— James Saft is a Reuters columnist. The opinions expressed are his own –

Government intervention or not, banks will be cutting up America’s credit cards at an unprecedented rate, with grave implications for the economy and company profits.

The U.S. Federal Reserve last week added more nutrition to its alphabet soup of rescue programs when it unveiled the Term Asset-backed Securities Loan Facility (TALF), under which, among other things, it will lend up to $200 billion to investors in securities backed by credit-card, auto and student loans.

It did so for a very good reason: the securitization market’s freeze now extends beyond mortgages, imperiling run-of-the-mill consumer financing and making it a certainty  that many people who use credit to get them over “cash flow” situations will be, well, denied.

And even though the U.S. car industry may implode if starved of finance and many students will have to defer education, the real potential disaster is in credit card funding, which could push lots of households over the brink and in the process consumption and every business which depends on it, which would be all of them.

Put simply, even with an apparent will to try anything to bring the wheels of finance back into motion it will be very difficult for government to quickly fill the hole left by private finance. Details of the plan are still sketchy, but let’s just take it for granted that it works, even if the plan, at only one year, will give them huge fears about how they get out of their positions at the end of 2009.

Beyond that, the Fed is seeking to kick start securitization by attracting back a species of investors, leveraged ones, who don’t really exist any more.

All other things being equal, the amount the Fed is putting into the TALF should take the ABS market back to about where it was in the first half of 2008, which itself was only a third of the volume we saw in 2007.

But all other things are not equal.

The banks that provide the bulk of credit card funding  generally want to cut back, pushed by their own woes, a conservative read of the economic situation and, potentially, regulatory changes that, while intended to ward off the excesses of the last bubble, will magnify the impact of its bursting.

Meredith Whitney, the Oppenheimer and Co analyst who has so far been ahead in identifying and explaining the weaknesses in the banking system, thinks over $2 trillion of credit lines, or 45 percent of lines available, will be pulled out from under American consumers in the next 18 months, a figure that puts the Fed’s $200 billion for asset backed finance in its proper perspective.

“We are now entering a new era within the financial landscape that will be characterized by expanded forced consumer de-leveraging with a pronounced downshift in consumer spending,” she wrote in a research note.

“We view the credit card as the second key source of consumer liquidity, the first being their jobs. Pulling credit at a time when job losses are increasing by over 50 percent year-on-year in most key states is a dangerous and unprecedented combination, in our view.”

BIG BANKS ALL WANT TO CUT BACK

Whitney notes that the three largest credit card lenders, Bank of America, Citigroup and JP Morgan, who between them account for more than half of U.S. credit card outstandings, have each discussed reducing card exposure or slowing growth. Capital One and American Express, who are another 14.5 percent, have also talked about limiting lending.

That will set the tone for the rest of the industry, which will be grappling with new regulation that, if goes ahead as planned, will impair profitability of credit card lending and push more off-balance sheet securitizations back on to the banking industry’s already strained books.

Cutting back on abusive lending and forcing banks to recognize and account for the risks they take are surely good things, but will have the perverse effect of making the credit crunch worse, at least temporarily.

And looking at the balance sheets of individual Americans, there is good reason to think that the credit crunch should get worse: that they should consume and borrow less and save more. I’d argue that far from being non-functioning, financial markets are closer to pricing in the true risk of lending to consumers now with credit cards charging about 10 percentage points more than 5-year Treasuries than they were six months ago when it was only about a 7.65 percentage point gap.

But the mother of all unintended side effects is that the faster consumers cut back, the worse it will be.

The kind of consumer cut back implied by the consumer credit crunch that now looks likely would blow a hole below the waterline in the U.S. economy, and in U.S. company profits and the stocks that reflect them.

The Federal Reserve and U.S. government’s use of unconventional measures is only just beginning.

–  At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For more columns by James Saft, click here. –

For full coverage of the crisis in credit, click here.

– James Saft is a Reuters columnist. The opinions expressed are his own –

The Citigroup bailout is sure to succeed, but only if you count avoiding making unpleasant but needed decisions as success.

It won’t work if you define success as building confidence and attracting private capital back to the banking system. It fails to work out a clearing price for rotten assets, and though it underwrites $306 billion of them even this huge sum is not enough to suspend disbelief.

It won’t even work if you define success as jump starting Citibank lending to private borrowers. The bankers have every reason to keep their heads down and pray they can slowly rebuild capital rather than lending into the biggest downturn in two or three generations.

At best it buys Citibank some time, though heaven knows what they can do in the next little while to stave off a cascade of writedowns in their housing and consumer loan books, much less their emerging market businesses.

It also, and I think tellingly, avoids taking a credible decision on whether Citigroup, and by extension the U.S. banking industry, can avoid explicit as well as effective nationalization.

We are in a really dangerous moment when is it apparent not only that no one really knows what to do, but that the people making decisions now are not the ones who will be left to sort them out once a new administration takes power in Washington. That provides a ready excuse to simply kick Citigroup’s can along the road.

One thing is very clear; the terms extended to Citigroup were a lot less difficult to bear than other earlier bailouts. I would guess that this is because the government is terrified that they have become the only game in town. The government is in a double bind; they must extend capital to banks or see them fail but every time they do it they make the banks less attractive to private money.

Any more radical solution would be difficult for a lame duck administration to attempt, and given the size of the banks involved, very daunting.

The United States will invest $20 billion in Citi preferred shares which will pay an 8 percent dividend.
The government will get 10-year warrants to buy $2.7 billion of common stock at $10.61 per share, as against Citi’s $3.77 price just before the deal was announced.

The government will guarantee $306 billion of Citi assets, with Citi taking the first $29 billion in pre-tax losses and the government on the hook for 90 percent of the losses after that. These assets will remain on Citi’s balance sheet and it will continue to get any income they generate but Citi will issue $7 billion of preferred stock, which will also pay 8 percent, as a fee. These assets will only be 20 percent risk weighted, which will free up an estimated $16 billion of capital. All in all, it was enough to underwrite a more than 70 percent rally in Citigroup shares.

Crucially, we’ve not yet seen any indication that we will get a full accounting of exactly how that $306 billion was valued, other than it was agreed between Citi and the United States. It is another example of the U.S. saying: “Don’t worry,  we will make it all OK,” without exactly specifying what “it” is.

CIRCLE OF CYNICISM

And of course without being able to see what the assets will actually fetch, especially in a declining economic environment, who would want to buy the pig in the bank’s poke?

That being the case, and in the firm expectation that loan losses will mount as the economy worsens, it’s a fair bet that the vicious cycle of writedowns and capital need will continue. In the absence of some real clearing mechanism for banking assets, and a willingness for government to pick up the pieces for those banks that can’t survive, expect more requests for life support from more banks.

But governments are finding it increasingly frustrating, at least publicly, that they pour money into banks yet see little in the way of lending come out the other end.

“The heart of the fear for all of us that still value free markets is that governments will eventually decide to nationalize whole swathes of the global banking system to ensure that the money they’ve invested in the recapitalization trade filters through into the wider economy,” Deutsche Bank credit strategist Jim Reid wrote in a note to clients.

“Ironically there may be a time when banks have to decide whether they need to make loans that may prove to be loss-making just to avoid governments losing patience and nationalising them.”
It is really a worst of all worlds, a circle of cynicism; governments prop up the good and the bad in the banking system, which in turn makes loans it doesn’t really think make any sense.

It’s a heck of a way to allocate capital, and almost as bad as the old system.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –