Summary
Credit will likely get tighter before it eases. 1) Bank Letter of Credits will be called upon to provide liquidity, making less funds available to be lent out. 2) Car manufactures and other industries dependent on consumers purchaing with the use of credit. 3) Traditional sources of debt for hospitals will decline, making it tougher for hospitals to purchase equipment and expand. 4) All this leads to a contraction of the money supply and a recession.
Analysis
I know much has been written on the loanable funds markets, but I believe the not everyone understands the extent of the problem. The article from Modern Healthcare, “Financial Meltdown Hits Home” illustrates the difficulty hospitals are having with traditional variable rate demand bonds (VRDB) that are credit enhanced with a bank letter of credit. As this source of financing evaporates, hospitals will turn to more traditional sources of loanable funds, namely conventional mortgages and fixed rate bonds. The problem with both of these sources is that the lenders require loan to value ratios and security on projects that will limit the amount of financing a hospital can do. And, this environment will be with us for a while. Today, it is estimated that there is as much as $6 trillion in debt enhanced by bank letters of credit. If hospitals are unable to market their VRDB and the money market funds that purchase these instruments put them to the letter of credit banks, the banks will have to provide the liquidity at a time when they are suffering from liquidity problems. At the Modern Healthcare article points out, and I personally can attest to as well, this process is happening across the country. The greater extent this happens, the more liquidity that will be drained from banks and the less money banks will have to loan out. Given the volume of enhanced debt in the country, the extent of this problem can be staggering. To reiterate what is happening, GMAC is having a difficult time selling their commercial paper. As a result, GMAC lacks liquidity and is offering incentives to auto dealers to place their loans with other lenders. The problem, other lenders do not have the funds either. GMAC is also asking dealers to start paying off on their flooring lines of credit. These actions will put many dealers out of business, which ultimately affects the auto manufacturer’s ability to sell vehicles. If investors do not return to the money market funds and GMAC cannot sell its commercial paper, GM could cease to exist. This scenario is playing out right now, the economy has not seen the effect of this yet. Hospitals are not the only entities competing for loanable funds right now. GMAC is not a bank and does not qualify for the bail-out funds. The upshot is that we very likely are heading into a prolonged recession with unemployment in excess of 10%. You can expect hospital will purchase less equipment this next year, and delay construction projects. Bank letter of credits have expiration dates. If investors do not return to the money markets, banks will be holding on to these notes in the form of bank bonds for extended periods. The banks may be forced to let the letters of credit expire just due to the shear magnitude of the liquidity problem these instruments pose to the banks. Hospital will then be forced to either buy their notes, or find other sources of financing. In either case, cash reserves will be used by the hospitals and cash or financing will not be available to fund capital expenditures. The more this takes place, hospitals will find their debt capacity is exceeded. Cash will be required to meet debt covenants and not be available to purchase capital assets. Banks act as multiplies of the money supply. $1,000 deposited in a bank becomes $5,000 in loans and the resultant expansion of the money supply. This multiplier effect is caused by the 20% reserve requirement banks have. This levering has been higher in brokerage houses. The problem is that this leverage also works in the opposite direction. As money leaves the banks and brokerage houses, the money supply contracts. Milton Friedman in his short book called “The Great Contraction” says the real cause of the great depression was not the drop in the stock market, but the contraction of the money supply. The money supply at the height of the great depression was only one-third of the level it was before the depression. This loss of leveraging and contraction of the money supply will lead to a recession, and the recession will not by-pass hospitals. Hopefully all of this is wrong, and investors will return to the market. My guess is that the leveraging will not be at its former levels, and it will take a long time for the economy to reach former levels. Now you know why they refer to economics as the dismal science.
