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'Cold Turkey' for Lenders

In this snip from Doug Noland's column (The Credit Bubble Bulletin, October 6, 2000) at David Tice's site, Prudent Bear (http://www.prudentbear.com/credit.htm), we see the result of credit risk to lenders described. Noland is here outlining the result to lenders when loan defaults rise. In his view the current problem is structural, not cyclical, and he presents some good arguments to suggest that we are now near the end of our tether.

"It is critical to recognize that the unfolding financial and economic crisis made a decisive move forward this week. Today, in particular, came the market's first recognition of the acute vulnerability for the entire financial sector to unfolding events. I am surprised that it has taken this long. But, as is often the case, these types of situations take much longer to develop than one would expect. But when they do "take hold," they then tend to unfold with ferocious rapidity. Right now, this is developing similar to 1998. In the Spring of that year problems began to fester in the market for Russian debt instruments. And while this development garnered little attention (apparent only by watching widening spreads), it was a festering problem for the highly exposed leveraged speculating community. Finally, a full-fledged crisis occurred as Russia defaulted and the dominos began to fall. Stung in Russia, the hedge funds and securities firms were forced rein in risk, dumping securities in various markets around the world. The dilemma, of course, is that highly speculative and leveraged financial systems are acutely vulnerable to any move toward liquidation. When the major leveraged players become sellers, there are no buyers."

The deflation of the '30's was in part caused by the decade long farm depression which had begun after World War I. Eventually the US farm community lost many productive farms as supply, which had been generated by the loss of farmland in Europe due to World War I, could not find sufficient numbers of buyers during the '20's.

In this example, the local banks were also vulnerable to crop failure, and I suggest that this could have and did precipitate asset sales on a large scale. As we know, these asset 'garage sales' occasionally lead to a time when there are 'too many' sellers and prices of certain assets fall. This can also be part of a more general price deflation, as we saw in the '30's.

This cycle problem is well known to farmers. It is also well known to those who studied the Asian meltdown of '98. At that time there were stories of large inventory buildups, as too many producers found too few buyers for their products. In our current setting, the asset buildup in Communications Technologies has in some ways paralleled the unfortunate overproduction that occurred in the late 1990's in Asia. There we found that overzealous lending by Japanese banks (and large rises in the local Asian stock markets) led to production that had undersized markets. Inventory buildups led to balance sheet problems as sales faltered and profits became losses.

At the time we read forecasts that the Asian Contagion would eventually reach America's shores.

It would appear that it has, but perhaps not as we expected. The mind-set, however, which motivates the large-scale misallocation of finance now appears to have infected the investment community in America. It has done this in the past, and during the past 50 years these errors have been papered over. I suggest that this time we shall not be able to cover our losses.

In Doug Noland's article we see reference to the same kind of overproduction, based not upon prudent investment by banks to develop a nation's needed productivity, but instead a mad rush by the financial community to maximize short-term investment returns. We have been in a rising rate-of-return environment. Financial houses chased rising rates-of-return out of necessity, as the fear was that competitors would outgrow those which failed to participate. In such a long-term rising rate-of-return environment some financial houses chose to grow their assets by imprudent debt expansion.

We saw this in the past as well when, during the rising interest rate phenomenon of the late '70s, lenders borrowed short and lent long. That is, banks and credit unions made long term loans such as mortgages, and these were not offset by equal amounts of long term deposits such as GIC's. (People were reluctant to lock in their savings in a rising interest rate environment.) Banks and credit unions fell into the habit of lending long and borrowing short-term. This worked in a rising interest-rate environment.

When interest rates finally began to fall in the early '80s many banks and credit unions found that their income from mortgages was too low and that many savers locked in high rates of return by buying high return GICs. The housing market had dried up by then, and there were few who could afford the mortgages available at the time. Thus many banks and credit unions found they had insufficient mortgage income to remain in business.

What is beginning to happen now is the final stage of this debt expansion cycle, in which those who have loaned long and have shrinking income forecasts will experience the 'cold turkey' withdrawal symptoms of the money addict now denied the ever increasing amounts of stimulant desired to create the same illusory wealth-effect.

The boom-bust cycle is unfortunately not a thing of the past, but simply a creation of greed that ignores the experience of the past, and is generated in part by lenders whose power to create and destroy credit is unregulated by the huge responsibility they have for the general welfare of our society.

Robert Bird

9 October 2000