A Systematic Credit Crunch is a Banker’s Biggest Fear

Freedom Financial Archive | Originally posted April 14, 2023
  • Fear around the credit crunch grows.
  • Will there be a credit crunch this year?
  • The domino effect of banks and companies living off cheap debt

Dear Reader,

The fear around a credit crunch is growing. Here are the details and what you can expect in the coming months.

There’s two sides to the credit crunch. One side is banks have written all of this debt, all these loans and mortgages at ridiculously low rates. Now they have a problem where rates are going up, but they need new cash to capture the higher rate to try to net out their exposure.

At the same time, the credit cards they've underwritten and issued are going sideways. People are struggling to pay off their credit card bills. The banks “bad debt” expense is going up, and their ability to write debt is going down.

Now, all of a sudden, they have a credit problem because their rates aren't matching up with what they should have done and where they should be. Which creates a long term problem from that perspective.

On the other side of it, you have people who are going to need debt. You're going to have people that are going to need loans, but you're not going to have anyone that's willing to write that loan or have the capability to write that loan.

As a result, you're going to have a failure of a credit cycle, where it may come down, but nobody's lending because banks are scared to lend. And that creates a credit crunch because now you can't get credit.

Even if you can, it’s only for the “best in class” and will be at higher rates.

Will There be a Credit Crunch This Year?

As the economy slows, the fear around a credit crunch grows with the Fed trying to “lend” liquidity into the market without conducting “outright” QE.

There are still significant pockets of liquidity, but it’s getting locked up in the overnight markets without much movement through the system. The slowdown in the money supply, which is needed to reduce rampant liquidity, is becoming a much bigger gear as we progress through the year.

In our view, the Fed will be unable to pivot for fear of making the same errors as in 1978, and as we have highlighted, their failure to raise rates and stop QE in ’21 and ’22 has put themselves in these dire straits.

The long term health of the economy requires them to hold strong, but the political winds are shifting and they will be faced with growing backlash.

Below is a quote from an article Mark Rossano wrote back in February of 2021, that I think sums up where the Fed sits:

“We have been in a world stuffed with liquidity and central bank easing since 2008, which is now setting off a chain reaction of rising rates.

Central banks need perpetual motion to keep the merry-go-round operation and a buyer of last resort . . . they are losing both.

The game isn’t over yet, but we are seeing the implications of what a bubble in everything looks like, and the fragile nature of the underlying economics. We are nearing the end of the circus.

Chairman Powell said: “[Lower interest rates] make it cheaper to borrow, they do raise asset prices, including the value of your home. But for people who are really just relying on their bank savings account earnings, you’re not going to benefit from low interest rates.”

The activity from the Fed has driven inequality to all new heights, with wage compression everywhere and asset prices flying. People have scrambled to get involved, but at the risk of losing everything in the GameStops and other meme stocks.

The coil continues to get wound and the spring is loaded. Bubbles have been inflated around the world, and because we are all so interconnected, the dominoes are in place.

A failed auction is just around the corner. That could be a bid-to-cover below 2 approaching 1, or a straight-up failed auction, where a key country fails to sell the full amount of debt being offered.

This means no more spending, this means austerity, higher taxes, it means money is no longer free. The party’s over!”

The Domino Effect of Companies Living Off Cheap Debt

The number one risk at this point is a systemic credit event. We've been saying since essentially 2020 that we expected rates to start going up – and that was going to create a cascading or domino effect.

This domino effect was not only going to impact banks, but also companies that have been living off of cheap debt, and really had no cash flow to speak of to support operations.

However, that was driven by inflation, which is why we said rates were going to go up. We thought inflation was going to surge, because of the massive amount of monetary policy getting dumped into the market.

Just think about it; Central banks stay hawkish, which is a risk. And they have to stay hawkish because inflation is still high. Therefore, the hawkishness of the banks have to keep rates elevated, and then those elevated rates create a credit event.

The likelihood of a credit crunch is high, but it’s hard to predict the exact point it will happen. Stay tuned and I’ll provide more updates over the coming weeks.

Thanks for reading,

Freedom Financial News