Saturday, May 5, 2012

The Future Of Credit: The Financial Sector

The following simple chart from Richard Duncan shows everything you need to know about our economy with one picture. It shows that total credit in the American economy grew from $1 trillion in 1964 to over $50 trillion in 2007; a 50 fold increase.
Duncan recently published an entire book on this chart titled The New Depression, which is one of the best books I have read in years. It is a must read for anyone who wants to know how the decade will play out ahead.

It is crystal clear that the growth in our economy over the past 40 years was fueled directly by the borrowing binge seen in the chart above. Consumers, businesses, banks, and all levels of government created this mountain of debt.

In 2008, when the subprime mortgage crisis hit, consumers hit the wall in their ability to borrow. The American economy, over 70% of which is made up of consumption, began to contract at every level when this occurred.

While consumers, businesses, and banks have been deleveraging (paying down or defaulting on debt), the government has stepped in to fill the void. This is why the line at the top of the chart is not falling but moving sideways.

It is the equivalent of two massive forces colliding. The government is doing everything to hold the credit markets up while the natural forces of the credit markets (think gravity) are collapsing downward. How this battle unfolds will determine the entire landscape of how our future will be shaped.

If the government cannot keep the credit markets pushed up before the private sector can step back in and take the baton with credit growth we will face a deflationary depression similar to what was seen in the 1930's.

We are going to go back to the chart above many times as we move forward, but right now I want to focus on just one part of how credit grows in our country: the financial sector. People become very confused when the see the following chart showing the monetary base growth since the crisis hit in 2008:

You can see the growth in the Federal Reserve's balance sheet. The Fed grows its balance sheet by printing money and purchasing assets in the banking system. Their two assets of choice during their quantitative easing campaigns have been mortgage bonds and treasury bonds.

What happened to this cash the banking system received when these assets were purchased? It is being held in reserves. Banks had an unlimited ability to leverage their balance sheet from 1964 to 2007, and they were a major part of the $50 trillion in credit growth. When the crisis hit and the value of their assets (such as real estate) began to fall there were no reserves available to cover these losses. The Fed has been pumping them with cash for almost four straight years to try and fill this gaping hole. The following shows their growth in "excess reserves" which is a mirror image of the vertical Federal Reserve balance sheet growth seen above:

Banks only survived the crisis because accounting rules were changed allowing them to market their assets to myth. They became zombie banks.

Let's say hypothetical Bank of Charlotte made a $1 million loan to a retail strip buyer. The strip lost two tenants and is now valued at $600,000. The bank has a $400,000 loss on its balance sheet. The Fed calls the bank and tells them they want to buy $400,000 of their residential real estate loans. The bank hands the Fed the bonds and the Fed drops off the cash. At this point the bank is still alive because it has the reserves ($400,000 in cash) available to cover the $400,000 loss from the retail strip.

This process has been happening at the largest banks across the country only it has been in the trillions of dollars through QE1 and QE2 (see charts above).

How much more cash will it take for the banks to get back above water? It is impossible to tell. As the value of both residential and commercial real estate continue to fall it means that they are clawing in quicksand to try and get back to zero. Until that point they remain "zombie banks," meaning if the accounting rules were turned back on they would immediately be bankrupt.

The true value of Bank of America stock with real accounting rules and no government backstop is zero, and the CEO of the company would tell you that. What is it worth with mark to myth accounting and a government backstop? I have no idea. Therefore I am not a buyer of the stock nor would I try and sell it short. I'd rather play black jack.

These excess reserves will only have the ability to become capital for new loans when the banks feel comfortable in both the quality of assets (or people) they are lending to and a large enough capital buffer is in place to cover previous losses.

Until that point the financial sector, along with consumers and businesses, will not be in a position to become a net addition to the credit markets.

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