There were some interesting charts and commentary in a recent issue of Contrary Investor showing the contraction in asset backed commercial paper. By permission from CI:



As of the end of May, the year over year change in US banking system commercial and industrial loans outstanding was close to 20%. Without belaboring the point, that's one very big growth number. Set against historical experience of the last few decades at least, we've never really seen annual growth like this.







Of course when looking at this data without digging a bit, the natural response is "what credit crisis"? Clearly the banks are lending with more than a bit of gusto, no? This simply flies in the face of conventional thinking, as well as the tone and detail of the most recent Bank Loan Officer Survey showing us that banks have tightened the credit reigns in a big way.



So it appears that although credit cycle woes have taken a very meaningful toll on the financial markets and the real US economy, US commercial banks haven't even blinked. In fact, they have hit the lending accelerator in terms of commercial and industrial loans, as their real estate lending activities have been curtailed significantly. Of course this is how it "appears" when looking at the raw bank lending data. But as always, appearances can be deceiving, especially in the modern US financial markets.



Let's quickly have a peek at an update of a chart we have probably shown you too many times this year. Specifically, what is important is the ongoing trend in asset backed commercial paper outstanding (the gold line).



Commercial Paper





Here's the deal. As we all know full well by now, the big boys in the US banking system have been heavily involved in off balance sheet shenanigans for many years now, these shenanigans now coming home to roost in a very big way. You know the vehicles by now - special purposes entities (SPE), structured vehicles (SIV), etc. Very much akin to the Enron structure before that house of cards collapsed due to sudden illiquidity.



The commercial banks simply thought they were smarter than the Enron crowd as they pursued off balance investment fun and games for profit over the decade to date period. As you also may be fully aware, many an off balance sheet "investment" for the banks was funded with asset backed commercial paper. The oldest trick in the book and really the oldest mistake in the book - borrowing short (maturity) and lending (theoretically investing) long. We've seen this mistake repeated so many times over our careers we've simply stopped counting. And literally every time it has ended in the same manner - in tears.



So as you look at the chart above, it is clear that asset backed commercial paper has been contracting very meaningfully since the summer of last year. In very rough numbers, contraction to the tune of maybe $225 billion. As you also probably know full well, many a bank has been forced (and will continue to be forced) to take many of these off balance sheet investments/assets back onto their own balance sheets in a formal manner. When this happens, the financing of these assets shows up as a loan. It shows up in the C&I numbers.



And so now we're sure you are starting to put the pieces of the puzzle together here. Since the end of July 2007, US banking system commercial and industrial loans have expanded by roughly $220 billion. Wow, what a coincidence, right? Wrong. Clearly, this is almost the same amount by which asset backed commercial paper has shrunk. Point being, bank commercial and industrial lending is not strong. It has not expanded meaningfully since last summer to fill the hole left by the contracting asset backed securities markets. To a very large extent, the increase bank C&I lending is simply the banks taking off balance sheet vehicles back onto their reported balance sheets in a formal manner. An illusion of lending strength? In many senses, yes.



The fourth quarter of 2007 witnessed the first quarter over quarter decline in total asset backed securities outstanding in history. Well guess what? Contraction continues. As of the first quarter of this year, not only do we now have two straight quarters of nominal dollar contraction in the total asset backed markets, but the first year over year decline on record. We do not expect this to change any time soon.







Is The Fed Easy?

We constantly hear from the talking heads that the Fed's recent policy actions are creating mammoth amounts of financial liquidity. But have these talking heads bothered to look at the data? If they did, they would have to change their tune.



Chart 1 shows that the year-over-year growth in the total assets of the Federal Reserve System was up 3.85% in the week ended June 18. Although total asset growth has rebounded from slightly negative territory of late April, the latest 3.85% growth still is low in comparison with recent years' behavior. So, the Fed is not creating massive amounts of credit on its own. In yesterday's comment, I noted that the Fed had reduced its holdings of U.S. Treasury securities by billions of dollars in the past six months. In effect, the Fed has been "sterilizing" much of the credit it has been creating via the discount window and its new borrowing facilities.



Federal Reserve Banks Total Assets







Now, let's take a look at what commercial banks have been doing with their loans and investments. Chart 2 shows that in the 13 weeks ended June 4, loans and investments at all commercial banks were contracting at an annual rate of 2.25%. It is true that bank credit growth ballooned in 2007 as banks were forced to take on credit that had originally been financed in the commercial paper market. But we seem to be over that "hump."



Bank Credit: All Commercial Banks





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