Credit Started This Recession; It Will Also Help End It

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.

Comments

[Jackson Cash:]

Not a chance. Credit is the red-herring.

Bad policy fueled by self preservation and greed caused the crisis and will continue to perpetuate it.

Jan 04 11:28 AM

[nmelendez:]

Credit the redd herring? NO!!!!! The red herring is the people whom everextended themselves!!!! That's the real problem. We all have debt. How well we manage our debt is what sets us aside.
My net distribution:

10% retirement
3% savings(tired of banks ripping me off)
38%loans
49% Food, clothes...living standard

Thats the way to live up until you are 65. By then your house and loans should all be payed up, 10 to 40 thousand in savings and 10 to 15 times that in retirement. That at least has been how i operate.

Jan 04 11:53 AM

[Firat Ünlü:]

If you're standing in front of a vending machine and press the button for a coke why should all of a sudden a pepsi come out?
The only 'credit' to get us out of here is credibility.

Jan 04 12:27 PM

[peterthepai...:]

credit is debt...

1. you cannot cure debt with debt...

2. if you need it you're bust...

3. ask the banks if debt is still the way to go...

Jan 04 01:08 PM

[The Sage of...:]

Interesting article. What surprises me is the thought that a "credit crunch" was a recently invented phenomenon. Banks have historically been involved in other "bubbles" over the last twenty or thirty years. There was the Latin American bubble, the oil patch bubble, the real estate bubble and others in previous decades. Too much capital chasing too few deals. These all resulted in the closing of the lending window at many financial institutions. In the end, banks and other lending institutions cannot satisfy their investors and other stakeholders by investing in negative yield treasury instruments. They need the cash flow to keep the lights on, pay salaries and offer a reasonable return to investors. So when the dust settles, the lending window reopens until the next blow up. Every financial crises brings out the banner of "this one is different", as does ever stock market euphoria. Unless there has been a change in the economic laws governing financial markets, the ship invariably rights itself. The question is how long will it take and how much pain will we suffer before we get there.

Jan 04 06:55 PM

[bthomas:]

Debt is money. Ask a banker. Credit is still overextended. Banks are holding (hoarding) Treasury's rescue (bailout) cash because of fractional reserve requirements. New loans will be made (Albeit fewer) to qualified borrowers then the current stricture in credit will ease, and new money will be made. Let's hope it is soon.

Jan 04 07:02 PM

[Greg Pinelli:]

This is typical of someone who doesn't have a clue about the age they are living in..the author of the article is correct. It doesn't matter a rat's behind if credit caused the problems we have..it's the NEXT fix and, believe me, the pushers will make sure the junkies get it. Really pal..you can't live in 1952 and survive in this world...those are the facts of life.


On Jan 04 11:28 AM Jackson Cash wrote:

> Not a chance. Credit is the red-herring.
>
> Bad policy fueled by self preservation and greed caused the crisis
> and will continue to perpetuate it.

Jan 04 08:53 PM

[Greg Pinelli:]

Ray..I think you're spot on about credit being the way out..I'm just not sure where it's the way out to.....
The Obama Administration is going to be very public savvy..and that means never saying NO...this guy is not about to be a one term fella.

Jan 04 08:56 PM

[Smarty_Pants:]

Our current problem was brought about by excessive credit spent on nonproductive pursuits. When the easy money runs out the debt still needs to be paid and we don't have the money to support it.

When you are deep in the hole financially you can't rescue yourself by taking out an even bigger loan to pay off the smaller loans whose payment stream you couldn't meet. How in the world do you expect to meet the even larger payment stream on the bigger debt?

What the current 'plan' of ever more lending to save the system means is an ever bigger problem down the road.

If you continue to give a heroin addict ever larger doses of dope to counter the withdrawl symptoms, eventually one dose will turn out to be the overdose that kills the addict.

The FED and USTreasury's plan is to continue increasing the size of the fiscal heroin dosage to 'cure' the symptoms. Eventually they will succeed in killing the economy.

Jan 04 09:12 PM

[Kevin Walmsley:]

You can't borrow your way out of debt, and instead of asking the question, "what should the government be doing to loosen up an economy that simply refuses to lend or borrow any more", perhaps they should ask something else. "What do hundreds of millions of individuals, tens of millions of households, millions of firms, and tens of thousands of banks know, that the government doesn't?"

The credit cycle is ending, that's what. And sometimes it's better to let a junkie go through a period of withdrawal, painful but (hopefully) brief, rather than keep up the addiction another day.

Jan 04 10:45 PM

[Kevin Walmsley:]

It's a good thing this crew of geniuses wasn't around to combat the dot-com collapse. We would have thrown hundreds of billions of taxpayer dollars at Global Crossing, Enron, and Dr. Koop.com. The end would have been the same, but the tab would be paid over the course of the next hundred years, rather than in 2002 and 2003.

Jan 04 10:48 PM

[Kevin Walmsley:]

Shoot. My apologies to Smarty Pants, who already used the junkie analogy. And did a better job besides, I may add.
Sorry.

Jan 04 10:50 PM

[Alan von Al...:]

I feel sorry for you, Ray. Once upon a generation ago, government policy mattered because the US economy was resilient enough to shrug off whatever wasteful, pointless crap that politicians inflicted. You know, Social Security. Medicare. Price fixing.

Not any more. The global scope is beyond government control. Citi's balance sheet is $2 trillion, bigger than the Federal Reserve (or six times bigger than it was before Paulson puffed it up and Bernanke traded all the AAA bonds away for worthless subprime drek).

Once upon a generation ago, Americans produced more than they consumed. Not any more. Sure, Mr. Obama and crew are going spend a bundle that they'll have to borrow overseas, and the Fed can puff itself up another trillion, maybe. Then what? We'll be so far in debt, the dollar will be worthless and taxes sky high. Inflate our way out of debt to whom? Our children.

But that doesn't matter to you, does it, Ray? You got yours.

Jan 05 03:44 AM