The Next Shoe

Yesterday, Jon Hilsenrath wrote that banks keep lending, but that isn't easing the crisis. He points to a recent paper by Harvard Business School economists David Scharfstein and Victoria Ivashina which says, by way of introduction:

There appears to have been an increase in drawdowns of revolving credit facilities. Many of these drawdowns are undertaken by low credit quality firms concerned about their access to funding.

Mr. Hilsenrath comments:

With [credit] 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. [..] Individuals might be using home-equity lines in the same way, tapping them for cash while the lines are still open.

The "credit crunch" we are in started with residential real estate. Weaker borrowers found that they could no longer refinance their homes at higher valuations, and thus were unable to fund current obligations through continued borrowing. They were forced to sell (or default and have their lenders sell) their properties at lower valuations. Lower valuations made credit harder to come by, and the cycle is still unwinding. The graph Mr. Hilsenrath plots based on Federal Reserve data scares me because it may point to a coming acceleration in that cycle.

While the going was good, borrowers established "just in case" home-equity lines of credit based on then-current, high appraisal values. Lenders were eager to lend, and some were unrealistically optimistic in their appraisals. The credit limits on these lines have not been revised. They allow homeowners to turn back the clock and borrow sums that vastly exceed their present equity.

The 20% spike in "revolving home-equity lines" on the right-hand side of the graph suggests to me that in recent months there has been an increase in the number of borrowers who are "under water," or have negative equity in their homes. This increase came about not (only) through falling property values, but rather through continued borrowing at bubble-era financing standards. In effect, these owners used their one last chance to refinance their way out of foreclosure.

Some of these new borrowers have steady income streams and will have no difficulty meeting their increased monthly payments. But I expect that some will simply burn through the cash they've just borrowed and default then, inevitably dragging property values lower still, pulling the "deleveraging" cycle tighter.

The ridiculous loans banks made during the housing bubble were like an anchor with a line attached to it, in the form of (no pun intended) lines of credit. We've thrown the anchor overboard, and I expect a jolt when the line feeds out.