Wednesday, November 26, 2008

Credit Expansion: Endgame

In a recent post where I revisited fractional reserve lending, I explained how as one goes below 10% reserves that small percentage changes result in drastic increases of the money supply. Additional capital can then be had through floating bonds, selling securities, and Federal Reserve bailouts. So we live in a system where people who have motive to borrow and means to pay back will find a loan—the limit is not with banks, but with borrowers.

Now, in recent times, in the latest mania, lending standards fell below even the ability to repay. The preponderance of stated income “liar” loans, negative amortization loans, option arm loans, and the general availability of mortgages over the Internet, seems evidence of that. Mortgages were originated with little discrimination figuring that house prices were only going to appreciate, so even defaults would be profitable. A nice theory.

Neither logic nor reality bears this out. House prices stalled in late 2005 or 2006 and began their descent about a year later. The timing varies by region, and I would argue the rate of correction depends on the economic capacitance of homeowners in the area.

In the end, credit expansion is limited by the ability to repay loans. If lending goes beyond that, defaults erode the capital base of banks. Money is created via credit when deposits are lent out, up to the reciprocal of the fractional reserve. That same money is undone when principle on the loan is paid back. Credit is a temporary increase in money supply that attenuates to zero over the life of the loan; though if rate of loan origination is stable then money supply holds constant.

But when a loan is defaulted, after the bank tries to recover what assets it can, what debt is left is a square hit to the capital base. If a dollar is deposited, and 90 cents is lent, and the loan defaults and only 50 cents is recovered through seized assets, then the bank is 40 cents in the hole on that dollar deposit. It will need to be compensated by successful loans elsewhere. The potential money supply hasn’t changed. Those 40 cents not recovered has been spent and redeposited elsewhere and is still in the banking system.

So if banks lend what borrowers cannot pay back, their capital base erodes. If this happens enough times, their solvency depends on government and taxpayer support. It will eventually become clear that the more the government subsidizes unsound lending practices, the less it will have for its infrastructure needs.

The limit of borrowing is where interest payments equal income minus subsistence expenditures. Credit expansion cannot go beyond that. If interest payments go beyond that, economic capacitance can hold for so long and then it requires a tax base willing to compensate the difference. Bailouts are unstable territory that only goes so far.

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