The financial conditions in the debt markets continue improving, causing yield curves to flatten and spread to narrow further. Indeed, cash and credit default swap spreads have broadly declined in the U.S. and in Europe, driven by receding risk aversion, more confidence in financial institutions (despite additional write-downs and fairly downbeat earning projections), and modestly better-than-expected economic data. Futures markets reflect a substantial shift in sentiment too, and indicate that U.S. and European central bank rate cuts are on hold for the balance of this year (inhibited partly by stubborn inflation pressures trending above mandated targets). Most economists have concurred and have modified their policy forecasts to reflect the same.
A number of key, short term money market spreads also have narrowed, indicating that liquidity among banks and broker-dealers has improved. The so-called TED (Treasury-Eurodollar) spread, which measures the difference between the three-month Treasury bill rate and the London Interbank Offer Rate (Libor), has declined substantially since mid-April. This was facilitated in no small part by critical initiatives to enhance liquidity from the Federal Reserve (such as allowing primary dealers to exchange less liquid mortgage-backed collateral for Treasuries), as well as actions by the Bank of England and the European Central Bank.
Unfortunately the macro-economics of this fundamental shift have not been reflected in lending practices. Lenders must realize that they need to move faster to clean their balance sheets; otherwise they will have cleaner balance sheets with fewer assets earning a return. They need to shift their lending practices or they will have weaker income growth for years to come. The worst of the credit crisis is over, however, funding costs remain high and the vise-like hold on credit could increase corporate defaults. With mark-to-market hits mostly behind the banks, lenders need to be concerned with their “no lending” policy and how it will impact capital spending, employment growth and production plans with a nine-month lag, which could lead to economic contraction and add a second phase to the economic malaise.
Balance sheet constraints and the reluctance of banks to lend to each other remains one of the principal impediments to normalized market conditions and a sustained economic recovery. We saw evidence of this in this month’s release of the Federal Reserve’s senior loan officer survey, which confirmed that banks tightened lending for the third consecutive quarter – 55% increased standards and 70% raised the cost of borrowing.
In our view, market conditions are unlikely to improve unless lending standards ease, financial institutions regain greater access to securitization, and perceptions change about strained liquidity and counterparty risks.
Lenders have been deeply worried about domestic GDP given the sharp decline in home prices over the past year, the surge in foreclosures due to dropping prices, unknown liabilities as result of inflation growth and consumer spending, the surge in oil (and more important, gasoline) prices and job reductions, mainly in the financial industry. As a result, lenders have tightened their credit requirements. However, they have ignored the bright spot in our economy related to the international scene – supporting the earnings of publicly-traded U.S. companies, a lower trade deficit, stable employment and a still strong economy with GDP growth – which has and will continue to reverse negative press and stabilize consumer spending.
In 2007, corporate profits earned abroad rose nearly 45% and these figures are expected to climb another 25% in 2008. According to NIPA (National Income and Product Accounts) data, U.S. companies experienced domestic sales declines year-over-year starting in the third quarter of 2007, but overall revenue comparisons have stayed in positive territory due exclusively to international strength. Many companies have noted that this trend has been in place as a result of both strong demands from developing areas like China, India, Brazil, the Middle East and Russia, and robust European trends, as the weaker dollar has made U.S. companies very competitive abroad.
We feel this positive trend will continue if the dollar gains in valuation, which is expected in the next six months. Because it is becoming increasingly evident that European business conditions have weakened fairly dramatically in the past few months and they need to consider the negative effect of Euro strength and reversal in monetary valuation could further strengthen the U.S. economy and further deteriorate European growth fundamentals for the next two years.
Therefore, the weakest link in our economy is still the banking industry and their current lending practices. This needs to change.
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My guess is that only bankers have read this article so far based solely on the lack of responses. Lending practices must change, the Fed has opened the reservoir only to have the liquidity collect behind the the next dam – bank balance sheets.