12/05/2010 – Signs of Deflation You Might Not Be Able To See Clearly

Continuing—and Looming—Deflationary Forces
The Fed and the government quite effectively advertise their
efforts to inflate the supply of money and credit. But deflationary
forces, to most eyes, are invisible. I thought I would point
some of them out.

1. Banks Are about 95 Percent Invested
in Mortgages

Figure 4, courtesy of Bianco Research, shows that U.S. banks
used to be fairly conservative, holding 40 percent of their assets
in Treasury securities. This large investment in federal government
debt, the basis of our “monetary” “system”,
served as a stop-gap against deflation. In 1950, even if mortgages
had been wiped out by a factor of 80 percent, banks still would
have been 50% solvent and 40% liquid. Today, banks hold federal
agency securities (backed mostly by mortgages), mortgage-backed
securities (meaning complicated packages of mortgages), plain
old mortgages that they financed themselves, and a few business
loan contracts. If these mortgages become wiped out by a factor
of 80 percent, which in turn would cause many of the business
loans to go into default, the banks will be only about 22% solvent
and 1% liquid. I believe the coming wipeout will be bigger than
that, but let’s be conservative for now. The point is that,
unlike Treasuries, IOUs with homes as collateral can fall in
dollar value, and such IOUs are pretty much the only paper backing
U.S. bank deposits. The potential for deflation here is tremendous.

2. More Mortgages Are Going Under

It has been well publicized recently that commercial real estate
has been plunging in value as business tenants walk away from
their leases, leaving properties empty. Zisler Capital Partners
reports, “Returns were negative for the past five quarters,
the longest streak since 1992. Property prices have fallen by
30 percent to 50 percent from their peaks. Much of the debt is
likely worth about 50 percent of par, or less.” (Bloomberg,
11/11) Needless to say, the fact that commercial mortgages are
plunging in value is stressing banks even further, which in turn
restricts their lending. This trend is deflationary.

3. People Are Walking away from Their Homes and
Mortgages

Great numbers of people are ceasing to pay their mortgages,
even if they have the money to pay them. When people walk away
from their mortgages, they are reneging on a promise to pay the
interest on the loan. … Refusal to pay interest is deflationary.
When banks can’t collect fully on their loan principal,
as is the case by law in the above-named states, it is deflationary.
Even in states where banks can go after other assets held by
borrowers, default is still deflationary if the borrowers are
broke. The reason is that, in all these cases, the value of the
loan contract falls to the marketable value of the collateral,
and a contraction in the value of debt is deflation.

Some people who walk away from their mortgages purposely damage
the homes when they leave. New businesses have sprung up to take
on the job of cleaning up the houses that former occupants trashed
as they left. Angry defaulters are stripping coils out of stoves,
pulling electrical wiring out of walls, ripping fixtures out
of bathrooms, yanking seats off of toilets, punching holes in
walls and leaving rotting food in the fridge. (AP, 8/9) Such
actions, and the threat of more such actions, lower the value
of the collateral behind mortgage debts, thereby lowering the
value of mortgages, which is deflationary.

4. Bank Lending Standards Have Stayed Restrictive

As people default on mortgages, banks are tightening lending
standards. Figure 7 shows that banks loosened credit standards
from late 2003 through the summer of 2007. By the end of that
time, you could borrow money if you were breathing and could
operate a ball-point pen. Banks have been tightening credit standards
ever since. The rate of tightening peaked in October 2008, but
the graph shows that over the past year various banks have either
left their new, tighter standards in place or continued to tighten
their standards further. Across the board, it is harder to get
a loan, and it’s staying that way. Lending restrictions
reduce the credit supply. This condition is deflationary.

5. Banks Are Cashing Out of the Credit-Card Business

Articles have revealed that banks are doing everything they
can to get credit-card debtors to pay off their cards. They are
raising penalties and rates, lowering ceilings and otherwise
bugging their clients to pay up, one way or another: Transfer
your debt to another bank’s card; default; pay us off; we don’t
care which. And it’s working. Through September, consumers
have paid down credit card balances for 12 months in a row. Figure
8 shows the new trend. The credit-card business was another formerly
humming engine of credit that is sputtering. You might call the
new program “cash from clunkers,” and it is deflationary.

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