DEBATE: IS THERE A "CREDIT CRUNCH?"

For the eleventh time in 2001, the Federal Reserve has just lowered short term interest rates; this time, to 1.75 per cent on the federal funds rate. This is the lowest level for that particular rate in four decades. Wall Street has been enjoying a pronounced, post-9/11 rally on the liquidity that the Fed has injected into the markets but also--and arguably more so--due to an increasing level of confidence that the Fed’s magic will finally start working, and turn around the U.S. economy by some time in 2002.

Now, we can’t entirely discount the Fed’s efforts. As I’ve said repeatedly, the Fed still retains some power to boost the markets solely through its dramatic inflation of the money supply. Further, by slashing short-term interest rates, many savings vehicles such as money market funds have become increasingly unattractive; this helps to "force" money back into the stock market.

What some of the born-again bulls seem to be missing, however, is that the Fed’s stimulus efforts are not making their way down the monetary food chain to Main Street. Specifically, there have been signs for months now that--far from new money being easy to obtain for everyone--many segments of the economy and, it now appears, the consumer market are increasingly unable to obtain new credit.

It must be remembered here that the "growth" of the economy and Wall Street over the last several years was due to the ability of virtually everyone--consumer and business alike--to obtain new credit. This fueled spending, new business start-ups, growing numbers of mergers (which also created new "money"), corporate profits and, ultimately Wall Street.

As I have written in recent months, this process has started reversing itself. As share prices have fallen--and as fear has increased on Wall Street--merger and acquisition (M&A) activity has fallen. Many companies which mere months ago were able to bring new debt and equity offerings public are now unable to do so; thus, they are starving, and even going out of business, due to a lack of money. Wealth creation in the form of the higher market valuations which previously resulted from one merger after another has also slowed considerably. Put it all together, and the kind of credit expansion vitally needed even to keep the economy from falling further is not evident.

Investment banks as well as commercial ones--far from passing along Santa Greenspan’s good wishes and increased credit freely--have been slowly but surely pulling in their horns. Those top-rated (by credit standing) companies able to obtain financing are actually paying higher interest rates on long term debt. At the other end of the spectrum, companies not exactly in the same league as the Dow 30 are seeing their financing costs soar; and that’s if they can obtain new credit at all. So for all the Fed thinks it’s doing, the message--and the money--is not getting through to all those who need it.

NOTED ECONOMIST WARNS OF CRUNCH

In the November 6 issue of The Wall Street Journal, economist John Rutledge offered an op-ed piece entitled, "A Credit Crunch Imperils the Economy." Rutledge made his case, in part, for how an arm of the Treasury Department is actually fighting the Fed’s efforts as follows:

". . .Interest rate reductions alone are not enough to jump-start this economy. We need to make sure cheaper credit reaches the companies that need it. Credit rationing, not interest rates, is the real problem with the economy.

"The Fed’s monetary stimulus has been hijacked by the bank regulators. These credit highwaymen aren’t bad guys, they are just doing their jobs. The Treasury Department’s Office of the Comptroller of the Currency (OCC), which is charged with regulating federally chartered banks, has a different agenda from the Fed. Its job is to protect bank capital, period. It does so with an army of bank examiners, who wield the blunt instrument of credit rationing inside the banks. For more than a year, these regulators have been diverting bank reserves into Treasury securities instead of business loans, in hope of restoring bank capital that was damaged by technology lending. Companies that rely on banks for working capital have been sucking air. . ."

"Ironically, when the Fed became alarmed at the shrinking economy and began to cut interest rates in January, the bank examiners, who report to a different master, tightened further. The business loan market is far tighter today than it was then. Two years ago banks were willing to lend a good company four to five times Ebitda, or earnings before interest, taxes, depreciation and amortization. Today banks quote a market of just over two times Ebitda but money is not, in fact, available even at that level.

"A further irony is that although banks have refused to lend to businesses, they have been throwing money at the consumer through mortgage and equity credit lines. This has produced a two-speed economy that has left many companies unable to produce products or to ship orders for lack of working capital. Stimulating consumer spending won’t solve this problem; we need a functioning bank market. . ."

O.C.C. CHIEF RESPONDS

For his part, John Hawke, Comptroller of the Currency, dismissed Rutledge’s claims of a crunch in his letter to the editor of the same newspaper, carried on November 19:

". . .First, there is no credible evidence of a credit crunch, let alone one caused by supervisors. Banks are awash with liquidity, and demand for business loans is weak. Many businesses are de-leveraging and implementing other austerity measures to counter weak economic conditions.

