Massive Fed Intervention Cannot Force Consumers to Borrow and Spend We hear this everyday: the banks aren’t lending. We’ve given them billions ($167 billion, to be precise) and those bastards are hoarding money. We’ve got to take the banks over and make them lend. Which is what Secretary Paulson has been doing. He’s injecting capital by investment and loans, boosting their capital reserves, and taking an ownership position in the banks. You may not think that bank nationalization is what’s occurring but what do you call an “investment” with strings attached. That assumption has now been proven wrong. A study put out by the Minneapolis Fed says that while banks have tightened lending standards by being less eager to lend, they are willing to lend to qualified borrowers: Said a South Dakota bank with $500 million in assets, ‘Credit has not stopped, but no credit will be allowed outside of policy limits and standards. … There is less tolerance for risk in this kind of market.’ So what is happening? According to the Fed study, reported in the January issue of the Minneapolis Fed’s fedgazette, there are just fewer borrowers: … [A] new credit environment is evolving: banks and credit unions are more cautious about whom they lend to, and fewer borrowers are seeking new credit in the first place. Good credit risk might have to look harder than they did a few years ago for financing and pay more for it. In general, financial markets might be described as returning to traditional standards, where credit history, down payments and metrics such as loan-to-value and debt-to-income ratios matter again. This was a large study; they canvassed 2,500 businesses and 367 financial institutions in their district. Here’s a chart showing the credit picture. The bottom line: banks have the cash but people are borrowing less. This has been the biggest credit cycle in America’s history. We have been running on the housing credit card for the past seven years in an unprecedented explosion of debt. The following chart shows that the purchasing power of the homeowners tripled from 2000-2006: The housing credit card has been cancelled. The following chart shows that homeowner equity has fallen to below 50% for the first time since 1945. This is exactly what happens in a credit cycle bust. Both borrowers and lenders are cautious and credit freezes. The same thing happened during the Great Depression, or for that matter, any depression. Consumers hunker down, fearing the worst. This isn’t necessarily a panic or wrong behavior by consumers. It is a rational act in an uncertain world. Just because the Fed and Treasury are flooding the system with credit isn’t going to change this behavior until (1) people see housing values in their neighborhood stabilize, (2) they are not afraid of losing their job, (3) they are not afraid their neighbor is losing his job, (4) their savings grow to offset future uncertainty, and (5) their personal debt is reduced. What to do? Spread the safety net and wait for things to sort out. This thing would be over in 24 months if the politicians did nothing. It’s never pretty. But it’s quick. What will happen with all of the interference with the corrective mechanisms of the market? This goes back to the Law of Unintended Consequences. The first result will be a continued freeze of economic activity as a result of market uncertainty. Until the housing market reaches bottom, until the massive expansion of debt and its related securitized instruments (subprime, Alt-A, GSE bonds, commercial real estate loans and MBSs, securitized credit card debt, and other CDOs) are quantified and properly accounted for on balance sheets, economic activity will remain suppressed. The Fed and Treasury are doing everything in their power to prevent this necessary correction of balance sheets. The unintended consequences will be stagnation, high unemployment, inflation, and further involvement of the government in the affairs of the free market which has always led to massive economic disruptions. As this Fed study shows, they will never have all the necessary information to fiddle with the economy. We will suffer because they believe they have the answers.
Why would that be? Consumers are cutting back. Christmas sales are starting to show that. A major privately owned high-end retailer in San Francisco told me that sales were off 35% already. No matter how much the Fed flogs this horse, it isn’t going to get up. We now know the problem isn’t the lack of cash or credit, but a combination of tighter lending standards and the relative paucity of borrowers. The Fed calls this “credit vertigo.” 
