What? A Credit Squeeze?
Jude Wanniski
February 27, 2002


Suddenly, the word is "credit-crisis." The Federal Reserve cut interest rates 11 times in 2001 and Chairman Alan Greenspan is assuring the Congress today that he has no immediate intention of raising rates. The economy may be recovering, but maybe it will be slow, or maybe it will not grow fast enough to use available resources. In its semi-annual report, the Fed cannot make up its mind. Today’s Wall Street Journal warns: "Tighter Credit May Stifle Capital-Spending Revival." Hello? Yesterday we had a report of consumer confidence falling sharply, to 94.1 in February from 97.8 a month earlier, and today we have producers needing working capital but unable to find banks willing to lend. Sure, General Motors skimmed a quick $3 billion off the top of the credit market Tuesday, after first trumpeting projections that the less-confident consumers will be buying more autos this year than had been expected. Says the WSJ: "Many small- and medium-sized firms complain that banks have tightened the screws on credit availability, and in the capital markets, Enron`s collapse and accounting worries have put a floor under borrowing costs for less than top-quality companies. These trends could damp companies` efforts to revive capital spending."

A year ago, trying to explain the slow grind of the monetary deflation to Treasury Secretary Paul O`Neill, I told him the economy was like a skinny kid being fed tax cuts and interest rate cuts and growing bigger as a result, but he was bursting out of his monetary suit. That is the squeeze we are in. A reporter asked me yesterday about the credit squeeze he had been hearing about and I e-mailed him this, rather than trust his note-taking: "The Fed cannot solve the liquidity problem by lowering interest rates. I warned the Bush people early in 2001 that cutting interest rates will not work. We have been in a monetary deflation which can only be resolved by inflating until the dollar gold price reaches the $325-350 level and stabilizing there. Or the economy has to squeeze into the monetary suit of clothes represented by $290 gold, where we are now. Gold is just a signal of inflation/deflation. The liquidity `crunch` is the squeezing process, which is accompanied by bankruptcies and falling wages and prices. The President can fix the problem with an executive order and the cooperation of the Fed."

Here is the assessment I got from our Christopher Ecclestone, who has been pondering all this while working on a Poly sector report on the regional banks:

Several forces are at play. The positive side has low interest rates and low demand for funds for invstment from mainstream companies (although that is reflection of another malaise). This should theoretically allow more needy cases to get to the front of the line for capital. But they are blocked by other over-riding forces at play.

First, tainted sectors are effectively called lepers at this point. These include telcos, lodging, airlines, tech hardware manufacturers and merchant generators. AES, one of the country’s leading generators, has publicly announced that it will renounce going to the capital markets. That makes others rattling their begging bowls look even more distressed. The response in this sector has been a swathe of fire-sale disposals of whatever is not nailed down, (e.g. foreign assets in Europe, Latin America and Australasia). Unable to move some of these assets, groups are now trying to offload core U.S. assets to raise funds. Why should this be? Some sectors are certainly terminal (e.g. broadband end of telcos and some of their suppliers). Rising consumer debt has really made the consumer king. Banks love shoveling it that way particularly if they can get a mortgage refinancing as security. Meanwhile, some sectors currently not tainted are raising money as fast as they can in case their turn is next. Some dubious areas that can still do fundings, but that may not always be so lucky, are retailers, automakers and investment banks.

Banks seem to be finding that deposit growth is slow and so lending is pretty flat (this is a preliminary finding). S&Ls have been doing a roaring trade in FY01 turning credit card debt into second mortgages. Beyond the actual loans we have some other trends. This is in the highest tier of banks (what is left of the money center banks and the super-regionals). We note the big defaults that JP Morgan Chase, Citibank and BoA have hit with. However, another dynamic is at work. The crisis in the various sectors mentioned has resulted in big drawdowns of credit lines that were never intended to be tapped. This has chronic patients draining money out of the banking system. Moreover, some of the old tricks (revealed by insurers post-Enron) of faking loans as commodity trades and hedging them using surety bonds have now been exposed. Insurers will not be covering this type of trade again. Word has it that one of the big banks faces up to a 30% loss of the business it does covered by derivatives if its credit rating moves down a notch.

The Enron debacle has removed capacity in energy trading and now its side effects are liable to affect the whole of the derivative business by big banks, which has allowed them to leverage their balance sheets in recent years. Such is the slimming down of credit markets that it is almost like a fat person that has had the infamous stomach stapling. The ribs are starting to show through the flaps of loose skin. Where is this going? Financial risk-taking has to tighten up. The broadband debacle makes clear that far too much capacity was built and most of it on borrowed money. There was a stunning lack of broader perspective in thinking that 20 major players were worth lending to when the number has been whittled to maybe five a few years later. Credit lines will be more sparingly given and the old adage that the only party worth lending to is the customer who does not need the money will become a maxim again (until it is forgotten by a new generation of bankers).

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A reading of Greenspan`s testimony today along with the Fed report itself offers little cause for celebration. No sooner had Bloomberg announced that Wall Street was rallying on the chairman`s remarks than its more sober message was digested into a flatulent decline. The 15% decline in new home sales in January did not help a bit, and the widening buzz about credit tightening as the word travels the banking circuit does not help either. If the recovery won`t come on the demand side or the supply side, where does it come from?  There is enough nervousness in the White House for a report of a decline in confidence in Larry Lindsey, the President`s chief economic advisor, and in Secretary O`Neill as well. O`Neill gave a nice little talk the other day on tax simplification, but it is irrelevant at this juncture. As if Vice President Dick Cheney does not have enough to do, he is being asked to take a look at the economy with his team. The thought occurs of N.Y. Met`s manager Casey Stengel years ago watching his players bobble the ball, wild pitch and strike out: "Doesn`t anybody here know how to play this game?"