Businomics Blog

Credit Crunch: Is it Real?

In a recent post I compared bank loans to businesses in this recession with the pattern in past recessions. I couldn't see anything that resembled a credit crunch.  I cautioned readers that those statistics did not include non-bank credit.  So I dug up the data on all credit to non-financial businesses, which includes corporate businesses, non-corporate businesses, and farm businesses.  Here's data for the last five quarters:

The underlying data are available here.

The only noticeable drop in credit was commercial paper, but check out the dollar magnitudes; they are small.  The increase in bank loans was almost twice the decrease in commercial paper.  As I pointed out last week, some of that decline in commercial paper probably triggered an increase in bank loans, as borrowers exercised standby lines of credit they had been paying fee for.

One could argue that this rate of increase is small, and that it's not sufficient for a healthy growing economy.  (Hey, you seen one of those lately?)  However, it's hard for me to say that the credit crunch was the cause of the recession, given the increases in credit to the business sector.

Now we have to reconcile the data with some of the horror stories I'm hearing from business contacts, including clients whom I trust.  It's probably true that some businesses are crunched, but plenty of others aren't.  The most credit-worthy businesses may be sucking down credit like beer in a frat house, while riskier businesses are getting turned down.  That suggest a sectoral problem rather than a system problem.

I'm growing increasingly skeptical that the massive Treasury operations are necessary.  Either they are unnecessary, or they have already worked.

Commercial Real Estate Loan Delinquencies: The Role of 'Maturity Defaults'

Today's Wall Street Journal reports significant increases in commercial real estate loan defaults and delinquencies.  Here's data through the fourth quarter on bank loans:

It paints a useful picture, but keep in mind that many commercial real estate loans are not from banks, and thus not reported here.

Two items for perspective.  First, we did not overbuild non-residential properties as we did residential.  This chart shows the share of GDP devoted to the two types of construction, with long-run averages in thin lines:

Not having overbuilt is not the same thing as being healthy.  The recession has been hard on vacancy rates and rental rates, so the sector is hurting.  However, note the difference from residential real estate: it was overbuilt even before the recession.

The second issue to get perspective is the role of "maturity defaults" in commercial real estate loan problems.  Here's what that means.  A typical real estate mortgage has a 5-year term.  The loan may amortize over 30 years, or may be interest-only (common a few years ago, but rare now).  Five years after the commercial mortgage was originated, the loan must be repaid and a new loan found.  (I'm describing typical terms, but there's variation from these.)

Suppose you bought an office building five years ago with 20% down, for an 80% loan-to-value ratio.  You have not missed a payment, the building's value has been stable, your amortization has paid down the loan balance by four percent of the building's original value.  A new loan will have a 76% loan-to-value ratio.

Here's the problem: nobody will make a commercial mortgage loan with a 76% loan-to-value ratio today.  You haven't missed a mortgage payment, your building is fully leased, you've been working down your principal, but the lenders are all scared.  Bank regulators are scared.  Secondary markets are scared.  So you have to pony up additional cash to bring the loan-to-value ratio down to at least 70%, and maybe even 65 or 60%.

What if you don't have the cash sitting around to do that?  You have a maturity default.  Your problem is that credit standards tightened faster than you were paying off your loan.

What does this mean for the larger economy?  If reflects a financial problem, not a real problem.  A real problem is real estate that isn't wanted.  A financial problem is useful real estate that doesn't fit lenders' risk profiles.  The lender will face the facts and let the loan ride.  The lender may be unhappy, and a regulator may be unhappy, but nothing bad is going to happen to the property.  Even if the lender forecloses, the building is still occupied.  There's no big impact on the economy.  In other words, the real situation is not as bad as it may appear.

How much of the total commercial real estate loan problem is due to maturity defaults?  A Deutsche Bank analysis suggest a whole boatload of loans won't qualify for refinancing in the coming years.  As I read their estimates, some 66% of loan values coming due in 2009-2012 won't qualify for refinancing.  The biggest problem areas are multi-family and office.

Credit Crunch: Latest Data Leads to Doubt

We all know there's a credit crunch, right?  That's the basis for the latest (March 2009) Treasury bailout proposal.  So I went looking for the evidence, just to prove to you skeptics that there really is a credit crunch.  I looked at business loans from banks (data here), comparing all the post-World War II recessions.  Here's what I found (latest cycle in thick blue):

The data link above has a plain-vanilla chart, in case you don't like my recession-comparison baby.

In the current cycle, see that bulge in loans that peaks about 11 months into the recession?  I think the data are misleading here.  When the commercial paper market closed down after the Lehman bankruptcy, large companies shifted to bank loans, using standby lines of credit.  The corporations had been paying fees for the credit lines, and the banks were contractually obligated to make the loans.  I haven't seen any estimates of how big that effect is, but I think it works itself out in six months or so, and may account for some or all of the recent decline in lending volume--but we really don't know.

