too much but did it against earnings power (or expected future earnings). In this case we borrowed too much based on asset (home) appreciation, and got way ahead of earnings power. As houses fall, the mortgages get written off, and consumer credit will have to wait until our earnings again catch up. 

The debt write-offs cause deflation, and as this chart shows we have been in a deflationary period for the past year. But we have had a relatively mild deflation compared with the scale of the excess debt. That is due of course to the Fed hiding the problem. When the second wave of the crisis rolls over, the Fed will be sorely stressed to continue to hide the hot potato. 

The Fed has an inordinate fear of deflation. So did Hoover in the 1930s, and his attempts to prop up wages and prices helped turn a bad recession into a long depression. 

Ironically they see the situation backwards. As the economy adjusts to excess debt and the pulling forward of GDP, debt write-downs reduce income and layoffs lower wages. With deflation, prices also drop, and less income goes a longer ways. It softens the blow.

Worse, the low interest rates devastate the return on capital. This gives capital an incentive to invest outside the US for higher returns - China? Australia? With a Dollar depreciation risk on top, it pushes investment away even faster. Deflation at least gives protection to the Dollar; but the deeper risk is as the Fed exits a round of deflation then gives way to inflation given the huge overhang of Fed liquidity created to bury the toxic debt. 

When might the chickens come home to roost? 

The second wave of mortgage problems crests in 2011, and can be postponed a bit. 

Fiscal policy in 2010, however, may create an additional set of stresses. The Bush tax cuts are set to expire, causing a huge tax increase in the face of a recession. The Stimulus will be past peak in 2010, and decreasing. The net impact will be a huge negative stimulus in 2010. This chart shows the Federal deficit in red and the change in it in grey; and the year after a stimulus it acts as a brake on the economy. 

Obama has room for a second stimulus. The deleveraging of total debt has been postponed by the Fed, but not avoided entirely. Private debt is still be written down faster than the increase in the Federal deficit. This gives room for a tax cut in 2010 to counter the expiration of the Bush cuts, and room for a second stimulus. 

We can debate the value of stimulus but it would have some short-term impact to at least ameliorate the potentially large negative stimulus next year. And maybe this time they can do a Stimulus bill that acts faster. 

The wildcard for the day of reckoning is a series of defaults come out of Europe. The mainline European banks are more over-leveraged than US banks, especially in Eastern Europe. Latvia just had a failed bond auction, and it is ratcheting Sweden. Other countries may follow. including Ireland. 

The bottom line remains: a continued if not accelerating decline in commercial and consumer credit. 

The longer the Fed tries to postpone the inevitable, the deeper the hole for the private economy to climb out of. All that is left is to try keeping the zombie banks at bay and the economy on some form of government life support until the US creditworthiness begins to seriously weaken. 

Comments

[Fed is Lousy Wizard of Oz]

The Fed can't affect social mood anymore than the Wizard of Oz could change the direction of the wind that brought his hot air balloon to the Land of Oz in the first place.

[Loompanics]

If you look at Yelnicks first two charts, all the credit lows were MAJOR buy points for stocks.

BUY buy BUY buy BUY!!!! Load em up for the long haul.....Neely's chart also confirms we're flirting major long term wave 4 lows.

[AussieRob]

Yelnick... As always, a well written commentary - if only it was a tad more positive on the future - alas one cannot alter the fact that we're headed into the next stage of the perfect storm. Maybe the O-man can sell his peace prize to raise funds to support the next stimulus bill ?

[mannfm11]

Well written. I was wondering if you were a bear or a bull, but this puts you in the bear camp. I was reading the report from the ex FNMA risk guy on FHA. Part of that report was a former report about the level of rising foreclosures in the late 1990's and what the possible reason might be. It occurred to me that worldwide deflation in some form may have begun around 1990 when it started in Japan and we didn't know it. Housing, blended with lower rates, allowed a continued counter force in the US and likely assisted in generating the cash to launch the bubble in stocks. But, due to the level of debt in the system, delinquencies and foreclosures mounted up.

In this vein, we have reached the point where good financing can no longer be effected. I sense that facts are going to completely dispell the Irving Fisher theory of debt deflation and in order to avoid such a deflation, we are choosing what could amount to total collapse. Instead of this wasteful nonsense, it would be wise for the government to close these banks and socialize the loss over a period of 10 years. I don't know if a good bank/bad bank would work, but the US population has been on a spending spree and we could stand to go a few years without being gluttons. Otherwise I sense we are headed to a total collapse of lending of any sort and a massive default on about everything.

[dacian]

Hey,

Actually this is related to you other post "Aborted run on the dollar".

"The internal debates inside the Fed to begin the exit, which would start with raising rates, is beginning to leak out."

I have a question: why the FED will ever exit? Can you explaing that? I mean they know they will make banks insolvent again? You need some serious arguments and figures here when you make such a statement; FED will keep rates to 0% for 2 years and won't swap those toxic instruments (maybe ever).

