SuperModels4/24/2008 12:01 AM ET
As loans dry up, so will economy
Those who say that the worst banking news is already out are more wishful than watchful. Take a look at what happens when businesses can't borrow what they need.
By Jon Markman
If you've been feeling pretty good about the prospects for the economy as the stock market has climbed off the mat, I suggest you forget the Dow industrials ($INDU) for a minute and look toward Yakima, Wash.
That's where Western Recreational Vehicles, a four-decade-old company employing 220 people, closed its doors last week.
The family-owned maker of Alpenlite-brand motor coaches and campers had survived every bad economy and spike in oil prices since 1971, but it had to shut down when banks yanked its credit. Without the ability to borrow to buy parts and maintain payrolls during a period of seasonally soft sales, as it has always done, a wonderful small business went poof.
Some 200-odd jobs might not seem like a lot, but multiply that times several thousand around the nation and you get an idea of the tsunami of pain that's rushing toward U.S. banks and the businesses they serve.
Credit is the fuel of industry, and it is a vanishing resource despite a campaign of unprecedented swiftness by the Federal Reserve to slash short-term interest rates. As it disappears from the landscape, so, too, will hopes of a broad, lasting recovery.
"What people are missing is that credit may be cheaper but businesses don't have access to it," says Peter Morici, an economist and business professor at the University of Maryland who has been critical of banks. "Most people want to deal in absolutes, but they need to realize that less is almost as important as none. If there's 25% less credit available, it's like having 25% less crude oil -- it's very bad news for the economy."
To the lifeboats
This is a relatively new phenomenon in America, which is why it is so hard to comprehend. Few investors have seen the effects of constricted credit, as banks until now adeptly summoned, bottled, distributed and marketed it. Credit has been like an aquifer that businesses figured they could depend on to be there when they needed it -- maybe more expensive at some times than others, but always available.
Yet banks' egregious greed and misdeeds of the past few years have made credit dry up, and so they're keeping what they can get to themselves. Reading through the recent earnings reports of Bank of America (BAC, news, msgs), National City (NCC, news, msgs) and Citigroup (C, news, msgs), it's hard not to get the impression that the banks have decided it's every man for himself -- the heck with the women, children and small businesses.
The banks seem to be under the impression that hoarding capital to shore up their balance sheets will return them to health, but my sources believe they are badly mistaken. By refusing to lend to businesses as they did before the advent of exotic and expensive derivatives, they risk killing their own business as well. If this is true, as I suspect, then banks' recent mild recovery will be short-lived, and investors should continue to avoid them.
The central problem, as veteran investment banker Byron Wien described it in a recent essay to Morgan Stanley (MS, news, msgs) customers, is that banks have entered a time of secular, not cyclical, change that will keep them from regaining their place atop the food chain for the next few years.
Let's look at how we got here before considering what happens next. Wien points out that before the 1980s, banks were conservatively managed private partnerships that were content to make a profit by borrowing money from customers' passbook savings accounts at relatively low rates and lending it out at out at higher rates.
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A new mortgage problem
The White House has proposed that lenders who renegotiate mortgages should get a guarantee from the Federal Housing Administration. But the FHA has its own crisis brewing, MSN Money's Jim Jubak says.
Then, in a newly deregulated climate starting in the Reagan administration, banks merged, got much bigger and global, went public, leveraged up their balance sheets at more than twice the rate of their industrial counterparts and developed a multitrillion-dollar derivatives business from scratch.
Masters of a shrinking universe
Through the 1970s, the banking biz was no great shakes and did not attract top college graduates. But as it became more competitive globally and further deregulation allowed commercial and investment banks to merge, pay scales escalated to the point where million-dollar salaries were common, opening a vast breach between compensation at financial and industrial companies. Tech boomed, overseas markets opened up, and bankers became masters of the universe.
After the tech bust of 2000, Wien explains, banking fees were under pressure, and brokerage commissions were shrinking. So financial-services firms were under the gun to find ways to provide their supergenerous compensation to employees. Leveraging superlow interest rates provided by the Federal Reserve after the 2001 terrorist attacks and recession, they found their answer in the invention of subprime mortgages.
Continued: The 'global liquidity factory'
These instruments opened up a vast new market for individuals with low credit scores, and their high but risky yields led to the creation of a derivatives market aimed at transforming them into highly rated securities that could then be sliced up and sold to unsuspecting buyers overseas. In turn, proprietary trading desks were expanded to trade these instruments back and forth.
All of these efforts to create what a Harvard endowment executive termed the "global liquidity factory" generated ungodly fees and were predicated -- as I have written earlier -- on the notion that the real assets underlying the loans and derivatives, U.S. real estate, would keep rising.
Now, of course, we know that as soon as home prices began to peak in 2006 and mortgage loans began to collapse, the bond values began to collapse, and the gig was up. Yet the banks had massive, expensive corporate machinery and personnel in place whose very existence depended on healthy securitization and derivatives markets, not to mention gullible customers.
Greedy little pigs
So the industry now has to deal with the fact that it has burned an entire generation of overseas clients who are faced with massive write-downs of the values of bonds they've bought over the past seven years. Those portfolio managers are still so angry at Wall Street banks that they don't want to hear about any new securitized debts, leveraged loans or derivatives of any kind, no matter how healthy and ordinary they may look. They have slammed the door.
It's this shutdown of the securitization market that is showing up now on banks' balance sheets as a big smokin' hole. Despite many bank executives' wishful comments to the media over the past few weeks that "the worst is behind" them, the business that supported million-dollar salaries to 25-year-old bankers fresh out of graduate school is dead.
As you can imagine, loss is painful, and, as in any other part of our lives, it's easier to just shut it out than deal with it. This has meant that banks are not yet cutting back their expenses and infrastructure to the extent necessary to allow them to get back into the business of borrowing money from depositors and lending it out to worthy companies like Western Recreational Vehicles.
The bottom line, Maryland economist Morici says, is that bankers grew to have such an "overenthusiastic opinion" of their self-worth that the idea of making loans that can't be securitized at high fees is unpalatable.
"There's a greedy little pig that has to be paid," he said. "They seem to think that they have alternatives so they don't need to resurrect their former business plans, but they're wrong. It will take a while, but they will learn they need to become plain old banks again."
Wien likewise concludes that banks need to face a "reduced level of profitability . . . going forward" until some new source of extreme profit growth emerges.
Video on MSN Money
A new mortgage problem
The White House has proposed that lenders who renegotiate mortgages should get a guarantee from the Federal Housing Administration. But the FHA has its own crisis brewing, MSN Money's Jim Jubak says.
Until they do, I'm afraid that bank shares will stagnate within a few bucks of current levels. In banks' weakened state, credit growth will also likely flat-line, reducing the entire economy's ability to expand. In this new Age of De-leveraging, perhaps we'll sense a turnaround is near only when a top MBA school announces that mining and agribusiness have replaced investment banking as the No. 1 choice of careers for new grads.
Fine print
To learn about the Robert H. Smith School of Business at the University of Maryland, where Morici is a professor, click here. To read a recent op-ed article by Morici, click here. . . .
To learn more about Wien and see his 10 predictions for 2008, click here or download this file (.pdf).
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At the time of publication, Jon Markman did not own or control shares of any companies mentioned in this column. |