Comparability issue: in the old days, bank loans were the primary mechanism for short-term corporate borrowing.  That hasn't been the case for some time; there's a lot of non-bank credit out there, not reflected in the chart. 

I can imagine three hypotheses about this recession:

1) The recession was caused by a credit crunch within the banking sector
2) The recession was caused by a credit crunch outside the banking sector
3) The recession was caused by non-credit issues, and the drop in credit is just a normal part of the recession.

It seems to me that for the first hypothesis to be true, we should be seeing a much more severe drop-off in business loan volume.

For the second hypothesis to be true, we should see wider risk spreads in financial markets, which we've certainly seen.  (See Calculated Risk's credit summary.)

For the third hypothesis to be true, we need other triggers.  Candidates for the other triggers:

• The drop in residential construction, as a consequence of past overbuilding
• A collapse of consumer confidence, caused by falling home values and bad news headlines
• A collapse of business confidence, caused by the above as well as regime uncertainty

It's quite possible that hypotheses 2 and 3 could be working together.

What's this mean?  I'm not convinced that the banking credit crunch is much different than in past recessions.  Businesses always have trouble get bank loans in recessions.  The tightening of bank lending standards in this recession is similar to the 1990 recession and the 2001 recession, according to the Fed's survey of bank lending officers (to see a chart, hit that link and then "Charts"). The point that data don't support the bank credit crunch hypothesis has been made by others, most notably researchers at the Minneapolis Fed.

It certainly appears that bank lending is not the central problem of this recession.  Tim Geithner's huge bank lending program seems unnecessary, given that bank lending isn't the central problem.  This is what I wrote for one of my consulting clients in December, before the Obama team took over:

The new Treasury secretary will be Tim Geithner, currently president of the New York Fed, whose career has centered around economic crises, including the Mexican crisis and the Asian financial crisis.  He knows crises, and that’s good, but his instincts are to put together a big bailout rather than let anyone go under.  However, there really are times when we want to let companies go under.  My judgment: his strengths match his weaknesses.

Business Strategy After the Recession

I talked Jim Blasingame, the Small Business Advocate, about the near-term economic outlook and about business strategy after the recession is over.  You can listen to the interview here.

Jim also has a very good post on his blog that expresses some of my thoughts in a different way. He says,

"The year 2009 is merely the transition year between how we used to do business and how we will do business in the future."

The New Treasury Program (March 2009 edition)

We have another new Treasury program.  The mechanics are best understood through the examples offered by the treasury (full details here), which describe a loan program and a securities program:

Sample Investment Under the Legacy Loans Program

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is
seeking to divest, the bank would approach the FDIC.

Step 2: The FDIC would determine, according to the above process, that they would
be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.

Step 3: The pool would then be auctioned by the FDIC, with several private sector
bidders submitting bids. The highest bid from the private sector – in this example,
$84 – would be the winner and would form a Public-Private Investment Fund to
purchase the pool of mortgages.

Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of
financing, leaving $12 of equity.

Step 5: The Treasury would then provide 50% of the equity funding required on a
side-by-side basis with the investor. In this example, Treasury would invest
approximately $6, with the private investor contributing $6.

Step 6: The private investor would then manage the servicing of the asset pool and
the timing of its disposition on an ongoing basis – using asset managers approved
and subject to oversight by the FDIC.

Over time, investment returns pay a guarantee fee to the FDIC, interest on the debt, a management fee to the investor, and then further returns split between the government and the investor.

Sample Investment Under the Legacy Securities Program

Step 1: Treasury will launch the application process for managers interested in the
Legacy Securities Program.

Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital
to participate in joint investment programs with Treasury.

Step 3: The Government agrees to provide a one-for-one match for every dollar of
private capital that the fund manager raises and to provide fund-level leverage for the
proposed Public-Private Investment Fund.

Step 4: The fund manager commences the sales process for the investment fund and is
able to raise $100 of private capital for the fund. Treasury provides $100 equity coinvestment
on a side-by-side basis with private capital and will provide a $100 loan to
the Public-Private Investment Fund. Treasury will also consider requests from the
fund manager for an additional loan of up to $100 to the fund.

Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total
capital and commences a purchase program for targeted securities.

Step 6: The fund manager has full discretion in investment decisions, although it will
predominately follow a long-term buy-and-hold strategy. The Public-Private
Investment Fund, if the fund manager so determines, would also be eligible to take
advantage of the expanded TALF program for legacy securities when it is launched.

The best independent commentary is at Brad DeLong's blog.

