Tuesday, May 12, 2009

For the benefit of Gaius Marius

 Gaius Marius of the (usually lower case) “decline and fall” blog left the following comment on my 77 Bank note.  

But American banks are not awash in funding – and given the profligacy (especially historic) of the American consumer – not to mention tax cut funded Iraq wars and the like – the US financial system is almost always going to be an importer of spondulicks. That might change in twenty five years – but it is not changing now.i think this is really the big question, isn't it? were not japanese banks in more or less exactly this position in 1991-2, but with corporate rather than consumer credits sucking up all available lending capacity? 

western banks are collecting fat spreads right now, but the true long-term test for the system won't be in loan supply -- it's in loan demand. if banks can't make sufficient new loans to replace the fat ones rolling off their books, earning power will diminish over time even as asset prices continue to deteriorate.

as i understand it,
japan ended up with massive excess funds in banks because (beginning in 1996) the private sector started to repay loans (ie, aggregate loan demand went negative), to the tune during the early 2000s of 5% GDP. but in 1989, the japanese nonfinancial corporate sector was increasing its bank debt at a rate of in excess 12% of GDP (and issuing debt on the order of 5% GDP in capital markets to boot). that massive 17%-of-GDP swing in private credit took ten years to effect. aggregate private sector loan repayment seemed to have ended in 2005, but has probably resumed in this crisis.

to prevent a crash in monetary aggregates, the government borrowed out these excess deposits, which at 77 bank shows up as a massive investment portfolio in JGBs. 

for what it's worth, i think a more appropriate comparison would be to the 77 bank of 1991. i have a sneaking suspicion that 77 bank was then also a mirror image of the current 77 bank, but i'd love to be disabused of that notion.


The comment is reflected in several emails I have received.  It seems several people had the same idea - though maybe less well articulated than Gaius.

Well Gaius – you can be disproved of the notion.  I have uploaded a 20 year balance sheet for 77 Bank here.  It is here.  The loan to deposit ratio started at 74 percent and wound up at 64 percent – with the mix of the loans moving towards lower margin government loans over time. 

Japan was long funding when it went into its crisis.  The crisis was long, slow and with thin bank margins but very little “crisis” but a lot of sustained malaise.  The banks got longer funding as the malaise/liquidity trap went on.

Korea and Thailand were short funding when they went into the crisis – and the crisis was severe and relatively quick.  Banks failed rapidly (and were bailed out in both countries either through subsidy or nationalisation).

Note that relatively quick in this context is a depression level recession lasting a few years - rather than a sustained malaise lasting decades.

Still this difference has profound investing implications - and also some policy implications - and that makes it worth thinking about. 


BwO said...

I'm still missing something here. Gaius seems to be pointing to Richard Koo's ideas. Koo distinguishes between the credit crunch (short funding) and a balance sheet recession (long funding but short borrowers) but he points out that one can be superimposed on the other. In the US, we are maybe getting past the credit crunch, but (arguably) the long consumer balance sheet recession is just getting going. I took this to be Gaius's point, a point it seems to me is confirmed by the 77 balance sheet history, and I don't see how John answered this. But maybe I'm just not following something.

With plenty of excess Asian savings and not a lot of borrowers you would expect rates to fall in the medium term. For now, US banks can make a fat spread because they have low cost government funding and people are still paying older higher rates on their loans. It is a race for solvency between this fat spread and the increasing losses. But even if you assume that the banks win this race, what have they won? Sure, they are solvent, but then the government starts raising rates and taking back its guarantees while there still aren't many new borrowers. The banks muddle through the credit crunch nuke-ing only to end up straggling around like cockroaches in the low spread post-apocalyptic fallout. Earnings power sucks. The stocks don't go to zero, but they don't go back to anything like their former profits and market caps. This makes sense intuitively as well, because it seems unsustainable to have a financial sector that is 30% of S&P profits, which is what the "return to normal" scenario that John is betting on would imply.

Anonymous said...

Nice write up this morning! Congratulations, once again.



Unknown said...

Congrats on the front page SMH coverage :)

Twas an unexpected surprise with my coffee.


gaius marius said...

thank you, john.

so in japan excessive funding became more excessive funding, with larger and lower-yielding investment portfolios. per your earlier comment -- Remember - for the most parts - banks intermediate current account deficits -- as japan made itself a current account surplus powerhouse, excess funds were accumulating in the banks well before 1990.

sustainable fat spreads are really good news for the american banking system from the credit crunch/zombie perspective, and more or less obviate the need of permanent large capital transfers to lenders as long as guarantees remain in place. but i wonder what the longer-run effect on the borrowers is?

clark is on the right track w/r/t me -- i've heard richard koo talk on the topic of collapsed private sector loan demand post-asset-shock, with the government needing to pull excess funds out of the banks as they accumulate, using fiscal stimulus to re-employ the funds and keep money circulating (and therefore sustain incomes and GDP as the private sector moves to surplus), breaking the paradox of thrift and effectively refinancing the private sector debt bubble onto the public balance sheet over the course of years.

the united states obviously fits the bill of a mirror-image big current account deficit country with underfunded banks. but with the global collapse of trade flows we're also seeing the twin deficits narrow pretty considerably. do you find it credible to think that american banks will witness a migration to narrower trade deficits and therefore better funding profiles as households slow consumption and set about repairing balance sheets?

given the balance sheet shock many of us are faced with, i have to imagine banks will be seeing net negative private sector loan demand for some time -- well after they've finished repairing. on the fed's bank data i think they already are seeing it -- nearly all activity seems to be refinancing while household credit outstanding is contracting. this would appear to aggravate the 'savings glut' problem. it also implies they'll be accumulating, if not japanese-level excess funds, significantly lower loan:deposit ratios provided that there isn't a deflationary crash in monetary aggregates to decimate deposits. (government willingness to support monetary aggregates with deficit spending/fiscal stimulus looks important in that light.) given that some funding will still have to be imported, i wonder if the fact that marginal interest rates are unable to decline to near-zero doesn't also serve to accelerate the household deleveraging.

if i read you right, what you're saying is that if the american administration -- on the koo model -- attempts to sustain systemic cash flows and GDP by countering persistent private deleveraging with public leveraging, it may not find excess reserves laying about on bank balance sheets to soak up with treasuries (as was the case in japan). if cash comes into US banks and isn't reloaned for lack of private loan demand, those banks would instead have the imperative to scale down their balance sheet by paying down expensive wholesale funding, in accordance with the shrinking current account deficit that the funding is ultimately derived from.

that issue, it seems to me, is currently being mitigated by near-zero-cost public financing of the banks -- which only replaces the wholesale borrower, with the treasury stepping in the place of the banks to import funding. it wouldn't be until the current account balance effectively zeroed that excess funds would start to pile up in american banks, if and when that happens, and true zombie banking kickstarted.

while it bodes well for the credit crunch, this all sounds a pretty grim longer-run economic proposition. am i getting that straight?

babar ganesh said...

gaius - perhaps the fact that housing prices are collapsing will allow nominal debt to decrease while consumption goes up?

or perhaps the fact that a lot of household debt has been refinanced at low interest rates will do the same?

or inflation will kick in, decreasing the real value of nominal debt?

or personal bankruptcies will clean the balance sheets of families?

i don't know the numbers, but these are possibilities.

in any case if the economy recovers below the level of 2006/7 but credit allocation is more sensible the "real" economy will be better off. just by not building exurbic kingdoms in the far desert we will all be richer.

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