July 2008

I found Kevin Depew’s 5 Things article from Monday (at Minyanville) to have an excellent summation of what a credit crunch is, and why it is important. Here are several excerpts that can act as a primer to anyone wondering what is going on…

1. What is a “Credit Crunch”?

The simple answer is that a “credit crunch” is a general decline in the the supply of, and demand for, credit.

[A] “credit crunch” occurs when banks become more risk averse – less willing to lend – even though interest rates may remain the same, and in extreme cases, even though interest rates may go lower.

2. Why does credit growth matter in the first place?

Because in our [economic] system, economic growth is dependent upon credit expansion.

As long as credit expansion and demand for credit continues at an accelerating pace, the appearance of prosperity continues as asset prices increase. The “accelerating pace” aspect is critical. It is the key to maintaining the boom.

As Michael Darda, chief economist for MKM Partners told the Times today, ?Access to capital and credit is essential to growth. If that access is restrained or blocked, the economic system takes a hit.?

3. What do we mean by “credit expansion,” anyway?

[For almost 20 years, banks lent money] at artificially low interest rates and, later, to borrowers with increasingly low credit quality. By offering willing borrowers money at artificially low rates, this encouraged [taking on more risk and] risk tolerances were widened.

This is how debt was pyramided to such an extent that one small setback, in subprime borrowing for example, resulted in such a widespread problem, problems which quickly spread to other, supposedly safe credit risks.

By offering willing borrowers money at artificially low rates, this encouraged increased time preferences among economic actors, which is to say that investment horizons were lengthened and risk tolerances were widened. This money was then overinvested and misallocated by investors in dot.com ventures and houses.

4. How, then, did we transition from credit expansion to a “Credit Crunch”?

This loss of capital creates risk aversion; lenders suddenly find they are not being repaid, say, by subprime borrowers who are defaulting on their mortgages. These lenders in turn – remember this is a fractional banking system – find that because they used the repayment of these loans as collateral for loans they took out to “malinvest,” suddenly discover they are unable to repay some of their debts. The lender’s lender is in the same boat, as is the lender’s lender’s lender.

So, what do these lenders do? They “de-lever.” In other words, they sell whatever they can – whatever is still liquid (say, U.S. stocks, for example) in order to raise capital to repay loans.

Lenders in many cases cannot, or are no longer willing to, extend credit … for they fear not being repaid.

I have heavily excerpted/edited the original article for content and clarity… see the original if you want it all in the author’s original context.

Additionally, I left off #5, which attempts to answer the question of “What Next?” Depew has a very interesting answer that is very optimistic in its pessimism… Quite entertaining.

Too amusing not to share… found on Minyanville.



Making the rounds…? Still President Bush says Wall Street “got drunk” and “has a hangover”.

The comic is from McClatchey.

On the lighter side… Just found, and thought it was interesting enough to share…? Stock Twits.? Just in case you want an even more spastic view of the markets…? but it might be useful to watch the rumor flow or day-trading junkies.

Also useful is BreakingNewsOn which attempts to identify breaking news.? There are a few news stories, including the passing of Tim Russert, that have supposedly popped up on Twitter well before any mainstream media.

Apparently T. Boone Pickens wants to solve our energy dependence issues…? and he thinks Wind is a good way to do it.? At right is an image of the wind potential of the world, including the “wind corridor” of the midwest.

Go to PickensPlan.org for more details of his plan.? Of course Pickens is a private investor and has put his own money into building wind farms, but the whole effort seems remniscient of Al Gore’s global warming campaign…? perhaps Pickens is thinking about his legacy as well as profits?

If you believe wind is a growth industry (which it will be if Pickens is right), you should know about a new ETF with the ticker FAN.? It’s only been trading for two weeks, but plans to track the growth in wind power by investing in ~50 companies active in wind.

It’s worth doing a quick review of personal finance tools…? while it’s fun to talk about the macro-economy, sometimes we just need to make sure our own little micro-corner of our personal finances are under control too.? The established players in the space are our old Quicken and MS Money:

I personally have a love/hate relationship with Quicken.? It is some of the worst software I’ve used, especially with the 2008 version.? It’s so bad that I would have stopped using it if it weren’t so darn useful.? A while back, I went looking for alternatives to Quicken or Money…

The main drawback to almost all of these is that they are online/website solutions.? Can I trust my personal finances to some company’s website?? Beyond the usual paranoia of trusting other people, some of the marketing material leaves me a little curious how serious their security really is.