My evaluation of the new treasury plan:  It's not what I would have done--I'm not convinced that we need this, rather than more reasonable behavior by bank examiners in the field (as I've written about here).  But here's what I like about it:  the private sector actions set the price of the assets.  We economists call this "price discovery," and the Treasury's use of this phrase demonstrates that they have listened to an economist, something many Treasury secretaries never have done.  Leveraging public money with private money is a good idea (if you're going to use public money at all).

However, Secretary's Geithner plan after plan after plan reminds me of the gardener who planted an apple seed.  The next day, he was surprised that he had no apple tree.  So he watered the yard.  The following day he was surprised that he still had no apple tree, so he fertilized to spot where he had planted his seed.  The next day, surprised again, he ran water for half the day.  The following day, surprised, disappointed and angry, he dumped a 50 gallon drum of fertilizer over the ground that had the apple seed.  He never got an apple tree from his seed.  He became a socialist.

Business Challenges After the Recession

I have created a Linked In poll asking if your business challenges after the recession will be substantially different from the challenges you faced before the recession.  It's only one question, which you can answer quickly by clicking this link.

The Fed's New Stimulus: A Trillion Dollars Worth

The Federal Reserve announced plans to buy more securities.  (Read their announcement here.)  This makes a lot of sense to me.  Monetary policy always works, albeit with a long time lag.  Some have argued that interest rates cannot go lower than zero, but there are only two interest rates near zero: Fed Funds and short-term Treasury Bills.  Longer maturities, mortgage-backed securities, corporate bonds and municipals all pay higher rates now, so their rates can be pulled lower.  The us hard-core monetarists, the level of interest rates is not as important as the injection of money into the economy, which this program does.  (For an elaboration of these thoughts, see my short video here.)

Doom-and-gloomsters have said that the American economy might have a "lost decade" as Japan's did.  Japan got interest rates low and figured they couldn't do anything more.  With deflation, though, their low interest rates were not particularly low in real terms.  Then they began "quantitative easing" and soon recovered.  I'm not sure whether everyone will agree that this step is quantitative easing, but it's certainly easing, and the economy will certainly recover.

Managing the New Turmoil in Banking

My article "Managing the New Turmoil in Banking" was published in the Deluxe Knowledge Quarterly.  You can read it here.

Key takeaway: bank customers used to take the soundness of the institution for granted.  Now they worry.  Perhaps needlessly, but they worry nonetheless.  Your personnel need to address customer concerns, even though they have never faced such a high level of worry, they are not trained for such issues, and their branch managers have no experience or training on such worries.  It's quite a challenge for bankers.

Housing Starts Weak Despite the Headlines

The Wall Street Journal says, "Surprise Jump in Housing Starts."

Yahoo Finance says, "Housing Starts Surge Unexpectedly."

So let's look at the data:



The uptick doesn't seem to match the headlines.  We've seen a few up months during the downward trend, so don't get too excited.  We are still overbuilt in houses, as shown by the vacancy data.

You might wonder why any housing units at all are being started.  Remember that housing is local, so there may be a community without the huge excess inventory.  Then examine the inventory in that community; there may be neighborhoods without an excess.  There may be types of housing and price points that are not in excess.  That justifies some new construction.

Economic outlook for housing: still weak all through 2009.  Sorry, don't buy the headlines.

Executive Bonuses: Be Careful in Your Criticism

So a company has lost a bazillion dollars, leading the government to pump in money to mitigate "systemic risk."  Should the executives get bonuses?

The answer is not as obvious as you might think.  Consider a bank that gave its branch managers performance targets.  One manager coached her employees well, worked long hours herself, and exceeded her targets by a wide margin.  In other parts of the bank, lending officers were making bad loans, the CFO bought bad securities, and the CEO spent millions redecorating his office.  Should this high-performing branch manager get the bonus that was promised to her?  Keep in mind, also, that as the financial crisis worsened, the importance of gathering and retaining deposits increased.  The branch manager's work became even more important than the original bonus plan anticipated.  Pay her a bonus?  Maybe so.

In some cases, the bonuses may be contractual obligations.  I have a lot of trouble with our government urging companies to break contracts.

I know bank CEOs who have stopped all bonuses, and their top-performing people probably understand.  But they also know that they have been $%^&*!'ed.  The company owes them.  From a public policy viewpoint, the companies should be allowed to pay the bonuses.  From a business strategy viewpoint, maybe conserving cash is more important that retaining staff.  The top performers will probably stay with you a little longer, but they need to be recognized today, and paid tomorrow.  Here's what I recommend that CEOs do in this situation:  Call the people who really deserve bonuses.  Recognize their achievements.  Promise that as soon as the company returns to profitability, the CEO will reevaluate the bonus situation.  Then pay delayed bonuses as soon as possible, before the CEO himself is eligible for a bonus or pay raise.

Be careful in judging the payment of bonuses.  There may be people who truly deserve them, even within a poorly-performing institution.