Liquidity is a Coward

By Chris Puplava, February 6, 2008

Just remember, liquidity is ultimately a coward. There's always too much when it's least needed and it's nowhere to be found when needed the most. At least that's what financial market and economic history has taught us repeatedly.

Brian Pretti
ContraryInvestor.com, Bail Bonds, 06/2007

The above statement perfectly describes the current situation in the economy. Liquidity is certainly needed as the economy is starting to decelerate in earnest as evidenced by yesterday's Institute for Supply Management (ISM) non-manufacturing report. The ISM Non-Manufacturing Index plummeted in January to 41.9, a sharp drop from December's 54.4 reading. Numbers below 50 indicate a contracting economy and January's reading was the lowest reading since October 2001, which was near the end of the last recession. Of note in the figure below is that the ISM Non-Manufacturing Index fell below 50 at the start the last recession and didn't break above 50 until near the end of the recession, making January's plunge another solid argument for the case that the U.S. economy is currently in a recession.

Figure 1

Source: ISM

Not only did the overall activity index fall sharply but so did the ISM Non-Manufacturing Employment Index, which fell from 51.8 in December to 43.9 in January. The ISM Employment Index corroborates weakness seen in the Household Employment Survey, which is on the verge of turning negative just as it did prior to the last recession.

Figure 2

Source: ISM/BLS

The economy is clearly beginning to break at the seams, this at the same time banks are tightening their belts to both consumer and corporations alike. Also released this week was the Federal Reserve Board's Senior Loan Officer Opinion Survey. The report showed tightening of lending standards across the board from consumer to corporate loans. There was a sizable tightening in standards seen in both large and small firms for commercial and industrial (C&I) loans in the first quarter, a significant shift in lending where banks were loosening credit standards 3-5 quarters ago. The rising of lending standards to small and large businesses is leading to a drop off in demand as loans are more difficult to come by.

Figure 3

Source: FRB: Senior Loan Officer Opinion Survey

Figure 4

Source: FRB: Senior Loan Officer Opinion Survey

The trend in bank lending to corporations also extends to the consumer who is having a harder time gaining access to various forms of credit. Banks have begun to tighten standards for credit cards and consumer loans other than credit cards, as well as raising fees for credit card transfers and other types of transactions.

Figure 5

Source: FRB: Senior Loan Officer Opinion Survey

The significant development seen in the fourth quarter survey of last year was a sharp rise in the net percent of banks tightening standards to prime mortgage borrowers. In the third quarter of 2007, only 14.3% of banks were tightening lending standards to prime borrowers. This number jumped to 40.8% in the fourth quarter as the credit crunch was moving up the food chain to affect even prime borrowers. The first quarter of this year showed that banks continued to tighten lending standards to various mortgage borrowers even further. The net percent of banks tightening for prime, nontraditional (Alt-A), and subprime borrowers rose to 52.9%, 84.6%, and 71.5% respectively. Further tightening of mortgage lending standards will take more and more home buyers out of the market as they can’tqualify for a loan. This will likely drive the supply of homes (months) to record levels, and housing prices dropping further.

Figure 6

Source: FRB, Senior Loan Officer Opinion Survey

Figure 7

Source: Bureau of Census, New Houses Sold

Figure 8

Source: Bureau of Census

Michael ("Mish") Shedlock's comments from his blog summarizing the details of the Fed's survey are provided below:

Banks are putting a stranglehold on credit

The Fed says Banks are getting much stricter on loans

Banks are raising their credit standards for mortgages, consumer loans and commercial real estate loans at a pace never seen in the 17-year history of the Fed's quarterly survey of senior bank loan officers, the Fed said.

Plain-vanilla business loans were also much harder to obtain, the Fed said. Banks expect more delinquencies and charge offs for most types of loans to consumers and businesses, the survey said. Banks said they were tightening their lending standards in response to weaker economy, reduced tolerance of risk, and decreased liquidity in secondary markets.

Banks are requiring more disclosures, more collateral and a higher interest rate before approving loans, the survey said. Demand is plunging for many types of loans, especially for residential mortgages and commercial real estate loans.

For consumers, banks are tightening up on all types of mortgages, not just subprime loans. And banks are less willing to approve consumer installment loans.

Tightening By The Numbers

• More than 80% of banks, the largest percentage ever, said they had tightened lending standards for commercial real estate loans.
• About a 33% of banks were tightening their standards for commercial and industrial loans, the highest rate in more than five years.
• Over 50% of banks tightened standards for prime mortgages, by far the highest percentage in the 17-year history of the survey.
• More than 80% of the banks tightened their standards for nontraditional loans, including jumbo loans and other loans that do not conform to standards set by Fannie Mae and Freddie Mac.
• About 70% of banks that offer subprime mortgages tightened their lending standards
• More than 90% of the banks responding to the survey said they do not offer subprime loans at all.
• About 60% of banks tightened their standards for home equity lines of credit

What makes the above developments significant is that banks are the transmission mechanism for channeling liquidity to both the consumer and corporations. When the economic spigot is cut off despite rising water pressure from lowered Fed funds rate, the economy buckles until the spigot is once again opened as banks remain the bottle neck in credit transmission. This reality is eloquently and simply conveyed by Paul Kasriel and Asha Bangalore in their recent U.S. Economic & Interest Rate Outlook, "Recession Now - Putting Our Forecast Where Our Mouth Has Been," provided below:

