written 7/25/2008

Credit is the fuel that drives the economy. If you want to beat the market or want to learn to invest, it is important to have a good understanding of how credit affects the economy. The huge loan losses banks are experiencing are limiting their ability to provide credit to help companies grow. If companies cannot grow their business, the economy will continue to remain in a recession. Investors stock portfolios will suffer further.

Credit Is the Fuel of a Growing Economy

Credit provides small, medium and large companies with the necessary capital to help them grow. A local auto repair shop with a growing customer base borrows money to acquire parts, equipment and tools so he can serve his customers. Without this credit, he is unable to properly serve his customers and grow his business.

A medium sized manufacturer needs to renew her supply of components before her company can build their new products. Without credit to buy the materials her company will not be able to produce the products it needs to sell to pay salaries and remain in business.

Credit, primarily from banks, provides the cash many business need to be able to fund their working capital and acquire equipment that make them more competitive. Without this source of funding many business must curtail their spending and put off growth plans. As a result, the economy will feel the affects as unemployment increases, sales and profit take a hit and stock markets retreat.

Bank Lending Constrained

Banks are unable to lend when they are capital constrained, especially due to large loan losses. The total volume of loans a bank can generate is limited by its available capital. Regulators use a series of capital ratios to determine the total amount of loan a bank can have on its books. The available capital of a bank is primarily comprised of equity capital. Regulators can allow banks to count certain supplementary capital items to be counted toward a bank's capital.  When a bank incurs loan losses, it directly affects their available capital reducing the amount of loans they can make.

About a year ago, the “analysts” estimated that the total write down of bad loans would be about $400 billion. Then by December 2007, the estimate doubled to about $800 billion. Then along comes a report from Bridgewater Associates that expects the number to double again to $1.6 trillion. Bridgewater is a very large hedge fund, who is also one of the top analytical firms. Up to now, the banks have been using a ‘mark-to model’ method of valuing the structured debt. According to Bridgewater, the modes used have grossly underestimated the actual losses. They doubt the financial institutions will be able to generate enough capital to cover the losses.

According to the report, “Lenders would have to curtail loans by roughly 10-to-one to preserve their capital ratios. This would imply a further contraction of credit by up to $12,000bn [$12 trillion] worldwide unless banks could raise fresh capital."

Not all of these losses are in the sub prime market. According to the report, more than 90% of the losses from sub prime loans have already been written off. Unfortunately, the losses from the prime, option-ARMs and Alt-A loans could be much larger than we have already seen. The sizes of these loan portfolios are much larger than the sub prime portfolios. Further, Bridgewater expects about $500 billion in corporate losses must be written off. This leads to the current estimate of more than $1 trillion in losses yet to be written off.

Much of the capital that banks have sold recently is to help bring the banks capital ratios within regulatory compliance. This does not mean they cannot make anymore loans. And if they can make any new loans the rates on these credits will be much higher. This is why the local auto repair shop cannot get new loans. Businesses across the United States are realizing that credit is either not available or the interest rates are much more expensive.

Weak Second Half 2008

With out sufficient credit to help fund businesses, investors should expect the recession to continue through the second half of 2008. Many analysts and especially the talking heads will focus on the mortgage market. However, the lack of available credit is spreading to everyone. And the problem is not that these companies have poor credit. The problem is that the banks are constrained as to the amount of credit they can make available. Even with the Fed Funds rate at 2.0%, the Federal Reserve cannot change the unavailability of credit. This means the economy will experience a prolonged weakness that will not end until the additional loan losses have been written off. If Bridgewater is right on the total size of the losses, we are not even half way there.

The lack of available credit will get worse creating a credit crisis. Many banks will try to raise capital to help shore up their capital base. However, the cost of this capital will be high, since any new investors want to be assured they will get their money back. Existing investors who hold bank securities will find the value of their shares will be diluted. Some might even find they have lost most if not all of the value of their investment.

As investors, we need to adjust our strategies to expect a weak second half of 2008 which might last well into 2009. Adjust stock portfolios by employing bear market strategies that take advantage of discernable trends and higher volatility in the markets. Moreover, reduce exposure to the financial sector as the credit crisis causes significant losses for banks and their investors.

Companies that have substantial cash, strong free cash flow and little or no debt will weather the credit storm the best. In addition, use protection strategies to lower the down side risk including buying protective put options and writing covered calls. Investors can also buy the short and ultra short Exchange Traded Funds that short market indexes or specific sectors, such as the financial sector. Protecting your capital is paramount during these difficult times.