"Second, creditworthy borrowers are receiving financing. Bond issuances are at a record high, with proceeds being used, partly, to refinance or reduce short-term bank debt. While not all borrowers can access the bond market, one might expect banks to be more aggressive in pursuing creditworthy smaller businesses as their larger customers move to bond financing.

"Third, banks themselves have recognized the consequences of deteriorating credit quality without government prodding. In this year’s joint supervisory review of large syndicated credits, the regulators downgraded ratings below those of the originating bank in less than 5% of the thousands of credits reviewed; only four appeals were taken from these decisions.

"Finally, banks are adjusting their customer credit risk profiles to better reflect deteriorating conditions. Dramatic reductions in corporate profit outlook are now showing up in bank and private-sector credit ratings. These changes feed into band credit risk models, which in turn indicate that higher returns and more conservative underwriting are required to compensate for the elevated risk of lending to those companies. . ."

Correct me if I am wrong, but doesn’t Mr. Hawke essentially confirm Mr. Rutledge’s chief premise in that last statement?

SO -- WHO’S RIGHT?

It’s clear to me from other sources that Rutledge is closer to the truth--and that doesn’t spell anything but continued trouble for the U.S. economy. In between the words of these two men, the WSJ carried other items regarding how--even for growing numbers of consumers now--credit conditions are actually tightening some. In a November 12 piece, the paper’s Patrick Barta wrote of how even mortgage underwriting is getting a bit tougher, in spite of rates being at 30-year lows recently.

"In recent weeks," Barta penned, "some lenders have issued new and tighter guidelines that will make it harder or more expensive for some borrowers to qualify for home loans. The changes so far are relatively modest, and are unlikely to affect most borrowers who have ‘prime’ credit. But the changes will affect subprime borrowers, who have spotty credit; some wealthy consumers buying homes valued in excess of $1 million; and "Alt-A" borrowers, who have good credit but for various reasons can’t qualify for a low-rate mortgage. The Alt-A category includes borrowers who are self-employed and therefore can’t easily provide income verification or other documents needed for a mortgage."

In my own area, I spoke recently with the head of a company which makes loans chiefly to these kinds of borrowers, as well as for debt consolidation. He informed me that he and his banks "upstream" are seeing quite noticeable changes in credit conditions, with loans now not being made that would have been six months or a year ago.

Jathon Sapsford, writing in the WSJ on November 14, added some hard numbers to the argument that business lending is tightening, in confirmation of Rutledge’s premise. Citing a quarterly survey of 57 large U.S.-owned banks, he reported that 51% said they are tightening their criteria for approving commercial and industrial loans to large and middle-size borrowers, up from 40% during the last survey in August.

Far from affecting only "marginal" would-be borrowers, Sapsford detailed how a variety of companies were starting to get the proverbial cold shoulder. "Many good companies with sound balance sheets are not able to get credit," said Jerry Jasinowski, president of the National Association of Manufacturers, in the article. "We’re not talking about borrowers from troubled areas like dot-coms or telecom companies. We’re talking about perfectly healthy companies."

Even before I first read the Rutledge piece--and started looking around for other confirmation of a crunch (or, in lieu thereof, evidence debunking the notion) I happened to chat with a local banker who is on the same hockey board as I am. He described to me in great detail how everything I later read from Rutledge and the related items was true--and then some. His bank over the last decade, he told me, has seen its new loans increase by 7-8 percent per year--up until 2001. This year, he said, they would be lucky to see "flat" results. Further, he indicated that his bank would see even tighter standards into at least the first half of 2002, and that virtually no small business loans were being made by his bank now.

The culprit, he told me, was the O.C.C.

It’s important for you all to keep in mind the critical truths about the very nature of our so-called fractional reserve monetary system, as I expounded on again most recently in July’s issue. Understanding what I wrote will show you the reasons why the U.S. economy cannot come back in a strong and sustained fashion with this kind of a lending environment. It’s a mathematical fact that credit must always be getting more plentiful and cheaper, just to keep activity moving forward; any disruption to this has a major effect. Once Wall Street wakes up to what the widening credit crunch--and higher borrowing costs for many businesses--means for the economy’s recovery prospects, we could easily see the strong rally posted over the last several weeks unwind.

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