Record $300 billion loss in credit to crimp economic growth

Posted Nov 28th 2007 9:49PM by Peter Cohan

The New York Times reports that since August, when two big corporate credit sources -- commercial and industrial bank loans and commercial paper - peaked at $3.3 trillion, there has been a record decline of 9%. This is a bigger and more rapid decline than any the Federal Reserve has seen since it began tracking these numbers in 1973. This matters because credit constriction will stifle economic growth.

The culprit for this record decline is the seizing up of securitization. Securitization is the "financial innovation" that allows banks to make loans and then sell them to someone else. This is critically important to banks because they need to retain a certain amount of capital on their books if they want to make more loans. With securitization, banks could originate the loans and then sell them -- thus freeing up the capital to originate and sell even more loans.

Unfortunately, that little game of financial musical chairs is through for now. Nobody wants to buy the bundles of loans -- whether backed by credit card receivables, mortgages, auto loans, or leveraged buyout loans. This is forcing banks to make loans and then keep them on their books. And it just so happens that many of the loans are going bad and the write-downs are cutting into banks' capital.

So what? Banks are simply going to stop making loans until they can either raise much more capital or the market for asset-backed securities revives. Until then, any company that depends on borrowing for its growth is going to find itself seeking alternative forms of financing. And if those are not available, they'll simply have to cut back -- on growth plans and workers.

The way to replenish bank capital coffers is to create a wider net interest margin. That is to lower the rates that banks pay depositors while raising the rates they charge borrowers. The wider that margin is, the more rapidly banks can pour profits into their capital accounts. Unfortunately, there is very little room for dropping deposit rates and given higher energy and labor costs, businesses probably can't afford to borrow at higher rates.

An economic adjustment may be at hand.

Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.

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Reader Comments (Page 1 of 1)

11-29-2007 @ 7:07AM

al coholic said...

If we make it possible for the banks to make more money by widening the spread, the higher rates that follow will lower demand further and could cause a constriction nobody would want to see.

It wasn't right for the system to morph from resonsible lending by banks who cared about the ability of borrowers because they kept the loans in house to the subprime mess we are in because banks sold dubious loans with a wink and a nod, passing them on as though they were AAA rated, but now that we've done it why should we reward those actions by bailing out the culprits?