Banks to trample growth in rush to deleverage: James Saft

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

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.


To get a sense of exactly how early we are in the process of deleveraging, have a look at the U.S. data on commercial and industrial lending.

Commercial and industrial loans by U.S. commercial banks are actually up almost 20 percent compared to May 2007, while consumer loans are up 9 percent. But much of that lending was either made under existing contracts banks would love to be rid of, or was a result of banks not wanting to burn client relationships before they absolutely had to.

They now absolutely have to burn clients and preserve capital, so we can expect that the effects of deleveraging on the wider economy, particularly corporations, is only beginning to be felt.

Credit spreads, the extra interest lenders charge corporate borrowers, are likely to remain elevated until deleveraging runs its course.

“Credit investors have one very clear message for equity investors: the duration of the slowdown will be longer than the stock markets think, and the effects of the credit crisis will stay with us for many years,” Dresdner Kleinwort credit strategist Willem Sels wrote in a note to clients.

“Tighter financing conditions and higher corporate defaults will directly or indirectly affect almost any corporate.”

It really does all come down to self-reinforcing cycles. During the credit boom money flowed freely, driving up asset prices and encouraging consumers to spend, thereby juicing corporate profits and justifying the risks lenders took.

But now money is tight, property prices are falling, consumers are constrained and corporate profits are beginning to disappoint: all forces that will reinforce one another on the downward trip.

The Federal Reserve has acted decisively, and who knows, they may not have to orchestrate any more bailouts, at least massive ones. But we have at least a year of financial deleveraging yet to come, a process that will transform the banking industry and make modest economic growth an uphill slog.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. --

Editing by Ruth Pitchford