The recent mayhem in credit markets that triggered the larger than expected Fed Rate cut and caused Mervyn King, Governor of the Bank of England, to volte-face, occurred because of unprecedented conditions that were so strained that major banks wouldn’t even lend to each other. As a result of Central Bank intervention, that situation is improving although, by no means, are conditions back to where they were pre-August. Nonetheless, in due course, it is very likely that major banks will trust each other again and business, in those terms at least, will get back to normal.
The credit crunch is however, accompanied by something more sinister – a credit contraction. There is no likelihood of any let-up of that condition. To give an example, only this week a client said that three of his friends who ran their own business, businesses that had been established for twenty years or longer, all suffered bankruptcy because banking facilities were unilaterally withdrawn. That’s what a credit contraction is all about. In only today’s Wall Street Journal there is an article headlined “Lenders cut credit for UK firms”, Paul Hannon and Joe Parkinson explain that UK companies will find it harder and more expensive to borrow. This data arose from a Bank of England survey that was only released yesterday. The banks’ first Credit Conditions survey found that banks and other financial institutions actively cut lending to companies during the third quarter and will do so even more sharply in the final three months of the year.
One of our prize possessions is an article by P Henry Mueller, written in 1978 when he was Chairman of the Credit Policy Committee, Citibank. The article discusses the relationship between the economic picture and the loan decision and was entitled “What every lending officer should know about economics”. He makes the point that economic activity is actually far more stable and its pattern of change more predictable than many believe and that it is possible to make accurate predictions about directions of change. He also, in some detail, itemised the stages of the cycle from boom to bust and how bankers react to the various stages.
To align Mueller’s article to the current situation we will look at the boom period which has just ended and then the bust period which has just commenced – remember this was written in 1978, see how redolent it is of current conditions.
The Boom. The behaviour of borrowers during this period is that:
• Their optimism mounts
• Orders and prices soar above historic norms, often at unsustainable levels
• Reluctant to turn to long-term financing, increases short and indeterminate credit substantially (Northern Rock borrowed short and lent long!)
The behaviour of the lenders is key:
• Optimism mounts
• Increasing amounts loaned against increasing cash flow; over generosity on the part of lenders. In some instances the liquidity supplied by the bank is all that is keeping the borrower afloat. (This could be shortened to say “Stupid lending practices”)
• Susceptibility to euphoria and loss of perspective of what constitutes a good credit. Mania for growth, going down-market to get it (“did somebody say subprime lending?”).
The Bust. This is the path upon which the developed world is now embarked, led by the USA. The behaviour of the borrower during this period:
• Pressure on working capital
• Pressure on the fixed debt servicing ability
• Takes large write-downs in recognition that assets are inflated. (That could in turn precipitate other problems if those assets represent security to the bank.)
The key to everything of course, is the behaviour of the lender. Expect lenders to:
• Discourage loans for purely financial activities – acquisitions or purchase of own shares and speculation (Headline in this weeks’ FT “Credit squeeze hits US buy-back activity.)
• Display less flexibility on moratorium or grace periods
• Raise interest rates and harden the fee structure.
Exactly the conditions suddenly faced by the three now bust companies referred to at the start of this Conclusion.
What a waste of time it was for Mr Mueller to have written this article and produced this data because nobody in banking has ever taken notice of it, this is not the first occasion since 1978 that banks have fallen into the trap of being susceptible to euphoria and it won’t be the last.
George Soros, in 1987, published his book The Alchemy of Finance. Central to his book was a concept he called “reflexivity”. He explained it as follows:
“The generally accepted theory is that financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly, because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal.”
His words are entirely appropriate for the conditions prevailing now. It really isn’t true that because the economy appears to be in good shape the financial problems will rectify themselves because the financial problems are seismic in their character; they will cause the economy to change. Credit contraction is an unavoidable consequence of the credit expansion that no amount of Central Bank easing will change.
The velocity of money will be dictated by the willingness of commercial banks to lend generously as if the boom still existed. The very structure of that boom was based upon the credit expansion which can no longer continue because it is obvious to everybody how ludicrous those lending practices had become. The truth of that fact is undeniable; no bank can revert to those practices again for many years to come. So it doesn’t matter what the Central Banks do, the commercial banks are now risk averse, looking to constrain not expand borrowing.
The economy which depends upon economic activity expanding will contract, recession will occur as a natural consequence of the credit contraction.
If it is certain that we are going to have a recession and we certainly think that is the most likely scenario then before the recession becomes official, stock markets and certain other asset markets such as property will be much lower than they are now. As Andrew Smithers said in his most recent commentary, the chance for a major stock market loss is much higher than that of a major rise.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit https://www.rhasset.co.uk/