Credit was at the heart of the current recession; it is also key to its recovery. The absence of a smoothly functioning credit system is life-threatening to a capital intensive economy. We saw that trust and confidence, two of the essential ingredients to a free flow of credit, were both lost in 2008, causing the economy to sputter to a halt. Consumers couldn’t get the financing they needed to buy big-ticket items; businesses couldn’t float short-term loans for production of new inventory, and long-term financing for plant and equipment expansion was simply not available.
This sorry state of affairs is quite perplexing to policy makers. It has been so long since we have experienced anything evenly remotely close to the present situation, that it is difficult to find anyone who can get a handle on it. In the United States we saw the utter bafflement in both the executive and legislative branches of government as to what to do. Ben Bernanke and Hank Paulson knew things were bad. They told the President and they told the Congress. But their first proposals turned out to be more comical than serious. Some were afraid the United States had become a Marxist state, but, if it is, it’s more like Groucho’s than Karl’s.
At present we are reduced to guessing about which policy would be most effective in getting out of the mess we’re in. How do you make banks willing to make loans and investors want to buy commercial debt instruments? The complexity of the issue has long lain buried in a market that seemed to work without anyone needing to know how it worked.
The New York Times phrased the problem well:
How long this situation lasts will determine the immediate course of the nation’s economic life. Will the recession, already a year old, drag on through 2009 — or even longer? Will the stock market revive soon or shrivel further? What of the beleaguered housing market?
It is clear now that the bulk of effort to bring the credit system out of the doldrums will rest with the incoming Obama Administration. For the few weeks left to Mr. Bush’s Administration, there is nothing that will be done that will make a difference. We have already spent $700 billion dollars which was literally thrown at the biggest banks and insurance companies. Yet we have little to nothing to show for the money in terms of a healthy credit market. Banks are as reluctant today as they were last month to lend money. Cash reserves in banks and, indeed, among almost all investors, is high. The Federal Reserve reported that bank holdings of cash reserves more than tripled to just over $1 trillion in the last three months.
There are a few policies in place, however, that will probably help get things moving. GMAC was provided with a multibillion dollar capital infusion and given permission to become a bank holding company. This is a good start. GMAC said it would begin making loans immediately to borrowers with credit scores of 621 or higher, a significant easing from the 700 minimum score required two months ago.GM said it would offer a new round of low-rate financing, including zero percent interest on some models. This can be a great help in getting American automobile production back to profitable levels.
The Treasury and Federal Reserve System are also putting their shoulders to the wheel. They are stepping in as buyers of commercial credit for securitized loans bundled by the banking system. Securitization has been essential in providing adequate short-term business credit in the past. But for now this market is frozen solid. It is absolutely necessary that this segment of the credit market begin lending again, and the Federal Reserve as buyer of last resort will encourage banks to make new loans that can be securitized.
Treasury action on behalf of Freddie Mac and Fannie Mae has also made huge sums available for home mortgages. Although the housing industry is still in the worst phase of a downturn, it is essential that mortgage money be available if the huge inventory of unsold homes is to be sold. The spread between home mortgages and long-dated Treasuries has narrowed lately, and that is a positive sign.
In February the Term Asset-Backed Securities Loan Facility will begin operations. This organization with the mind-numbing name will provide financing for some short-term small business and consumer loans.
The last piece of the recovery puzzle may well be the huge stimulus package being worked on now by President-elect Obama and Congress. It may be as much as $1 trillion, and it will unquestionably affect the economy in a positive way. Jobs in construction and materials industries will be boosted by the spending program, and the new jobs it will create will be a major step forward in getting consumer spending back to pre-recession levels. This will not be an immediate effect, however, and it is not going to bring us out of the recession before late this year.
Ultimately, for a robust recovery to begin, credit markets must be returned to good health. Higher employment will help, because people with jobs qualify for more credit than unemployed people. But the financial sector must be healthy enough to resume lending. The government programs now in place will help some, but ultimately it is the bankers who will have to come on board. In this respect, it is a psychological problem as much as financial.
There is no single variable I can recommend that will be a reliable indicator of a recovering financial system. But, there are three, which taken together, will provide a good snapshot of the health of credit markets. Keep an eye on these three variables and you will have a good idea of the stage of recovery.
First, short-term Treasuries need to come off the zero level. Yields are so low because of the flight to quality that has occurred all over the world as the price of U.S. Treasuries was bid up. When investor confidence begins flowing back into commercial loans, the short-term Treasury rates will nudge up. That will be a good sign.
The Ted Spread, shown below, is also a good indicator of investor confidence in the business lending world. This marks the spread in interest rates between Treasury Bills (90-day Treasuries) and the three month LIBOR. Historically, this spread has been about 25 basis points. As you can see from the chart, it is now closer to 150 bp. Although this is substantially lower than it was in October, it still needs to come down by about half to two thirds. Look for a narrowing as a good sign that credit confidence in business lending is strengthening.
Finally, the 30-day commercial paper rate is also a good indicator of lender confidence in the business world. For now, the 30-day rate is around .35%. This annualizes at 4.2%, about four times higher than similar maturities for government obligations. Look for a fall in this spread as a good sign that things will be getting better. This variable is also something of the inverse of the short-term Treasury rate. As lenders open up to business borrowers, they will necessarily short their position on Treasury obligations.
2008 was a wrenching year, and our economy will be suffering from its effects for a long time to come. From what can be seen in the charts above, there has already been some movement towards normalcy. The LIBOR rate was over 4% for a 30-day loan in October, so, as you could imagine, there was little lending between banks at a 48% annualized rate. I hope by mid-year all three of these charts will have moved to a more positive space. If so, it could be said then that a recovery is underway.