Although the Federal Reserve has been quite aggressive in reducing the fed funds rate and will likely continue to be aggressive, we expect an anemic recovery. Why? Because the financial sector is likely to incur some large losses in this downturn. The losses will not be confined to securities related to residential mortgages, but will involve credit card debt, auto loans, commercial mortgages and high-yield securities (known as junk bonds in a less politically-correct era). The financial sector, especially the banking system, is the transmission mechanism between the Federal Reserve and the private sector of the economy. If the financial transmission is not functioning properly, the Federal Reserve can mash on the monetary accelerator but little power gets transmitted to the "wheels" of the economy. Credit losses can lead to capital inadequacy of the financial system. Capital inadequacy means that the financial system cannot extend as much credit to the private sector as otherwise would be the case. So, even though the Federal Reserve is offering to extend credit to the financial system at relatively low interest rates, the financial system, because of capital inadequacy, cannot, in turn, extend as much credit to the private sector. This was the situation that prevailed in the United States after the economic recovery began in April 1991. The Federal Reserve continued to reduce the federal funds rate through September 1992 with little to show for it. It was not until the second half of 1993 that the financial sector had rebuilt its capital to the extent it could step up its lending to the private sector in earnest. That is when economic activity began to behave in a more normal cyclical fashion. So, a good "model" for the 2008 recession might be the 1990-1991 recession.

Paul Kasriel, Asha Bangalore
Northern Trust, U.S. Economic & Interest Rate Outlook, 02/04/2008

Paul Kasriel and Asha Bangalore are correct in comparing the current situation more to the 1990-1991 recession instead of the 2001 recessionary experience. The 1990-1991 recession was a consumer-led recession as opposed to the 2001 business-led recession, and also saw a significant housing downturn. The current situation will be a consumer-led recession whose roots were sown in excess housing activity. Additionally, they make the claim that it wasn't until the second half of 1993 that economic activity began to improve with an easing in bank lending standards despite the Fed slashing interest rates two years earlier. This is indeed the case as shown below with the year-over-year (Y/Y) rate of change in real GDP being negatively correlated with bank lending standards for C&I loans. Real GDP bottomed on a rate of change basis when banks began to loosen credit to the corporate sector, and a sharp rise in C&I loan standards in 2000 precipitated a decline in real GDP in 2000-2001. Again, as banks lowered lending standards in late 2001 real GDP bottomed and began to accelerate once more.

Figure 9

Source: FRB/BEA

This same trend in bank lending standards with real GDP is also seen in relation to consumer loans. As banks are less willing to lend to consumers (tighten lending standards) there is a drop in economic activity. Conversely, as banks relax lending standards and lend to the consumer, an acceleration in real GDP ensues. Shown below, bank willingness to lend to the consumer leads real GDP by roughly nine months and the decline in bank willingness to lend signals continued economic weakness ahead. An economic rebound is not likely to be seen until bank willingness to lend to the consumer bottoms, with the economic rebound bottoming with a nine month lag.

Figure 10

Source: FRB/BEA

So, despite the Federal Reserve lowering interest rates and the White House bringing fiscal stimulus of roughly 1% GDP, don't expect a significant recovery in the second half of the year as the consensus does until banks start lowering credit standards to act as the transmission vehicle of Fed liquidity instead of a bottleneck. This isn't likely to happen until bank capital ratios improve, which in turn will only stop bleeding when housing stabilizes and mortgage losses subside.

Driving this point home, adjustable-rate mortgages are still in the peak resetting period and mortgage foreclosures and defaults are likely to continue to rise. There is also a lag between default rates and mortgage security losses, which means that banks aren't likely to lower lending standards any time soon. The take home point is that financial pundits and economist forecasts are far too optimistic with a consensus belief in the second half rebound theory. This is not likely discounted by the markets that expect the light at the end of the tunnel in the near future. I don't have to mention either how markets respond to disappointment, meaning we could be in store for more market weakness than the housing-bottom/market-bottom calling consensus on Wall Street expects.

Figure 11

Source: Moody's Economy.com, DismalScientist

Today's Market

The markets traded up initially after the release of the productivity and costs report from the Bureau of Labor Statistics for the fourth quarter, with the report showing productivity growth rising by 1.8% (SAAR). The early gains were erased when Fed Reserve official Charles Plosser said that "we must not lose sight of the other part of the Fed's dual mandate - which is price stability." The hawkish tone from Plosser was enough to erase the markets' gains, with the markets continuing to slide into the close.

The Dow Jones Industrial Average fell 65.03 points to close at 12200.10 (-0.53%), the S&P 500 gave up 10.19 points to close at 1326.45 (-0.76%), and the NASDAQ fell 30.82 points to close at 2278.75 (-1.33%).

Treasuries fell with the yield on the 10-year note rising 2.7 basis points to close at 3.614%. The dollar index was up, rising 0.05 points to close at 76.17. Declining issues represented 61% and 62% for the NYSE and NASDAQ respectively, reflecting a mostly negative market move.

Chris Puplava

© 2008 Chris Puplava

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