Market Impact: 2009 Watch List – Part2

When will credit flow start in right earnest?

Much of the funds infusion into the banks is being held as cash and is as large as $1 trn. While the credit situation has improved over the last two months it is still tight by relative standards. Banks coming out of this self imposed discipline will be the key to make money move/circulate. How much ever money the Fed pumps into the system unless it circulates the desired effect will not be there.

This reluctance to lend is both psychological (the anchoring of a recent experience) and strategic as these institutions, post infusion of funds, have probably just about restored their capital adequacy. Now they also have a fear that the projected recessionary/deflationary scenario will create loan losses and they need sufficient strength at that time to raise further capital to ensure capital adequacy. Also with the raging unemployment and falling real estate prices any further lending may lead to good money going after bad money.

In the current context, any sign of weakness will result in downgrade by other banks/institutions as counterparty risk will be considered higher. This has its own chain effect.

This then becomes a circular problem as inadequate credit availability in turn reinforces the recessionary/deflationary forces. The thrust required to move out of this orbit -the 'escape velocity' has to be provided by the stimulus packages and massive government spending. Assuming that these packages work and bring back employment and consumer spending, it will put businesses back into business and in turn improve the asset/loan quality of banks. This comfort will then give banks the confidence to lend in right earnest.

Also covering default risk in the CDS market itself has become risky and the only insurance that anyone would trust today is that of the government or if it government backed.

There are other implications too. As a NYT article observes

“A big worry is the future of securitization, a key mechanism of modern banking that enables banks to bundle loans and bonds into securities for sale to investors. This crucial market is moribund now that many of its creations have plunged in value. Some question when, or if, certain areas of securitization will revive.

Securitization, which works like a shadow banking system, has radically changed banking and the credit markets in recent years. Three decades ago, banks supplied $3 out of every $4 of credit worldwide. Today, because of securitization, that share has dropped to about $1 in $3.
Unless financial companies can securitize debt — which, in turn, depends on investors’ willingness to buy the bundled loans — credit will remain tight even if banks resume lending.”

Thus as and when the credit market unlocks the level of overall level of credit will not be the same as was experienced in 2006–07. The leveraging capability of all institutions will be drastically reduced either voluntarily and/or by market forces and/or by legislation. The aggressiveness to lend will be lacking. Modest growth objectives will be set. Many of the large banks have government in them and will find interference in the name of checks and balances.

How long will such packages take to show tangible results and provide the ‘escape velocity’ to the banks, given the political process (as touched upon in my previous post) is anybody’s guess?

Copyright © 2008 Tradesense