A Glut of Purses

By DAVID MOON, Moon Capital Management
August 20, 2006

In the last three years, the Fed funds rate has increased from 1 percent to 5.25 percent. How effective was this dramatic rate escalation at dampening the supply and demand for credit?

Not at all.

Not only are debt levels not decreasing ' or even leveling off ' but consumer debt is actually growing faster this year than in any year from 2001 to 2005.

Consumer debt increased at a seasonally adjusted annualized rate of 5.7 percent in June, according to the preliminary estimate. That's more than twice the 2.5 percent annualized increase in our real gross domestic product in the second quarter of 2006. Our debt is growing twice as fast as our economy.

This, despite a quintupling of rates by the Federal Reserve Board.

What gives?

The lending standards of most financial institutions.

I recently visited with the head of an industry-specific lending division of a major regional bank. He explained that his competitors had lowered the amount of collateral they were requiring borrowers to put up or were eliminating certain types of loan guarantees.

This had the effect of instigating a sort of price war among competing banks. It also provided credit to a bunch of borrowers who, only a few years ago, would not have qualified for these loans.

Short-term interest rates have increased much more than longer-term rates. In this type of interest rate environment, the profitability of bank lending typically declines. One reason is that the spread shrinks between banks' cost of funds and the rates they can charge borrowers. Yet with the recent exception of mortgage activity, bank-loan profits remain high ' and are still increasing.


Because of an increase in loans. If your margins decline, you're tempted to make it up with more volume. And if the pressure to increase quarterly earnings is great enough, you increase your lending volumes by dipping down to a lower-quality borrower.

During the Great Depression, massive numbers of Americans lost their jobs. Unemployment reached 24.9 percent, real estate prices fell 53 percent and more than 40 percent of the banks in the country went bankrupt.

In the depths of that depression, 1932 and 1933, Americans actually spent more money than they earned. With a quarter of the population not earning anything, that shouldn't be a surprise.

The next time Americans spent more than they earned was in 2005. Unemployment was only about 5 percent throughout that year.

An old Spanish proverb says, 'He who has four but spends five has no occasion for a purse.' The handbag department at Saks should be worried.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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