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Sunday, 10 February 2008

The Collection Agency – Weekly Report

The Collection Agency – Weekly Report

10th February 2008

Welcome to The Collection Agency Weekly Report, a new way to present my thoughts on the macro-economic outlook and the possible effects on financial markets. This first edition is a trial run of what hopefully will become a weekly event, seperate from but not replacing the Occasional Letter. At the end of the report is an email address, please feel free to send any constructive comments about this report. Now, on with the report.

Evidence from the US Federal Reserve shows lending standards have tightened appreciably in the past 3 months. Although this is lagging information it is of great importance as it shows the level of liquidity available to consumers and business. Whilst it can be risky to extrapolate a forward outlook from past data in this circumstance we see no current indicators that say conditions have reversed.

The Fed gathers opinions from the largest banks in each Federal Reserve District by asking them to complete a survey. The sample is selected from among the largest banks in each Federal Reserve District. In the table, large banks are defined as those with total domestic assets of $20 billion or more as of Sept. 30, 2007. The combined assets of the 33 large banks totaled $5.69 trillion, compared to $5.95 trillion for the entire panel of 56 banks, and $11.07 trillion for all domestically chartered, federally insured commercial banks.

As we are trying to look forward I want to concentrate on what the banks are doing in relation to the lending of credit to commercial and industrial (C&I) business and consumers.

Let’s look at C&I loan standards.

Standards for large and middle-market firms (annual sales of $50 million or more):

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Standards for small firms (annual sales of less than $50 million):

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Standards across the board tightened in the 4Q and especially in the smaller banks. With 25% of the banks surveyed tightening and no banks easing, qualifying for credit for businesses has become more difficult. It’s not just small business either as we can see above, the tightening of standards is universal. Banks are not tightening because of a recession risk per se. It would appear their actions are intended to discourage overall lending throughout the economy.

It could be said that banks are just more cautious in their use of capital but further evidence points to other measures that have been taken to discourage business borrowing. It also reveals the weakness of banks in the current climate.

Let us look at the terms and conditions banks require for making a loan. I will just use the data for large and middle market firms as the figures for small firms are comparable. Whilst the maximum size and maturity of credit lines and loans has tightened as would be expected with a squeeze on standards, we also see the following:

Costs of credit lines:

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Spreads of loan rates over your bank's cost of funds (wider spreads=tightened, narrower spreads=eased):

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Premiums charged on riskier loans:

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There can be no doubt banks are raising costs, including spreads over their own funding (borrowing). This is not a move to protect against default in risky loans either, you can see that above as I have included premiums asked for riskier loans. Costs for loans not considered risky have also risen, even as prime rates have fallen.

The Fed began cutting its headline rate in September ’07, having cut the discount rate in August that year in response to the arrival of the credit squeeze in July. The banks received the survey in early January of ’08 and the returns were due by the 17th . That means the period reported on does not include the emergency inter-meeting cut and the further cut at the FOMC meeting in January. It does mean the Fed knew that lending standards had tightened considerably and this may well have been the reason for the Fed to dramatically cut its own Fed Fund Rates in an attempt to loosen conditions. It may well have realized that “baby step” reductions in the Fed Fund Rate were having little effect on bank rates beyond the published prime rate.

Has the Feds action had the desired result? At face value it may seem so as the prime rate that banks quote has dropped with the cuts in FFR. The differential has remained at 3% (Jun 06 PR – 8.25% / FFR - 5.25%, Feb 08 PR - 6% / FFR - 3%) but actual spreads above the PR have increased.

We already know that the sub-prime mortgage market has reduced to the point of almost being closed and that the standards for prime mortgage products have tightened. What though of the consumer credit card and loan market? Are stresses in bank capital resources showing here too?

As you can imagine the survey shows lending standards to have tightened with stricter criteria for fund amounts, credit scores and a widening of spreads for those that meet the requirements of a prime customer. The tightening for those with sub prime credit scores has been more severe.

Let’s see what the Fed survey shows:

The extent to which loans are granted to some customers that do not meet credit scoring thresholds (increased=eased, decreased=tightened):

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Spreads of loan rates over your bank's cost of funds (wider spreads=tightened, narrower spreads=eased):

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Banks are tightening and increasing costs to consumers even with a Fed easing policy in place.

Finally what does the Fed survey reveal about why banks feel they need to tighten lending and raise costs to borrowers? The Fed asked the banks the following questions:

“Assuming that economic activity progresses in line with consensus forecasts, what is your outlook for delinquencies and charge-offs on your bank's loans to businesses in 2008?”

Outlook for loan quality on C&I loans:

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Outlook for loan quality on commercial real estate loans:

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Outlook for loan quality on subprime residential mortgage loans:*

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*For this question, 47 respondents answered “My bank does not originate this type of loan.”

In fact a similar picture exists for all type of loans at all levels of risk, deterioration in quality is expected by the majority of banks. Why do banks think this will happen? Again, the survey reveals the expected path banks see in the future when it asked for “possible reasons for tightening credit standards or loan terms”:

Deterioration in your bank's current or expected capital position:

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Less favorable or more uncertain economic outlook:

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Worsening of industry-specific problems:

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Up until the survey was completed banks did not see deterioration in their capital as the main risk to loans, the concern was with the economic outlook and industry specific problems. Just under 25% of the banks in the survey did see a risk to their capital positions going forward. I expect that to have increased of late, with the threat to Bond (monoline) Insurers becoming greater by the day. For the purposes of this letter we will adopt the 25% as a conservative measure of what assets may be at risk.

