A primer on subprime (3 of 5): Brace for tough times

Equity markets have generally risen from their year-lows as confidence returned that financial markets would not completely collapse, thanks to governments supporting the banks. The respite is welcome, but I believe the trend is still downwards.

I expect global economic growth to come in near zero, or even negative next year. The International Monetary Fund (IMF), which has been coming up with new, ever-lower forecasts, now projects 2.2% global GDP growth. It's hard to see how even that can be achieved with the United States, the the world’s largest consumer nation, in recession, Eurozone suffering and the Arab economies struggling to deal with oil prices well below levels they had come to think of as normal.

Economic growth will also be hurt by the credit being curtailed. A commercial banker friend tells me his bank is revoking credit lines, even of clients who are not showing any signs of distress. The bank is conserving capital in anticipation of tougher times ahead. Already Maybank has reported an increase in total NPLs.

Some ultra-pessimists are suggesting deflation and depression. With so much capacity, companies desperate for cash flow to stay afloat will slash prices and be happy with just covering variable costs. That is a possibility, but I am hopeful governments, central bankers and regulators have learnt from the Japanese lesson and will act to combat that scenario.

The base case is ugly enough. US banks are not out of the woods yet. The latest survey of syndicated debt (ie loans given out by three or more banks) found that US$373.4bn of such loans were “criticised” ie in actual or potential difficulties at the end of 2Q08 - this is nearly triple the US$114.1bn recorded in 2007. Even more worrying, the report said many of the loans could move to more severe status such as substandard, doubtful or loss-making. Such “classified” credits were also rising rapidly, soaring 128% to US$163bn.

Not surprisingly, potential capital-crimping bad loans has reduced banks' willingness to lend. The latest quarterly Fed survey in the first two weeks of Oct found a great majority of banks had “continued to tighten their lending standards and terms on all major loan categories over the previous three months.”. Prime (or good borrowers) were affected along with borrowers with poor credit histories.

1. 95% had tightened lending terms to large and medium-size businesses;
2. 20% had cut limits for existing credit card accounts held by prime, or strong credit, customers.
   

I see at least one more cycle of bank issues in the US. The contracting economy and tighter credit will hurt businesses and consumers, which in turn will lead to more loan defaults and another round of bank failures. In the meantime, the rest of us in Malaysia who didn't get to enjoy the party during the boom years will have to suffer along.

Part 3 on Wed: What we can do.