The Crowding Out Effect

Based on recent developments, including the desperate scramble to arrange a bailout for bank-affiliated investment funds known as "SIVs" (the Naked Capitalism blog is the go-to source for insights on this particular smoke-and-mirrors operation), the walls seem to be closing in on banking sector.

Unfortunately, while it may seem all fine and dandy to say, as some do, that the greedy bankers had it coming to them, the truth is that the shock waves from this unfolding fiasco are likely to be far-reaching. In other words, it won't just be bad news for Wall Street; Main Street will suffer, too.

In "Banks' Debts Threaten Growth," the Financial Times reports on what happens when lenders' highly-leveraged balance sheets are subjected to what might be described as a kind of "crowding out" effect.

Big US commercial banks have seen $280bn of new debt come on to their balance sheets since the credit squeeze, threatening to undermine economic growth by inhibiting their ability to make new loans.

The banks have been forced to take on to their books large amounts of commercial paper and leveraged loans after investor demand for such assets dried up in the summer.

David Rosenberg, economist at Merrill Lynch, said that this amount had risen to $280bn since the start of August.

He added that according to data from the Federal Reserve, large bank capital - represented by net assets - had declined by $40bn since the beginning of August. "This has never happened before over such a short timeframe and this is rather serious because such a steep and sudden compression in large-bank capital has the potential to create a negative lending environment," he said.

If left unchecked, this could "significantly inhibit" economic growth, he added.

European banks are facing similar pressures with many observers expressing concern at the ability of some smaller lenders to handle the potential strain on their balance sheets.

Fears over the effect of the credit squeeze on US bank balance sheets was one factor behind the US Treasury's encouragement of the creation of a "super fund" to take on the assets of troubled investment vehicles.

The three top US banks - Citigroup, JPMorgan Chase and Bank of America - this week unveiled plans for a fund that would buy up to $100bn of mortgage-backed assets from structured investment vehicles.

Citigroup, which manages $80bn of assets in such vehicles, has bought some of the vehicles' commercial paper.

On Monday, Citi said it was suspending share buy-backs because its capital ratios had weakened partly due to the large amount of commercial paper and leveraged loans it had taken on.

According to Moody's, the credit rating agency, assets held by bank-sponsored special investment vehicles fell to $320bn from $395bn in July.

"The large banks have been forced to take commercial paper back on their balance sheets and as a result are choking on assets they did not plan on having - thereby tying up regulatory capital and in turn possibly leading to a reduction in credit extension," said Mr Rosenberg.

He pointed out that 30 per cent of the growth in the debt that US households took on was backed by asset-backed investors.

Leverage in reverse. It's not a pretty sight.

Comments

[Mark Palermo]

I fear this. I hate it, too, because it is an example of the financial institutions’ utter and complete failure to do what they are supposed to – manage risk. They bent all of the rules. First, it’s a bit of creativity. Make loans but “move the risk off balance sheet” like that makes the risk go away. That works so well, now it’s time to make more loans because this structure, without the usual mess of regulatory controls, is really profitable. In fact, make more loans, more, more!..What, there is nobody left who can afford to buy a house? Get creative! Teaser rates, structured finance for the average person who cannot afford a home. Go ahead, bend those time tested rules of lending. Who needs income! Will we ever learn?
I question the “Daddy” SIV at www.polecolaw.blogspot.com
Thanks for the post.

[John T]

I've noticed on my credit cards that citibank and chase have been moving up the due dates on payments. I would not be surprised if they need the money now!