Bert Dohmen: This Is The Sharpest Tightening of Credit in History

(Written by Bert Dohmen, contains excerpts from our recent Wellington Letter issue)

We wrote in our March Wellington Letter that the free market, i.e. the banks, will now do what the Fed has refused to do: Tighten credit! The Fed only hiked interest rates, which actually fuels inflation. Most central banks make that mistake.

A credit crunch will now reduce inflation, but in a very painful manner. A lack of credit means an avalanche of bankruptcies. They should hit record highs.

The economy and real estate are very dependent on smaller banks. An article on zerohedge recently stated:

“banks with less than $250bn in assets are responsible for roughly:

1. 50% of US commercial and industrial lending,
2. 60% of residential real estate lending,
3. 80% of commercial real estate lending, and
4. 45% of consumer lending.”

That is serious dependency.

Bloomberg said:

“Commercial bank lending dropped nearly $105 billion in the two weeks ended March 29, the most in Federal Reserve data back to 1973.”

This is the greatest plunge in new business loans in recorded history for this statistic and therefore the sharpest tightening of credit conditions in history.

Read that again! Note the “greatest plunge in new business loans on record” and “sharpest tightening of credit in history.”

But it wasn’t produced by the Fed intentionally. It was done by the free market being shocked by a sudden confidence destruction in the banks. That makes it much more serious.

Whereas central banks may be able to handle problems of deposit outflows from some banks, the huge problem is CRE loans (commercial real estate) that are coming up for banks in the next 2 years.

Can it improve meaningfully in the future? Read this:

According to a Morgan Stanley analyst, total “US securitized credit – CRE debt of $1.35-1.46 trillion (30-32%) matures by year end 2025.  Banks hold ~42-56% of maturing debt.”

How will banks refinance perhaps $650 BILLION of the commercial real estate debt? That of course will be a depressant on banks and the credit markets until that time.

The “Dohmen Theory of Credit & Liquidity,” which we developed in the 1970’s, says that the primary determinant of major stock market and economic trends is the change in credit and liquidity, i.e. from expansion to contraction, and vice versa. All the metrics used by most analysts are derived from change in credit and liquidity, and lag very much.

The big outflow of deposits resulted in the often mentioned plunge in M2 money supply this year, the sharpest since 1958. M2 declined in December, January, and February. According to one analyst (Trevor Jennewine), the last time M2 declined before that was December 1958, although that was a miniscule decline of 0.16%.

The decline in February was 2.35% from the prior year.

See the chart below showing the huge plunge in year-over-year M2 percent change over the past few months.

During the Great Depression M2 fell 2.35%, the same amount as now.

This is ominous but fits what we have said the past 18 months, namely that this coming recession/depression could be worse than in the 1930’s because the Fed’s bubble machine allowed the greatest creation of credit in history. Deflating that huge bubble will be extremely painful.

Combine that with the huge tax increases planned in Washington and you have the prescription for the same thing that caused the 10-year depression in the 1930s.

The alternative to that is super-high inflation produced by central banks panicky efforts to avoid a depression. It all depends on political choices. With the current leadership in high places, the choice may be super-high inflation. We will see.

There are two different reasons for the current credit crunches, i.e. unwillingness of banks to make loans: A) either banks want to reduce risk in an uncertain economic or B) they don’t have the reserves to make the loans.

We believe it is both. Much of the lack of new loans seems to be an outflow of deposits. Look at this chart below via Zerohedge showing the huge outflow of deposits from both large and small domestic commercial banks. Deposits are the basis for making loans, with a multiplier effect. Banks are probably making almost zero new loans, waiting to see if the outflow of deposits has stopped.

CONCLUSION: Credit crunches are vicious. In the 1980 credit crunch, and other crunches, banks stop making new loans, even to their best customers. They tell their best customers “We know you have the best credit, but we don’t have the ability to make new loans.” That may happen again.

We remember in one of the prior crunches, a number of large well-known banks even cancelled credit commitments to real estate developers, although it was a ‘breach of contract.’ When the developer said he would sue, he was told “go ahead, but it will take you 5 years to get into court and by that time you are broke.”

The very negative implications must get top consideration for investors. A credit contraction means a similar contraction in stock prices. A record contraction, if it persists, may give us a record stock market contraction.