Nov. 2, 2009 (Erwan Mahe) In a modern economy, credit availability, both in terms of quantity and costs, is a major component in any analysis of future growth potential.
The death of securitisation had earlier choked off the credit flow to the real economy, since it deprived banks of their ability to easily refinance loans by packaging them as bonds, which ended up being sold to investors throughout the world. These packages involved loans to consumers (Credit Card, Mortgages, Student Loans), to businesses (CMBS) and to LBO funds (CLO).
With investors having deserted these products a long time ago, given a lack of confidence in what they viewed as overly complacent (to put it mildly) rating agencies, all these credits remain in bank balance sheets at a time when they are trying to improve their capital ratios, thus, pushing them to either launch a succession of capital increases or to reduce outstanding loan volumes.
Given the painful consequences of rights issues, as illustrated by the behaviour of equities suspected of being on the verge of launching such operations (ING, RBS, Lloyds), the only thing left for banks wishing to strengthen their balance sheets is to reduce their loan exposure, regardless of the admonitions of politicians and central bank officials, who demand that they lend to the economy in exchange for the heavy funding they received at the height of the financial crisis.
This is true for European banks who, according to Mr Weber, will not be able to count much longer on the ECB’s long-term financing (LTRO), but also for certain American banks, who fear a second wave of commercial real estate loan defaults when they can no longer reasonably hope to raise capital through IPOs, given that uncertainty relating to the State’s role in their management scares off potential investors.
For all these reasons, we have attributed a high probability to a debt deflation scenario. While we know some readers may be tired of hearing about this issue, the mechanism of this process is relentless, despite the strong measures taken by central banks, and we see no escape from it in the near future.
And that is leaving aside the shrinkage in the demand for credit, with those most in need of a loan turned down by banks and the most credit-worthy refusing to increase their debt load when real interest rates are still too high in comparison with their potential investment projects.
The only two exceptions to this phenomenon remain:
- · Carry Trade against the dollar, which financial investors carry out by borrowing the American currency and selling it immediately so as to buy any risky asset elsewhere in the world. Betting on the dollar’s depreciation (thus, a negative financing rate) and the (direct or indirect) support provided assets by QE programmes, these highly profitable transactions since the beginning of the year remain exposed to a dollar rebound, once such positions become overcrowded, which would lead to flood of sales of thusly financed assets.
- · The Chinese credit wave: Domestic banks have no choice but to obey government orders to open the lending spigot, and borrowers could not care less about project profitability, which explains the explosion of industrial overcapacities in certain fields (steel, aluminium, cement, etc.). This situation is beginning to worry officials, but it remains to be seen whether or not they will be able to remedy it. In the meantime, these investments in industrial overcapacities explain why we continue to characterise Chinese production facilities as a "planetary deflationist black hole”, unlike certain monetarists who base their analysis solely on changes in monetary aggregates.
Aside from these two very particular cases, the picture in the West remains dark. I would like to take this opportunity to link certain points between these lines, including the economic outlook which I believe is laden with major risks.
As such, CIT’s bankruptcy filing this weekend by, which, although expected in past days, will have serious consequences on the fabric of American SMBs.
Founded in 1908, the leading American lender to this economic sector is the fifth largest bankruptcy in asset size in the history of the United States ($71bn in assets). It granted $84bn in loans during 2007, and a mere $4bn in the first six months of 2009.
Even if this bank comes out of Chapter 11 in the next month, which appears unlikely despite management’s hopes, it is hard to imagine it returning to the sort of market share it held in 2007. As such, retailers and wholesalers in the United States will have to turn to the major lending networks to finance their inventories and sales.
Based on the available information about the desire of these banks to pick up the slack left by CIT, we are more than a little doubtful about the transfer of this business activity.
As such, we are now observing an unprecedented contraction in the credit card offering to consumers.
According to a study published by Mintel Comperemedia, offers of credit cards to US households fell by 71% on an annual basis in the last quarter and by 85% from the peaks of 2005/2006!
Beyond the quantitative contraction, this tightening of credit is also qualitative, since interest rates are up sharply, from 11.43% to 12.53% on a sequential basis, although the base rates have not changed. Some Citigroup cards were charging up to 29.99% in October! Offers of fixed-rate credit cards with overdraft rights now represent no more than 6% of the total.
And, just by chance, SMBs will be the most affected part of the economy by this evaporation of the consumer credit offering: They do not benefit from the same infrastructure as the major multinational firms which offer their clients direct financing!
Given that SMBs have traditionally been the most ready to re-hire as the economy comes out of a recession, thus helping to bring down the unemployment rate, the present situation does not really inspire confidence in the sustainability of the economic rebound, predicted by the proponents of a V-shape recovery.
And the 9 new bank bankruptcies this weekend in the US, bringing the number since the beginning of the year to 115, also point in the wrong direction.
Just a point on Japan, given current rumours of sovereign default, based on the unbearable ratio of government debt to GDP at 220% and the collapse of the household savings rate from 15% in 1990 to 2% today.
On the contrary, this illustrates just how dangerous the deflationist trap is!
Some are applauding that labour cash earnings, published this morning, are only down by an annual -1.6% in September, beating expectations of -2.1%, and that, given the decline in prices observed for the period, these earnings are up +0.9% in real terms.
Unfortunately, this is the 16th consecutive annual decline in nominal terms, which doesn’t leave workers much to celebrate about.
But it is above all the phenomenon of debt deflation that really stands out, the main problem being that, while government debt is being financed at very low interest rates (0.65% on five years), its revenues (and tax receipts) continue to contract (-27% since the beginning of the crisis, with the GDP down -9%), leaving public finances in the grips of a devastating scissors effect.
And one of the only ways out for an export-driven economy, indebted exclusively in its own currency, to pull out of such a quandary is to depreciate its currency in order to increase its revenues and tax receipts.
The current changes in the dollar-yen parity (-27% since 2007) and thus in that of the yuan-yen hardly help matters …
We no longer have advised positions on Bund options, being a bit twitched by our directional bias (decline in long-term rates) and our feeling that implied interest rate option volatility does not reflect the extent of current uncertainties, especially for a week particularly rich in publications, with the RBA tomorrow (+0.25 bp?), the FED (change in language expected by some, which I view as unlikely), the ECB, ISM, Factory Orders and unemployment in the US, among other goodies!
On option indices, the advised hedging strategies are behaving pretty well, with delta negative declining quickly and being replaced by substantial long theta.