Anyone tried these out and have some feedback or suggestions?

Sorry to keep bringing pessimism to the forum, but that’s just what stands out for me as I absorb news and such.? There’s a future post in what I perceive to be a large asymmetry in naive perspectives amongst the bullish lot.? Anyway, on to a quote from Paul Volker via Marc Fleury‘s blog:

Simply stated, the bright new financial system ? for all its talented participants, for all its rich rewards ? has failed the test of the market place.? Paul Volcker, April 8 2008

What’s the fallout?? Why is it not just about write downs and losses?? The current financial situation have not only caused losses, but they’ve also taken away the most profitable business for most banks and brokers.? From Nouriel Roubini (emphasis mine):

So how will mortgage brokers, banks, broker dealers, monoline insurers, rating agencies generate revenues and profits now that this slice & dice scheme has unraveled? The current market delusion that the worst is behind us for financial institutions is based on the view that most of the writedowns of the toxic assets have already been done. But this is not just a balance sheet problem. Now financial institutions have a more severe P&L problem, i.e. how to generate income and earnings from now on when they cannot originate junk any more. The entire income generating model of financial institutions ? make income out of securitization fees rather than by holding the credit risk – is broken now that the generalized credit bubble (not just subprime mortgages) has burst; thus, how will these financial institutions generate earnings over time? Capital losses are one-time problems; but destruction of the income generation process is a more severe and persistent problem that will require banks and other financial institutions to rethink their overall business model of credit risk transfer.

I know Quicksilver will respond with some comment about how Roubini is always bearish, but Nouriel also happens to have hit on an important point here.? Where will the income generation come from for banks?? If the Fed and Treasury really are trying to give the banks time to grow their way out of the current mess, where will that growth come from?

This is a little old (June 2, 2008), but worth sharing…? John Hussman reviewed the FDIC Quarterly Banking profile…? here’s what he found.

?Industry earnings for the fourth quarter of 2007 were previously reported as $5.8 billion, but sizable restatements by a few institutions caused fourth quarter net income to decline to $646 million.?

Note what the FDIC is saying here. The banking industry reported $5.8 billion in earnings to its investors, but restatements took that total down by 89%. Stop and think about that – only 11% of the earnings that were reported to investors survived after the restatements. And yet, investors seem naively willing to take recent earnings reports, guidance and charge-off levels at face value, as if these reports can be trusted. Unfortunately, all that seems to matter to investors over the short-run is whether earnings-per-share can beat estimates by a penny, regardless of whether they are massively restated later.

Quite an indictment…? and the whole article is worth reading if you want to understand the state of banks today, and why they’re still not as cheap as one might think.

The FDIC shut down IndyMac over the weekend, and I read the following quote in the International Herald Tribune:

The bank is scheduled to reopen Monday as IndyMac Federal Bank, FSB, under the oversight of the?FDIC.

The FDIC estimates its takeover of IndyMac will cost between $4 billion and $8?billion.

I was wondering, where does that $4 to $8 billion come from?? Here’s an explanation from the internets:

Where does the FDIC get its money?
From assessments on insured banks, and interest on U.S. Government securities it holds.

How much do the insured banks pay the FDIC?
Insured banks pay annually a gross assessment of one-twelfth of 1 percent of their total deposits.

What direct commitment does the Treasury have to the FDIC?
The 1947 amendments to the Federal Deposit Insurance Corporation Act provide that the FDIC can borrow up to $3 billion from the U.S. Treasury at its discretion. The law directs the Secretary of the Treasury to put up this $3 billion any time the FDIC wants it.

NOTE: The website/book is from 1962, so the details may have changed since then (it references a $10,000 insured amount, which has obviously changed).

IndyMac had about $20 billion in deposits earlier in the year…? which means their annual assessment would have been around $17 million dollars…

Just like the PBGC, it may be self funded, but as soon as demand for coverage overwhelms that self-funding, it is ultimately the tax payers that are on the hook.

Next Page »