What’s worse than deflation?
Debt deflation.
Which, tellingly, is also known sometimes as “worst deflation”. Original.
Severe episodes of debt deflation cause depressions. In a debt deflationary scenario, the collateral which secures a debt falls in value, leading to a forced devaluation of the debt, or else its liquidation, which in turn causes further falls in collateral value. For example, a mortgage in which the market value of the property falls below the price of the loan.
The stock market crash of 1929 was in its own way caused by a form of debt deflation. In that case, the collateral was stock, purchased using leverage through brokers loans or through investment trusts.
After the initial crash in the autumn of 1929, the three year downward drift that followed - the really painful part - was caused by the economic after-effects of the crash.
Viz:
The risks of debt deflation are greatest when banks are involved. Banks tend to use a combination of leverage and their position as maturity transformers to handle all sorts of assets. Which is why when one leveraged asset class to which a bank is particularly exposed suffers, there is a high risk of contagion to other asset classes. The stock market crash of 1929 brought down a number of banks. It triggered a banking crisis that was particularly painful because of the leverage involved.
The point here being, that the health of the banks - and specifically the number of assets they are exposed to which are “bad” - is of critical value.
Out yesterday was the FDIC’s quarterly banking profile. It does not make for cheery reading. One in four institutions lost money last quarter, the number of banks on the FDIC’s failure watch list increased from 117 to 171 and the assets of “problem” institutions rose from $78.3bn to $115.6bn.
And banks balance sheets continued to rot - debt deflation spreading:
There is some hope. The Fed’s new TALF facilities, for example, should provide support to various non-mortgage ABS such as those backed by credit card loans, auto loans, student loans and such. For the time being, this is a critical piece of support for banks. In the medium term though, it isn’t clear how the coming economic recession will affect the performance of such securities from the ground up. A spike in credit card arrears, for example, would make the Fed’s liquidity support seem like pushing at a string.
Just like in 1930, it will be the economic fundamentals that give the best indication of where things are going. House prices continued their downward trend yesterday. High unemployment is not even yet a factor.
The biggest problem now though is that “bad loans” just sit where they are - with the banks - quietly impairing balance sheets but not posing an outright threat because of various government support actions. This would be a Japan-like scenario. And it’s one that has quite a lot of currency, not just because of similarities in monetary and fiscal policy. Take the saving of Citi on Monday for example. The $300bn odd of problem assets are still there on Citi’s balance sheet… Citi is still exposed to take significant first losses on them. The government’s actions seem more a sop to shareholders - more specifically the share price - than anything else.
Related link:
Tits on a bull - Willem Buiter’s Maverecon blog
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