Credit deflation is not just some abstract concept, it is real life activity. The article linked below highlights some concrete activities that coincide with real credit deflation. During the credit inflation, eventually rising prices allow fundamentals to be thrown out the door. As the tide rises, so to speak, you need not swim with a suit, everyone’s malinvestment is hidden by the increasing liquidity associated with ever-expanding credit. However, at some point, individuals get too far out on a limb. Fundamentals no longer support asset values. The riskiest borrowers default, the lenders must then deal with the asset that collateralized the loan.

In the linked article Bear Stearns and other large investment banking institutions are described having to deal with rotten foreclosed properties en masse, as foreclosures pile up due to the effects of overly risky loans issued during the insane housing boom. Now that the tide has turned, the naked have been exposed and the process continues. As further homes either sit untended, or are auctioned at fire sale prices, the values of neighboring homes decline as well. This further diminishes the issuance of credit as borrowers don’t want to borrow to buy declining value assets and lenders fear lending in an environment where they may have to foreclose and face a huge write off on their investment.

Over time, the tide of rising liquidity and eventually foolish extension of credit reverses and credit deflates. This credit deflation accompanies a decline in most asset values as credit often underpins irrational asset values in the face of spotty fundamentals. When all is said and done, one does not want to be leveraged to the hilt holding risky assets during a credit contraction.

Click here to read the full article.

Meanwhile, Michael Panzner explains, from a different perspective, “the smell of contagion in the air.”

Filed under: Social Mood, Economics