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The Current Credit Crisis

Why it is so dangerous and potential implications

Prepared by Robert MalvinRobert.Malvin@gmail.com

Economic Theory of Money Supply Doesn’t Include Debt

• Economic Theory focuses on M2 (cash and checking accounts) to measure money in the economy and control inflation

• Milton Friedman is famous for his theory that inflation is always a monetary phenomena

• Definitions of money don’t include debt, in fact recently Fed even eliminated the more broadly defined M3 that included large time deposits, money market funds, short term repo securities and other larger liquid assets

Inflation is a Monetary Phenomena

• Inflation or rising prices can only occur when demand outstrips supply, if the money available to spend grows quicker than an economies ability to produce prices will rise

• Debt must be included in the definition of money because money borrowed competes equally with real money in the marketplace to buy goods

Look No Further than the Housing Market

• Recent policies allowing banks to use increased leverage flooded the market with cheap and overly abundant debt

• This cheap and careless debt was driving up prices in the housing market - inflating the price of housing assets to unsustainable levels

• The deflation of this bubble is constricting the real money supply and in turn constricting the economy

• Over reliance on debt is TOXIC because it is taxed with interest payments in the future

Banks Cut Lending

Faced with exposure to massive bad loan portfolio’s the banking industry has cut lending to increase reserves and limit exposure to weakening economy and an over leveraged consumer that can’t realistic increase debt

Commercial and Consumer Loans Violently Reduced

• Massive reduction in lending therefore consumption

• How can this do anything but restrict spending of both consumer and producer

FDIC Quarterly Banking Profile Second Quarter 2009

Economy over reliant on debt put’s a death grip on growth

Adjusted for inflation household or consumer debt became larger than the money supply in late 80’s

Including producer and government debt and this graph would look just plain silly

Household debt surpasses total money supply

http://research.stlouisfed.org/fred2/

Banks leveraging the money supply has been irresponsible

This is only the leverage of household/consumer debt created by the banks

The Debt Tax (Interest) is the equivalent of a death strangle on our economy because of the massive amount of debt to real money

The Contraction in the debt to M2 is causing the recession

Increasing M2 to offset decreasing debt would solve the problem

http://research.stlouisfed.org/fred2/

This Caused Loan Losses to Explode

One Month Decrease can Be Followed by More Increases

http://research.stlouisfed.org/fred2/

Bank Losses Will Continue to Increase

Large gap between the loan loss reserves and noncurrent loans (more than 90 days past due) suggest that current reserves will need to be increased for the foreseeable future

This is a major drain on banks earnings

FDIC Quarterly Banking Profile Second Quarter 2009

Banks Want Capitalism for Everyone BUT Banks

• When a typical industry comes under profit pressure of increased costs or declining prices banks expect those businesses to buck up and survive or fail

• When banks come under the same pressures they go to the Fed to have their input costs dramatically reduced by lowering of Fed Funds rate

• By lowering the cost of borrowing dollars banks can offset declining earnings (bad loans) by reducing the cost of inputs (money)

• For any other industry this would be a government subsidy that capitalists would find atrocious but banks have convinced society that increasing the cost of funding debt (and in turn bank profits) is non negotiable for the economy (good if you’re a bank)

• When they hold to this standard foolishly passing the tipping point of debt to real money in the economy what ensues is a full fledged credit crisis that spirals out of control

• Perhaps they are unwilling expose the dirty little secret of government subsidizes that fuel the big banks even at the cost of our entire economy - after all how can they continue to grow profits if we reduce the amount of debt in our economy?

How Big is Our Subsidy to Banks?

Average Assets Q2 2009

Net Income Q2 2009

Government Aid from Fed Funds Rate

Interest Expense Q2

2008

Interest Expense Q2

2009

All FDIC Insured Banks $ 12,099,360,000,000 $ 2,897,000,000 $ 81,940,193,244 $ (79,043,193,244) 2.61% 1.86% 28.74%Banks with Assets > $10B $ 9,515,905,000,000 $ 6,053,000,000 $ 85,490,890,520 $ (79,437,890,520) 2.64% 1.64% 37.88%

JPM $ 2,055,326,500,000 $ 4,862,000,000 $ 30,441,111,939 $ (25,579,111,939) 2.55% 0.91% 64.31%Citigroup $ 1,908,342,500,000 $ 5,872,000,000 $ 24,036,337,125 $ (18,164,337,125) 3.02% 1.60% 47.02%

Bank of America $ 2,474,682,450,000 $ 7,471,182,000 $ 18,653,809,853 $ (11,182,627,853) 2.72% 1.78% 34.56%Wells Fargo $ 1,289,080,000,000 $ 6,217,000,000 $ 12,784,579,808 $ (6,567,579,808) 2.08% 0.96% 53.85%

Prior Lake State Bank $ 181,193,000 $ 1,574,000 $ 1,251,221 $ 322,779 1.90% 1.19% 37.37%

Net Income With Government Aid

Removed

Reduction in COGs from Fed

Fund Rate

The Fed Funds rate subsidy contributed $82Billion to banks in Q2 2009 this is $320Billion in annualized subsidies

The largest banks benefitted the most and would have suffered huge losses without this subsidy

This is chasing dollars out of low risk investments into the stock market as investors chase yield

Banks are still issuing fewer loans than they did previously because of high unemployment

The dollar has devalued by 20% causing real inflation of foreign goods even though demand will be decreasing

Rising prices with decreasing consumption will cause a dangerous spiral and impair American business that sell real goods and services

Not Reducing Debt Strangle Will Lead to a Death Spiral in our Economy

We have surpassed the debt levels that were the cause of the great depression

Why would deleveraging this debt be any less painful?

It won’t be unless the Fed acknowledges the banking industries culpability and decreases debt burden on consumer and forces banks to take significant debt write offs to re-establish realistic levels of money supply and debt in our economy

http://mwhodges.home.att.net/nat-debt/debt-nat-b.htm

Percent Change By Day from Market Top

• Market has corrected to 1929 levels 3 times already

• We are currently very close to achieving a rally to 75% of top (S&P 1,203 and Dow 10,600) similar to what happened in 1929

• Hopefully the Fed and Washington will get it right but I’m not holding my breath

Hope Rally

of 1929

Hope Rally

of 2009?

Cheaper Money for Banks and Continued Overreliance on Debt is NOT a SOLUTION

• We must curb the leverage in the banking industry

• We must provide debt relief to overleveraged consumers

• We must remember that while people borrowed more than they should have THESE PEOPLE are RESPONSIBLE for keeping our economy growing by CONSUMING

• We must increase the supply of M1 and M2 to a point where it is greater than Household Debt

• This would be best done by lowering personal income taxes and funding that reduction with an increase in M1 (actually print real money to pay gov’t expenses)