As loans dry up, so will economy

By Jon Markman

If you've been feeling pretty good about the prospects for the economy as the stock market has climbed off the mat, I suggest you forget the Dow industrials ($INDU) for a minute and look toward Yakima, Wash.

That's where Western Recreational Vehicles, a four-decade-old company employing 220 people, closed its doors last week.

The family-owned maker of Alpenlite-brand motor coaches and campers had survived every bad economy and spike in oil prices since 1971, but it had to shut down when banks yanked its credit. Without the ability to borrow to buy parts and maintain payrolls during a period of seasonally soft sales, as it has always done, a wonderful small business went poof.

Some 200-odd jobs might not seem like a lot, but multiply that times several thousand around the nation and you get an idea of the tsunami of pain that's rushing toward U.S. banks and the businesses they serve.

Credit is the fuel of industry, and it is a vanishing resource despite a campaign of unprecedented swiftness by the Federal Reserve to slash short-term interest rates. As it disappears from the landscape, so, too, will hopes of a broad, lasting recovery.

"What people are missing is that credit may be cheaper but businesses don't have access to it," says Peter Morici, an economist and business professor at the University of Maryland who has been critical of banks. "Most people want to deal in absolutes, but they need to realize that less is almost as important as none. If there's 25% less credit available, it's like having 25% less crude oil -- it's very bad news for the economy."

To the lifeboats

This is a relatively new phenomenon in America, which is why it is so hard to comprehend. Few investors have seen the effects of constricted credit, as banks until now adeptly summoned, bottled, distributed and marketed it. Credit has been like an aquifer that businesses figured they could depend on to be there when they needed it -- maybe more expensive at some times than others, but always available.

Yet banks' egregious greed and misdeeds of the past few years have made credit dry up, and so they're keeping what they can get to themselves. Reading through the recent earnings reports of Bank of America (BAC, news, msgs), National City (NCC, news, msgs) and Citigroup (C, news, msgs), it's hard not to get the impression that the banks have decided it's every man for himself -- the heck with the women, children and small businesses.

The banks seem to be under the impression that hoarding capital to shore up their balance sheets will return them to health, but my sources believe they are badly mistaken. By refusing to lend to businesses as they did before the advent of exotic and expensive derivatives, they risk killing their own business as well. If this is true, as I suspect, then banks' recent mild recovery will be short-lived, and investors should continue to avoid them.

The central problem, as veteran investment banker Byron Wien described it in a recent essay to Morgan Stanley (MS, news, msgs) customers, is that banks have entered a time of secular, not cyclical, change that will keep them from regaining their place atop the food chain for the next few years.

Let's look at how we got here before considering what happens next. Wien points out that before the 1980s, banks were conservatively managed private partnerships that were content to make a profit by borrowing money from customers' passbook savings accounts at relatively low rates and lending it out at out at higher rates.

Then, in a newly deregulated climate starting in the Reagan administration, banks merged, got much bigger and global, went public, leveraged up their balance sheets at more than twice the rate of their industrial counterparts and developed a multitrillion-dollar derivatives business from scratch.

Masters of a shrinking universe

Through the 1970s, the banking biz was no great shakes and did not attract top college graduates. But as it became more competitive globally and further deregulation allowed commercial and investment banks to merge, pay scales escalated to the point where million-dollar salaries were common, opening a vast breach between compensation at financial and industrial companies. Tech boomed, overseas markets opened up, and bankers became masters of the universe.

After the tech bust of 2000, Wien explains, banking fees were under pressure, and brokerage commissions were shrinking. So financial-services firms were under the gun to find ways to provide their supergenerous compensation to employees. Leveraging superlow interest rates provided by the Federal Reserve after the 2001 terrorist attacks and recession, they found their answer in the invention of subprime mortgages.

Continued: The 'global liquidity factory'

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