Looming Debt Crisis

Not to upset you or anything, but I thought I would draw your attention to a looming problem. Blame the Financial Times for this one because, although I have mentioned it here frequently, a guest column in this morning’s paper reminded me to mention the it again.

This problem is the refinancing schedule of large scale debt in the US. It looks ugly. Over the next few years our financial system will need to absorb about $4.2 trillion in refinanced debt, much of it commercial mortgages of highly dubious value.

I note this only so as to warn you all that the banking system is very far from being safe and sound. Those debts are huge and are currently clogging up bank balance sheets.

This refinancing flow is a natural result of the absolutely stupid run up in credit the banks provided during their lunatic years back in the early 2000’s. Much of the debt is now sitting in toxic securitized debts like Collateralized Debt Obligations [CDO’s] and is cluttering up bank balance sheets. To the extent that this debt is not being carried at a decent market value – and banks are highly resistant to marking their longer term assets to market so I expect many of these toxic assets are being treated as if they are just fine – any ability to refinance will be stalled until the underlying assets are revalued. It is that revaluation we should all worry about: it will knock a hole in bank capital. The big question is whether the damage will be enough to trigger another wave of bail outs.

All the focus so far has been on unwinding the over exposure to consumer debt. Mortgage Backed Securities were the first big wave of debt implosions and they tended to be consumer based. The reason that the commercial mortgage and other speculative non-consumer loan markets have not similarly imploded is that the banks extended term credit even to low rated borrowers. Typically a bank would have kept the credit terms to less than a year – 364 days is popular – but in those insane years terms were extended out for years at a time. This may work to our advantage: not everything will be due at once so the banks can work out the losses over time. But there is an obvious downside: because the bitter pill of loan losses will be spread over time so will the drag on bank profits and their willingness to make new loans.

So the upcoming surge in refinancing could act as a dampener on the provision of credit to healthy growing companies just as we need them to have access to loans to keep on growing. So GDP could suffer.

This is the second big step the economy needs to take as we unwind the preposterous debt build up of the bubble years. Refinancing of all that speculative debt, and the recognition that much of it was pure illusion and should be wiped out, will drag on our growth prospects for years to come. It also underlines the fact that consumers were not to blame for this bubble. Residential real estate is just one part of the problem. Commercial real estate is a much larger part. As long as those big empty apartment buildings remain empty someone, somewhere, is going to take a loss. Everyone will be in denial until the moment of truth. That moment is the day the loan comes due and has to be refinanced and we all realize the building has practically no value.

Worse: if the Fed acts to curb inflation over the next year or two, interest rates will rise making it even harder to refinance: the loan carry costs may stress borrower income statements too much. But, conversely, if the Fed keeps rates too low we run the risk of inflating another credit bubble.

Ugh. No one said cleaning this mess up was going to be easy. Just very expensive. On that we can all agree.

So: watch this space. The upcoming torrent of refinancing may well yet shock the system into another credit crisis.