Tuesday, 18 November 2008

Where financial gangrene threatens to develop in the US financial system

Socialist Economic Bulletin has noted that the huge financial effort put into trying to prevent the collapse of the most important, that is the system making, banks is draining resources out of the rest, i.e. 'the periphery', of the financial system.
Alongside the effect this is having on countries such as the Ukraine, Pakistan, and Argentina, an important new paper by Victoria Ivashina and David Scharfstein of the Harvard Business school analyses the operation of this process within the US financial system itself.
They note that in the US: 'new loans to large borrowers fell by 36% during the peak period of the financial crisis (August-October 2008) relative to the prior three-month period and by 60% relative to the peak of the credit boom (May-July 2007)...
'Although new lending has fallen, since September 2008, there has been a sharp increase in commercial and industrial (C&I) loans reported on the balance sheets of U.S. banks... [Some analysts have] interpret[ed] this as new bank lending; however, our evidence is inconsistent with this view. Instead, we suggest that the rise in C&I loans on bank balance sheets comes in good measure from an increase in drawdowns on pre-existing revolving credit facilities ("revolvers").
'These drawdowns are not just from high quality borrowers who are shifting from the commercial paper market because of disruptions in that market. Many of them are very large, low credit-quality borrowers, who are now borrowing on the generous terms that were offered during the credit boom, though they are now much riskier. While this may help these firms, it may also crowd out new lending to other firms. The amount of outstanding revolvers is very large, and banks may be holding back on new loans to protect against flood of draw-downs if the economy continues to deteriorate.'
They conclude: 'New lending in 2008 was significantly below new lending in 2007, even before the peak period of the financial crisis (August-October 2008)... new lending to large corporate borrowers peaked in the period, May-July 2007. In September 2007, concerns about the credit risk of all types of collateralized debt obligations (CDOs), led to a drop in institutional demand for syndicated loans... By May-July 2008, lending was 38 per cent lower than the peak of the credit boom....
'The decline in new loans accelerated during the financial crisis, falling by 36 per cent in the August-October 2008 period relative to the prior three-month period. Thus, bank loans fell from $667.4 billion in May-July 2007, the peak of the credit boom, to $414.8 a year later, and then to $264.7 billion three months later in the August-October 2008 period. The drop in October, 2008 was particularly steep. Lending during the peak financial crisis period was just 40 per cent of peak lending little over a year earlier...
'During the peak period of the financial crisis (August-October 2008), non-investment-grade loans fell by 50% relative to the prior period, while investment grade loans fell by 19%. '
This analysis describes graphically how blood is being drained out of the US financial system despite the huge increase in taxpayer bailout activites to the banks.
Noting the operation of this process the Wall Street Journal comments: The worst of the credit crisis is being felt not in banks but in financial markets. Loans from a bank might stay on its books. Increasingly in the past decade, loans were packaged into securities and sold to investors around the world - pension funds, endowments, mutual funds, hedge funds and others. Institutional investors gobbled up this and other kinds of credit that didn't come via traditional commercial banks, such as junk bonds or commercial paper.
'To get credit flowing, policy makers need to repair financial markets as well as banks. But investor confidence in credit markets has been shattered, in part because many debt securities performed so much worse than their credit ratings suggested they would.
'Issuance of asset-backed securities - instruments used to package credit-card and auto-loan debt during the boom - was down 79% in the year through October from last year, to $142 billion, according to Dealogic data. In 2005 and 2006, investors snapped up more than a trillion dollars of these instruments. Junk-bond issuance was down 66% in the first 10 months of the year from the same period in 2007. '
In short, the system making banks have been propped up through very large transfers of taxpayers funds. Financial circulation has been restored in the core of the system. But circulation is stopping in the periphery of the system both geographically and in terms of financial markets within the most economically developed economies themselves. This is now where the credit crunch is most advanced.
In addition to the importance of this development itself a key issue will be whether the poisons being produced from this financial gangrene will invade the core of the financial system again.

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