[Newbietrader]

The Fed wants a lower dollar. The Europeans want a lower dollar because it benefits the carry trade.

Some Fed peole are worried about a dollar/financial crisis and the price of gold is showing that others are worried as well.

But the dollar will continue to go down because the Europeans NEED it to go down. They are worse than us as you stated, so any increase in the dollar will cause a major melt down in Euro land.

Its all about the carry trade. The yen is being replaced/joined by the dollar. And as long as this is in effect, the markets will go UP.

[Rodney]

Many of you don't understand that the market will disappear soon, a la the Russian market in 1918. Not like the 4-day bank holiday of 1932, there are no firewalls today. It will be like trying to untangle a spider's web. This will be months or years and all the while we're hitting big waves down you won't see the numbers! You see the speeches on TV and the blood in the streets but no numbers, no exchange, no indices, no stock prices. What will finally allow the markets to open is a worthless dollar but, again, that will take years to happen but you can be sure there will be no market until it happens. So this Dow 400 or Dow 40 garbage is just that: garbage. The Dow is going down until the market becomes irrelevant and then the Dow will not exist.

Now I hope to make a few bucks on this last wave down but I will get out early, early, early. A couple of "circuit breaker" market lock-outs and--poof--that's it. Game over. Phone lines go busy. Markets close and DO NOT REOPEN. I will not get cute and smart because I need something to buy food and gas with!

[Eventhorizon]

Hey Y-Man

Very thorough analysis ... but, couple of nit-picky things:

"You can see in the chart how much the Fed has buried, inside their Maiden Lane vehicle and using the TALF program. Total bank reserves have hit an all time high.A huge chunk of it (70%) are "non borrowed reserves" which as best as I can figure from the Fed's gobbleygook are the reserves burined int he Fed. They are not being used for active lending."

What you can actually see from the chart regarding buried toxic assets, is how much progress the Fed has made rehabilitating its balance sheet. At one point, they carried about $1.6tr in toxic waste (the teal and purple bands - dubious financial instruments used as collateral for loans from the Fed to the banks) that they have successfully reduced to about $400bn - 75% reduction. They have replaced this by expanding Treasury and MBS holdings to hold their total balance sheet more-or-less constant. The issue now comes down to the quality of the $800bn of MBS they hold - but at least we know what they are - and how much further they reduce the remaining $400bn.

Non-borrowed reserves (as far as I can tell) have nothing to do with the Fed. They reserves held at the Fed by the banks that hey didn't borrow from the Fedin the first place. i.e. they are specifically NOT derived from the various emergency programs. At least that's my understanding, if I am wrong please correct me!

[Eventhorizon]

On re-reading your paragraph, I guess I have misunderstood your second use of the word "buried". I took it to be in the same pejorative sense as you used it the first time (like "hidden") where as I think you mean it in the sense of "sitting idle" / "frozen".

[yelnick]

Event, thanks for the comments. I am unsure of what the gobblygook means, so would welcome any reader's clarification. And yes you make a fine point (which I had blogged previously) - the Fed is trying to swap out of many of its rescue programs, and is using QE to repair the mix of assets back to govt backed stuff. I think a lot of complaints of QE have missed one of their motivations. Nevertheless a lot of toxic waste remains inside the Fed, and the credit crunch continues to worsen.

[Newbietrader]

something everyone has to remember is how the dow/sp500/naz whatever index youpick changes its make up regularly.

why is the dow up? cause C and GM were removed and replaced, automatic increase in the dow

sp500 will replace wyeth with FSLR soon, instant increase in SP500 index

the "market" keeps going up because crap stocks get thrown out of the indexes and replaced with ones that are moving higher.

[george]

http://safehaven.com/article-14697.htm

this is an interesting
article with charts comparing
current action to 1987.
he is predicting a crash.

[rc]

Yelnick: another excellent, thought provoking article.

george: interesting link to the ending diagonal. There are ending diagonals, rising wedges, on all the major US equity indices. Using log scaling, the Nasdaq may have broken below and has now come back up to the lower trendline. There also seems to be a symmetric pattern where the initial large move from March was echoed with a smaller move, and now, perhaps, the weakest echo.

The Nasdaq and small caps are the most stretched. Looking at a chart of AAPL as a bellwether, it's very overbought and is at multi-year resistance. It's now at highs from 2007 and 2008, and at 190, not far from its all time high at abt. 200. How many iPods, iPhones and Macs are consumers going to buy this holiday?

This market is due for at _least_ a significant correction.

[george]

http://www.traders-talk.com/mb2/index.php?act=attach&type=post&id=13444

this link has really good
technical indicator coverage
of the rising wedge pattern
in the market averages mentioned
in the safe haven link above.
many technical tools most people
don't look at.
tim ord takes a bearish stance.

[manav]

Big picture, lets not forget we are far far away from the all-time highs hit in 2007 in the US markets, in fact most global markets. And the bull camp temperature is already rising, which would worry me if I was a long term bull.