The Fed survey has a summary of the assets of banks in the survey and for all domestically chartered, federally insured commercial banks:

“The sample is selected from among the largest banks in each Federal Reserve District. In the table, large banks are defined as those with total domestic assets of $20 billion or more as of Sept. 30, 2007. The combined assets of the 33 large banks totaled $5.69 trillion, compared to $5.95 trillion for the entire panel of 56 banks, and $11.07 trillion for all domestically chartered, federally insured commercial banks.”

Again, let’s be conservative and use only the assets of the banks within the survey, namely $5.95 trillion for the 56 banks used (although only 53 banks answered the question). 9 banks said their capital position was important, of which 7 were large banks. Using the 7 large banks only and again being conservative, let’s assume that only these 7 will have problems, i.e. are going to default and the malaise doesn’t spread to other banks. A minimum of $140Bn worth of assets are at risk. More realistically I suspect that figure should be doubled. It should also be noted that other banks may have deterioration in their capital position but when the survey was answered did not consider it to be important. That answer may well change in the coming months.

Banks are in a weak position and face a double whammy. Not only are capital positions under threat but the usual remedies of hoarding cash by restricting lending and raising the cost to borrowers may not be enough to cover the liabilities. Further downgrades of financial derivatives, bonds, junk bonds and falling stock prices will be a blow from which some may not recover.

Finally the survey reveals the one factor that most worries banks as shown by their answer to the following question:

”How significant do you anticipate the following potential obstacles to be for your bank to undertake the loss-mitigating strategies”

Borrowers are less motivated to retain possession of property:

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We are already seeing stories in the media about people walking away from overpriced assets, many of whom are not in foreclosure. It looks to me that banks expect this pattern of behaviour to grow. I doubt it has been built into the risk models used when packaging and rating CDO, MBS etc.

How has the change in the banks attitude affected the consumer? We have already seen the slowdown in housing sales accelerate and be joined by the drop in car sales. Have smaller purchases been cut too? The following is typical of how retail spending is being reported:

From ICSC: "January sales grew by 0.5 percent on a year-over-year comparison for the same month of 2007 on a comparable store basis for U.S. chain stores. The softening of retail spending was across the board especially for luxury and department stores sales, which have dropped significantly from last year, weakening the overall sales gain for January. Wholesale clubs, the only category showing considerable growth (+6.3%) demonstrates that consumers are being conservative in their spending. Editor's note: 1.5 percent of the 6.3 percent growth rate for wholesale clubs can be attributed to gasoline sales."

It’s not just consumers that are retrenching as the latest jobs report shows:

(AP) –“Nervous employers cut 17,000 jobs in January -- the first such reduction in more than four years and a fresh sign that the economy is in danger of stalling. The Labor Department's report, released Friday, also showed that the unemployment rate dipped slightly to 4.9 percent, from 5 percent, as the civilian labor force shrank slightly.”

Joel Naroff, president of Naroff Economics Advisors had this to say:

“The mind-set of businesses people is one of some fear and uncertainty about the economy's direction, he said.”They are thinking if there is some capital spending I should postpone for a while, I should do that. If there is some hiring I don't necessarily need to do right now, I can put that off for a few months to see what happens," Naroff said. "The problem with that thinking is that more economic weakness or a recession can become somewhat of a self-fulfilling prophesy."

Although the Fed is aware of the problems it is also becoming clear that reducing the FFR is having only a limited effect. Banks will not be able to loosen their own standards until capital reserves are deemed sufficient and bad debt has been cleansed by a recovery in prices or being written off.

Until this happens credit availability will continue to contract for all sectors of the US economy. A lack of credit coupled with a demand to pay off existing debt will have dire consequences for any possible expansion of the manufacturing sector, small businesses and the self employed. Most at risk are those parts of the service and manufacturing sector that are reliant on discretionary consumer spending.

One last chart that shows an interesting development when comparing Dow Industrials and Morgan Stanley’s Consumer and Cyclical Indices. Unlike 1999/2000 when the Cyclical and Consumer Indices gave an early warning of impending recession, this time no warning was forthcoming.

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Without wanting to sound too obvious it would appear that the root cause to the current situation is very different to that which led to the recession at the beginning of the decade. Then a slowing of consumer spending and capital investment by companies led to a drop in productivity and rising unemployment. These conditions were alleviated by reducing the cost of borrowing and relaxing standards to all time lows, re-inflating the economy.

This time is indeed different. As banks fight to survive an attack on their capital reserves they have withdrawn liquidity by reducing the amount of credit and raising its price to help bolster income flows.

Until their reserves are once again capable of covering both the Basel 2 requirements and are able to absorb losses from the bad debt on the balance sheets, credit conditions will remain tight.

I hope you enjoyed reading this report. As I mentioned this is a trial run of a new format and I would be interested in constructive remarks about its layout and content. Send an email to

All rights reserved. Copywrite Mickp aka The Collection Agency.

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