The Great Credit Shrinkage

by Timothy Lutts

I originally wrote about the great credit shrinkage in December 2008, and it still seems sensible. In the four years since the financial crisis of the time, individual and corporations have reduced their debt loads substantially. Now we need to get our governments to do the same. (April 2013)
Credit Shrinkage

Back on September 11, 2008 a few days after the U.S. government took over Fannie Mae and Freddie Mac, I looked into my crystal ball and wrote the following.

“I think the housing industry peaked in 2006 and that it will be a VERY long time before that peak is exceeded.

In my mind, just as the failure of the sub-prime market triggered the collapse of the housing industry, the collapse of the housing industry will trigger the deflation of our debt bubble. Eventually, if all goes well, the end result will be a smaller debt load for the U.S. and a smaller debt load for American consumers as well…which in my mind means living in houses we can afford.

Now, I admit that I’m going out on a limb here, but I know that in the stock market when trends run to extremes, the ensuing corrective actions persist far longer and further than anyone anticipates. So why not in the credit market as well? Why shouldn’t our debt bubble shrink as we restore our balance sheets—both personal and federal—to more sane levels?

And as our debt bubble shrinks, a process that in my mind should go on for decades, I ask what the American financial landscape might look like in the decades ahead.

Imagine if there were a national consensus that shrinking debt would help save America.

Our representatives in Washington would cut spending and raise revenues, through higher taxes and perhaps even asset sales. Individual Americans too, would cut spending. Health care costs would stop their steep ascent. Savings rates would grow, and there would once again be more focus on earning interest than paying it.

Borrowing rates would fall, and the remaining lenders would compete hard for a share of the shrinking pie by lowering interest rates.

Unfortunately, all that reduced spending might mean that GNP would fall, too…and we’ve been taught that recessions are bad. But in a new reality where reducing debt is paramount, might that perception shift?

If we can all agree that living within one’s means is better for the average American, then why not for America as a whole? Why can’t improving our national balance sheet, and getting control of our finances, be as important as growing? With creditors like China and Japan, we may have no option.”

Three months after writing that, I see nothing I want to change in it. The trends have continued as expected, and the future as I envisioned it still seems likely. Of course, I wasn’t smart enough to advise selling short back in September 2008; at that time, the market was already about 25% off its high, and I’ve learned over the decades that it’s best to short when the market is high, not low.

But we weren’t so foolish as to advise investing against the market’s main trend. Our growth-oriented advisories have continued to advise holding cash…and that’s been good advice.

So, looking at the big picture again, here’s what’s new in the past three months.

The U.S. government has been cranking up the printing presses, printing billion-dollar bills and handing them out left and right to big troubled entities whose failure would bring “unreasonable” pain. If you’ve a little company and you’re in pain, tough luck.

Adjustable rate mortgages continue to roll over into less affordable fixed-rate mortgages. At the end of the third quarter, 7% of mortgages were delinquent, and the number is no doubt higher today.

The unemployment rate is now 6.7%, the highest level in 15 years.

November automobile sales plummeted 37% from the year before, to the lowest level since 1982. The guys from Detroit went to Washington begging for money.

The brightest guys in the room, the managers of Harvard University’s endowment, lost $8 billion—or 22% of their assets—in four months. Department heads at the school have been asked to reduce their budgets 15-20% in the year ahead.

Oh, and the National Bureau of Economic Research finally figured out that the recession started in the third quarter of 2007. That information plus $1.25 will get you a paper cup of coffee at Starbucks.

A recession is not really such a big deal. Usually they’re half over before you even know they’ve started. I’ve lived through eight in my lifetime.

A depression is worse. I haven’t been in one of those, and in fact there is no precise definition of a depression. Previous depressions include the five-year period that followed the Panic of 1837; the 23-year period that ran from 1873 to 1896, now known as the Long Depression, and, of course, the Great Depression, which ran from late 1929 to early 1933. At less than four years, that was the shortest.

We may well be in a depression now…or headed for one.

But in my mind, the future is likely to bring something new to America, and for lack of a better term, I’m going to call it the Great Shrinkage.

In this Great Shrinkage, as I ventured before, credit will shrink and equity will increase.

The stocks of MasterCard (MA) and Visa (V), by the way, show no signs of strength. If my crystal ball is correct, both companies came public near the end of the long buildup in credit. Competitor American Express, meanwhile, is going to become a bank holding company.  Does someone at American Express see the writing on the wall?

In this Great Shrinkage, the number of colleges will shrink, as fewer parents choose to borrow the big bucks required. Demand will soar at state colleges and private, for-profit educators that provide career-oriented educations but have no football teams.

States and municipalities will cut non-essential services, and find new ways to charge for services that were previously free. Pensions and disability payments will be carefully scrutinized for fraud and waste.

Savings rates will climb…but with demand so high, returns from savings will stay extremely low.

Speaking of credit, I recently was given a report written in 1965 by Jim Fraser, a money manager from Burlington, Vermont who hosted the annual Contrary Opinion Forum for decades. The focus of the report: “Crises and Panics.” Jim studied nineteen financial crises going back as far as 1745, describing the climate at the time and the event that in every case broke the camel’s back. What I took away from the report was Jim’s simple observation that every crash, without exception, began when credit that had been extended was not returned as expected. Today’s situation, therefore, is unusual only in degree…and perhaps in the extent that our government has chosen to step into the breach, in an attempt to halt the natural fall of the dominoes by injecting government money into the system.