The easiest way to become rich, is to take other people’s money and give none of it back… — kavips

Leap back two years ago. In a speech given before the New York Bankers Association (NYBA), OTS (Office of Thrift Supervision) Director John Reich expressed concerns about weakening credit quality at some financial institutions. Specifically, he identified inadequate loan documentation, misaligned loan pricing relative to credit risks, declining underwriting standards, liberalization of loan terms and an increasing reliance on wholesale funding as areas of concern to OTS. (Article from Mortgage Banking: May 1, 2006.)

It appears that banks have (two years too late) finally taken up his advice. Now that our economy is collapsing and the Federal Reserve is trying every trick it can think up to loosen credit, the amount of loans going out into the commercial market, can be best described in three words: shrink, shrank, shrunk.

As the new owner of $172.5 billion of preferred shares and warrants in 208 U.S. financial institutions, the Treasury Department hasn’t succeeded in thawing frozen credit markets, leaving taxpayers propping up an industry that won’t lend to them.

More than 8.5 trillion has been pledged by the Federal Reserve and U. S. Treasury to back up financial institutions. Instead of making it easier to obtain a loan, getting approval has become more difficult. Fed reported that about 85 percent of U.S. banks said they had tightened standards on commercial and industrial loans to companies with more than $50 million in annual sales, up from 60 percent in July. Ninety-five percent said they increased the cost of those loans. About 70 percent said they made it more difficult to obtain prime mortgages, and almost 65 percent said they did the same for consumer loans.

Not the best statistics to get the economy going again..

While mortgage rates have declined, they haven’t fallen as fast as bank borrowing rates, meaning financial institutions are demanding more profit for every dollar they lend.

Average rates on 30-year residential mortgages fell to 5.14 percent last month, according to data compiled by McLean, Virginia-based Freddie Mac. That’s down from 6.67 percent in June 2007, before the worst turmoil in the housing market. At the same time, the spread of mortgage rates over the 10-year Treasury bond yield rose to 2.958 percentage points from 1.567 or soared inexplicably 88.7%!

With the exception of GMAC, which immediately began offering loans to GM customers with lower credit scores in order to halt the decline in auto sales, most financial institutions that received TARP funds have been reluctant to lend.

If they can’t make loans, many banks may hold on to the government capital until stability returns — or use the money to finance takeovers of weaker rivals. Pittsburgh-based PNC Financial Services Group Inc. did that last month when it acquired Cleveland-based National City Corp. — hours after receiving approval for $7.7 billion from the government.

But had they opened the gates holding back credit, last week’s evidence shows what might have been the economic outcome of doing so…..

Mid-Michigan General Motors dealers say the loosening of credit requirements by GMAC Financial Services has prompted an increase in traffic to their showrooms.
CNN reports that some dealers reported that 40% of their sales for the month came in the last two days. It was on Dec. 29, that the U.S. Treasury Department gave GMAC $5 billion from its $700 billion Troubled Asset Relief Program, and agreed to lend GM up to $1 billion to support GMAC.

“I’ve got a showroom full of people,” Jim Messick, general manager of Graff Chevrolet of Mt. Pleasant, Michigan, said earlier this week. “It’s really helped.”

“It’s beyond hopeful. We have already seen an increase in sales by 20 percent. It’s almost equal to what we were down,”
Machunsky said of his sales in New Hampshire.

With the economy slowing, banks are seeing a big decline in the number of people seeking loans because nervous consumers and small businesses are scaling back their borrowing.

In fiscal 2008, the number of small business loans issued by banks plunged 30 percent compared with the previous year, according to the U.S. Small Business Administration. Over the same period, the dollar value of those loans fell from $20.6 billion to $17.96 billion, a 13 percent drop.

The pullback is partly a result of tighter credit availability among lenders and declining creditworthiness among borrowers. But it also reflects a big drop in consumer spending that is forcing small businesses across the country to put off expansion plans and cancel orders for new equipment.

The reluctance to take on loans boils down to fear.

The Treasury’s goal is to revive lending — and thereby stem the credit crisis — by freeing up potentially massive amounts of loans. For every dollar a bank keeps as capital, it can lend out as much as $10, which means the $250 billion injection could in theory result in $2.5 trillion in available loans.

But banking experts say lending such a vast amount would be almost impossible given the economic downturn.

If small businesses see that the bailout is starting to take hold and confidence is returning, they will be more likely to seek loans, helping kick-start the economy’s recovery, according to experts.

One example of a business owner looking for signs that it’s safe to borrow again is James Duran, CEO of a Silicon Valley staffing company that does business with big tech companies like Google Inc. and Yahoo! Inc.

Last year, he had as many as 200 employees. Today, he’s got just 15 — cutbacks that mirror job losses across his industry.

He said he has a $1 million line of credit to help build back his company but that he would be “crazy to use it now.”

“Once I see this cloud of uncertainty lift and companies go back into hiring mode, I’ll start using that money,” he said. “But we’re not even close to that.”

What we are seeing is a circle of borrowers and lenders each depending upon the other to make the first move.. Banks are depending upon the economy to signal it’s safe to lend again, and customers who seek those loans, are depending upon the economy to signal that it is safe to again apply for a loan. Neither one is moving until they see a change in the economy.

It’s the economy… stupid… all over again. And it goes further back than that: FDR said in speaking of the 1933 crises…. we have nothing to fear, but fear itself.

Since the practice of calling in loans greatly precipitated the Great Depression, a review of 1930’s history is appropriate today in anticipation of what can again become our fate if we make the same mistakes, and follow the same choices.

When the stock market fell in 1929, brokers called in their loans, leveraged 10 to 1, which of course could not be paid back. Banks began to fail as debtors defaulted on debt and depositors attempted to withdraw their deposits en masse, triggering multiple bank runs. Government guarantees and Federal Reserve banking regulations to prevent such panics were ineffective or simply not used. Bank failures led to the loss of billions of dollars in assets. Outstanding debts became heavier to bear, because prices and incomes fell by 20–50% while the debts remained at the same dollar amount. After the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. (In all, 9,000 banks failed during the 1930s). By April 1933, around $7 billion in deposits had been frozen in failed banks or those left unlicensed after the March Bank Holiday.

Bank failures snowballed as “desperate” bankers called in loans which the borrowers did not have time or money to repay. With future profits looking dismally poor, capital investment and construction slowed or completely ceased. In the face of bad loans and worsening future prospects, the surviving banks became even more conservative in their lending. Banks built up their capital reserves by making fewer loans, which exponentially intensified deflationary pressures. A vicious cycle developed; the downward spiral accelerated.

The liquidation of debt could not keep up with the fall of prices which it caused. The mass effect of the stampede to liquidate, increased the value of each dollar owed relative to the value of declining asset holdings. The very effort of individuals to lessen their burden of their percentage of debt, effectively increased it. Paradoxically, the more the debtors paid, the more they owed. This self-aggravating process turned a 1930 recession into a 1933 great depression.

Today, in order to open access to short term credit, our real focus must be focused on the psychology of how to alleviate that fear of losing one’s money… Something that is simply said……but is hard to do.


The economy must be fixed, or more appropriately..must be perceived to be fixed, before the buyout strategy to loosen credit within the markets can begin to take effect. As we saw with GMAC’s bold move, loosening credit coupled with great deals, does move out old inventory. But as we still see today, the problem is in getting banks to do what GMAC just did. After all, it goes directly against the advice given to them two years ago…..