Bad Loans, Banks, and the Coming Credit Crunch

I've been thinking about the health of the banking sector of the US economy, and pulled together a couple of charts that have gotten me thinking. And worried.

First, take a look at this picture of the total quantity of loans outstanding at commercial banks in the US, broken down by type of loan.



The two things that strike me about this picture are 1) the obvious cyclicality of lending, particularly to businesses (more about that later); and 2) the incredible growth of real-estate lending over the past several years. Note that all series have been deflated by the CPI, and thus reflect real changes. Even after adjusting for inflation, real estate lending has nearly doubled since the start of 2000.

Now consider that the Mortgage Bankers Association (MBA) recently estimated that about 5% of all mortgages are currently in default, and that the delinquency rate that is growing rapidly. Suppose that we use that statistic to infer that 5% of commercial banks' real-estate loans will shortly have to be classified as non-performing. (Since commercial bank real-estate loans also include commercial real estate loans this estimate is a bit high, but since we know that the big growth in real-estate lending over the past several years has been for residential and not commercial property, the 5% figure at least makes a good starting point.)

That would imply about $170 billion in bad loans, or about 3% of the $6.1 trillion in total outstanding loans (real-estate plus non-real estate loans) on the books of commercial banks. Not all of that $170 bn will be lost to banks, since they should be able to foreclose and sell some of the underlying properties, but it seems safe to guess that banks will end up writing off some fraction of that total - probably many tens of billions of dollars worth of loans, or several tenths of a percent of all bank loans.

Now comes the scary part. Consider the following picture, which shows the rates of non-performing loans and loans that banks have had to write off over the past 19 years.



As of December 2006, both ratios were at comfortingly low levels. But the MBA data suggests that -- even if delinquency rate abruptly stops rising today -- we should expect the ratio of non-performing bank loans to rise by a few percentage points, and the portio of bank loans that banks are forced to write off to rise by some tenths of a percentage point. Those developments would quickly move the series in the graph above into the range where they were during the period 1990-92, when bad loans caused the massive Savings and Loan crisis and a widespread recession-causing (or at least recession-exacerbating) credit crunch through the US economy. (At this point, feel free to refer back to the top chart to see the effects of that credit crunch on business lending in the early 1990s.)

I hope it's now clear why I'm in the camp of those who are worried about the financial spillovers that the housing slump will have on the broader US economy.