As regards the Indian markets, I sense the opposite. We are not too far from the all-time highs and yet most people here remain sceptical, which to my mind is solidly long term bullish.

[Wave Rust]

george,

Basch called for crash in april 2007

Ord has been short since the spx was at 883

both using log setting for making the chart support their view.

markets get corrections and one is coming quite soon.

but not a crash. maybe 2 months of returning to and testing the July 09 lows for a B wave.

rising wedges don't cause crashes as basch implies with his 1987 chart.

bad technical analysus is just as good as bad fundamental analysis

one or two more push ups will get you a good sell

relax, a long way to go before the ''end of the world'' crash.

this aint 1930 or 1987 or 2008

ask yourself, how fast does the market get oversold? what does it take to get traders shreaking with crash talk?

when everybody has open wounds and 3rd degree burns from the crash, a small rise in temperature feels like a scalding.

a mini crash to the july lows will "feel" like the sky is falling with hot rain.

selling this week or next, then buy when the rain stops.

wave rust

[Free]

http://safehaven.com/article-14697.htm

this is an interesting
article with charts comparing
current action to 1987.
he is predicting a crash.

--------------------------

another "crash" fanatic.. earlier there were folks calling for a significant correction citing a H&S formation.. the formation was confirmed when the neckline was broken.. but the market recovered without even reaching the target for a H&S.. then continued higher.. if price break below the rising wedge, no guarantees it will correct significantly.. let alone result in a crash.. we need more indications to call for a crash. seems like there are quite a number of folks out there recklessly calling for one..

[min]

...seems like there are quite a number of folks out there recklessly calling for one..

And that in itself ought to tell you something, right?

[rc]

The rising wedges and very overbought technicals suggest at least a significant correction is due.

At the March low, clear in retrospect of course, there were long-term technical divergences -- for example, the MACD was much higher on a weekly chart. There are some short-term divergences now, but not the same long-term ones.

So, perhaps a correction of the March rally followed by a push to new highs (Dow 10 - 12K?) while setting up the divergences signalling the resumption of the bear -- the primary 3rd down. Just a guess at a scenario... which is all we can do.

[Correction long overdue]

I see a long overdue correction coming of up to 5%. We have been on a pretty strong rise close to 50% since march, so I think we will be getting a cold shower soon. Seatbelts on, people.

[Correction long overdue]

Actually, just checked yahoo finance and found out that s and p 500 is up 61% from the March low.

That's a 61% rise in just seven months! So the correction might be a little sharper, say 7-8%.

So seatbelts on snugly please.

[Correction long overdue]

Incidentally, gold is most surely not up 61% in that time period. So I think that hurts the argument that the stock market is up because of inflation.

[yelnick]

Dacian, the Fed has already been quietly exiting, using QE to improve the quality of its assets and reducing its holdings of toxic assets. It was easier to do in a poor (downward) economy than a recovery. Part of its issue now is does it believe this really is a V shaped recovery, as the punditry is all saying this morning (Monday). It is worried a continued exit would lead to inflation. I think the debate is around an option to begin raising rates to try to thread a needle - slow down the V while continuing to exit. But could that turn a V into a W? In the end the Fed appears to be using obfuscation as a way to try to exit.

[Joseph Martin]

The credit crunch is going to be hard for many people. Along with increasing prices there is also the possibility of losing your job and not being able to pay utility bills or a mortgage. In these times of financial hardship and general monetary belt tightening, many people look around to find sources of extra income. Reduce your costs and raise your income - this is the simple sounding answer to the credit crunch problem.

[min]

or have ourselves a little revolution if there are not enough jobs to be had?

[LoneStarHag]

Rodney said:
"Many of you don't understand that the market will disappear soon, a la the Russian market in 1918. Not like the 4-day bank holiday of 1932, there are no firewalls today. It will be like trying to untangle a spider's web. This will be months or years and all the while we're hitting big waves down you won't see the numbers! You see the speeches on TV and the blood in the streets but no numbers, no exchange, no indices, no stock prices. What will finally allow the markets to open is a worthless dollar but, again, that will take years to happen but you can be sure there will be no market until it happens. So this Dow 400 or Dow 40 garbage is just that: garbage. The Dow is going down until the market becomes irrelevant and then the Dow will not exist.

Now I hope to make a few bucks on this last wave down but I will get out early, early, early. A couple of "circuit breaker" market lock-outs and--poof--that's it. Game over. Phone lines go busy. Markets close and DO NOT REOPEN. I will not get cute and smart because I need something to buy food and gas with!"

Rodney, just how are you going to buy that food and gas under the scenario you are describing? Do you expect to find the gas pumps working down at the local 7-11, or even find someone at work there? Even if someone is on duty, do you think he or she will accept your lame Krugerrand for a carton of milk or a tank of gas?

Doomsday types who think they have everything figured out and think they will survive financial Armageddon don't really think ahead very far. You might survive for a while in your cave with your guns and gold and bottled water and canned beans, but at some point you will exit your cave and discover circumstances you had not anticipated.

Hag