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Credit Losses Keep Doubling, $400bn, $800bn, $1600bn

Posted by commendatori on August 2, 2008

Credit is the fuel that drives the economy. If you want to beat the market or want to learn to invest, it is important to have a good understanding of important factors that affect the economy. The large loan losses banks are experiencing are limiting their ability to provide credit to help companies grow. If companiescannot grow their business, the economy will continue to be weak.

Credit Is the Fuel of a Growing Economy

Credit provides small, medium and large companies with the necessary capital to help them grow. A local auto repair shop with a growing customer base borrows money to acquire parts, equipment and tools so he can serve his customers. Without this credit, he is unable to properly serve his customers and grow his business.

A medium sized manufacturer needs to renew her supply of components before her company can build their new products. Without credit to buy the materials, her company will not be able to produce the products it needs to sell to pay salaries and remain in business.

Credit, primarily from banks, provides the cash many business need to be able to fund their working capital and acquire equipment that make them more competitive. Without this source of funding many business must tighten up their spending and put off growth plans. As a result, the economy will feel the affects as unemployment increases, sales and profit take a hit and the markets reset their expectations.

Bank Lending Constrained

Banks are unable to lend when they are capital constrained, especially due to large loan losses. The total volume of loans a bank can generate is limited by its available capital. Bank regulators use capital ratios to control the total loan exposure of any one bank. When a bank incurs loan losses, it directly affects their capital ratios and reduces the amount of loans then can make.

About a year ago, the “analysts” estimated that the total write down of bad loans would be about $400 billion. Then by December 2007, the estimate doubled to about $800 billion. Then along comes a report from Bridgewater Associates that expects the number to double again to $1.6 trillion. Bridgewater is a very large hedge fund who is also one of the top analytical firms. Up to now, the banks have been using a ‘mark-to’model’ method of valuing the structured debt. According to Bridgewater, the models used have grossly underestimated the actual losses. They doubt the financial institutions will be able to generate enough capital to cover the losses.
According to the report, “Lenders would have to curtail loans by roughly 10-to-one to preserve their capital ratios. This would imply a further contraction of credit by up to $12,000bn [$12 trillion] worldwide unless banks could raise fresh capital.”

Not all of these losses are in the sub prime market. According to the report, more than 90% of the losses from sub prime loans have already been written off. Unfortunately, the losses form the prime and Alt-A loans could be much larger than we have already seen. The sizes of these loan portfolios are much larger than the sub prime portfolios. Further, Bridgewater expects about $500 billion in corporate losses that must be written off. This leads to the current estimate of more than $1 trillion in losses yet to be written off.

Much of the capital that banks have sold recently is to help bring the banks capital ratios into regulatory compliance. This does not mean they cannot make more loans. If they can make any new loans, the rates on these credits will be much higher. This is why the local auto repair shop cannot get new loans. Businesses across the United States are realizing that credit is either not available or the interest rates are much more expensive.

Weak Second Half 2008

With out sufficient credit to help fund businesses, investors should expect a weaker economy in the second half of 2008. Many analysts and especially the talking heads will focus on the mortgage market. However, the lack of available credit is spreading to everyone. The problem is not that these companies have poor credit. The problem is that the banks are constrained by the amount of credit they can make available due to their weak capital position. Even with the Fed Funds rate at 2.0%, the Federal Reserve cannot change the unavailability of credit. This means the economy will experience a prolonged weakness that will not end until the additional loan losses have been written off. If Bridgewater is right on the total size of the losses, we are not even half way there.

As investors, we need to adjust our strategies to expect a weak second half of 2008 and possibly into the first part of 2009. We need to employ bear market strategies that take advantage of discernable trends and higher volatility in the markets. For example, biotechnology has been outperforming the market recently. This has been a good place to have invested even in a week market. Moreover, industry and market Exchange Traded Funds (EFTs) that short the market are appropriate when this bear market reaches key resistance levels.

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