Before trying to determine where the economy is heading, it is crucial to understanding what is going on with the credit markets and bank lending. On that note, the Wall Street Journal reports that banks keep lending, but that isn't easing the crisis.

(emphasis mine)

Banks Keep Lending, but That Isn't Easing the Crisis
By JON HILSENRATH

All around Washington, policy makers are scrambling to figure out how to get banks lending again. Lawmakers have criticized banks for not using new federal money to make loans and have threatened to place conditions on additional money. Regulators last week sent out a directive, encouraging banks not to hold back on lending.

But there's a flaw in that logic. Banks actually are lending at record levels. Their commercial and industrial loans, at $1.6 trillion in early November, were up 15% from a year earlier and grew at a 25% annual rate during the past three months, according to weekly Federal Reserve data. Home-equity loans, at $578 billion, were up 21% from a year ago and grew at a 48% annual rate in three months.

The numbers point to one of the great challenges of the crisis. The credit crunch is surely real, but it is complex and not easily managed. Banks are lending, but they're also under serious strain as they act as backstops to a larger problem -- the breakdown of securities markets.

The worst of the credit crisis is being felt not in banks but in financial markets. Loans from a bank might stay on its books. Increasingly in the past decade, loans were packaged into securities and sold to investors around the world -- pension funds, endowments, mutual funds, hedge funds and others. Institutional investors gobbled up this and other kinds of credit that didn't come via traditional commercial banks, such as junk bonds or commercial paper.

To get credit flowing, policy makers need to repair financial markets as well as banks. But investor confidence in credit markets has been shattered, in part because many debt securities performed so much worse than their credit ratings suggested they would.

Issuance of asset-backed securities -- instruments used to package credit-card and auto-loan debt during the boom -- was down 79% in the year through October from last year, to $142 billion, according to Dealogic data. In 2005 and 2006, investors snapped up more than a trillion dollars of these instruments. Junk-bond issuance was down 66% in the first 10 months of the year from the same period in 2007.

A new paper by Harvard Business School economists David Scharfstein and Victoria Ivashina sheds light on how the recent rise in bank lending plays into this. Bank loans are rising, the economists say, because companies -- from General Motors to Tribune -- have turned to banks for precautionary cash. With markets shut down, they're drawing on existing credit lines to meet financing needs or simply to have money in reserve in case they need it later.

Many of these firms lined up credit facilities during the boom, when terms on loans were forgiving. Between April 2006 and April 2008, bank rainy-day credit lines, known as revolving credit facilities, increased by 36% to $3.5 trillion, the professors show. Individuals might be using home-equity lines in the same way, tapping them for cash while the lines are still open.

The point is that banks are being forced to act as backstops to a reeling financial system just as the banks, too, are vulnerable. Simply demanding they lend more misses the broader point of the role they're playing in the crisis, and how to manage it.

"They provide a measure of protection to vulnerable firms, helping them forestall financial distress," the Harvard professors argue. But there is a dangerous downside. During the boom, many of these credit lines were extended to firms with shaky prospects, like GM. Now, banks are on the hook to lend to them, often even if they don't want to. This is likely crowding out making new loans to healthier firms, the professors say.

Crowding out is one problem. Another is the markets. During the boom, many bank loans were packaged into securities. With markets for those securities shut down, banks have lost this important escape valve for making new loans.

Using a different database called DealScan, the professors looked at new bank loans to large corporate borrowers -- the kinds of loans that typically get resold and packaged into securities. While overall banks' loan books are growing, this kind of lending, which used to get distributed among banks and other investors, fell by 46% in the August-to-October period from the same period a year earlier.

Add in the fact that many banks are short of capital because they have been forced to write off a rising tide of bad loans on their books. Mr. Scharfstein concludes in an interview, "It may be unrealistic to expect them to lend more aggressively."

My reaction: I will write a longer piece on this soon. For now, here are the central points of this article:


1) Securitization is dead. Up until the middle of last year, banks were in the business of selling loans using securitization. This means they make loans to consumers and businesses, package it into securities, and then sell those securities to investors. Banks used the money from the sale of securitized loans to make new loans and repeat the process. As long as investors kept buying their debt . However, because banks sold so many of the securitized loans turned out to be toxic, investors don't trust banks and aren't buying them anymore. With the market for their securitized loans dead, banks have to keep the loans they make on their books until maturity instead of selling them right away (with 30 year mortgages, this is a looooong time).

2) Credit lines are being tapped. Both businesses and consumers are borrowing from banks using revolving credit facilities and home equity lines. This means that government bailout money is going towards these existing lines of credit rather than new loans to consumers and businesses.

3) Rising defaults are eating away at banks' capital. The write-offs from a "rising tide of bad loans" is causing capital shortfalls at banks, which drastically impacts their ability to lend. When banks are short capital, they either need to raise capital (from investors or through government bailouts), sell assets (no one wants to buy their toxic assets), or make less loans. As loans continue to default, banks will have to slow down lending even more despite the various capital injections to date.


These three factors combined leave banks with little money available for new loans to consumers and businesses. As bank lending continues to slow, the downward spiral in our economy will accelerate.