Banks to trample growth in rush to deleverage: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

LONDON (Reuters) - The process of taking leverage out of the financial system, only now in its early stages, will put an increasing drag on economic growth and corporate profits.

Deleveraging, cutting back on the amount borrowed as compared to equity, is the dominant theme in markets and economics in 2008 as the financial system recoils from the massive losses in structured finance and the housing bubble.

Those losses -- which are still mounting and being recognized -- have piled up faster than banks can raise new capital, leaving the system today more extended than it was before the crisis began.

JP Morgan has estimated that banks have raised more than $300 billion in new capital, as compared with $400 billion in recognized losses, a figure others have estimated could ultimately reach $1.3 trillion.

And since markets are now more volatile, which requires more equity as a cushion, and in light of what will be huge regulatory pressure to take less risk, investment and commercial banks will be trimming their sails for a long time to come.

While banks and other financials are scrambling to cut back on their lending, there is also pressure to make what debt financing remains longer term, especially among investment banks chastened by the flameout of Bear Stearns.

"Broker-dealers were very reliant on short-dated funding," said Jan Loeys, head of global asset allocation at JP Morgan in London.

"To avoid all going the Bear Stearns way they are scrambling to get proper long-dated funding. That is an avalanche at the moment which the bond market is having trouble absorbing."

Borrowing short and lending long, the basis of all banking, was taken to extremes though numerous bank-affiliated schemes that counted on the willingness of money market investors to provide a steady stream of funds for that little extra in interest.

Loeys thinks those schemes, which provided $5.9 trillion in financing at their peak, were actually a large contributor to the "bond conundrum" that puzzled Alan Greenspan in 2005 when long-term rates fell even as he hiked short-term ones.

So now that's over, what will be the costs?

Loeys argues that the cost of borrowing will go up across the board, but even more for those who wish to secure long-term funding. He expects inflation-adjusted government bond returns to return to their historic averages. That implies an extra 1.75 percent of yield on a 10-year bond above current rates at today's expected rate of inflation.

While a steeper and higher yield curve will help banks to make money, ultimately easing the credit crunch, structurally higher interest rates will be a big brake on economic growth, hitting both businesses and consumers.

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