Credit Crunch: Pushing on a String?

I am not a fixed income specialist. To be totally honest, I have never owned a bond (I'm having too much fun in the stock market!?). But as I see the current credit crunch unfolds, I am reminded of credit crunches of the past. This similarity is not necessarily a good thing.

In my way of looking at the credit market, the key factors important to this discussion are 1) demand for money and 2) the supply of money. Demand is mostly a function the general economy. Businesses need capital to expand and borrowing money is a great way to get that capital. A slower economy will obviously negatively impact demand. The cost of money (interest rates) is also important and the theory is that when rates fall, the demand for money increases, all else held constant.

The supply of money seems to be a function of monetary policy and the willingness of banks to lend. Monetary policy can generally be determined by the actions of the Federal Reserve and the direction of the rates it influences. As rates fall, we can say that monetary policy is easing and when the rise, monetary is deemed to be tightening. The absolute levels of interest rates at which we can determine "easy" or "tight" money seems to be more difficult to calculate. Nevertheless, I think we can safely say that the Fed appears to be in a solid "easing" mode right now.

The banks' willingness to lend, in my view, is the trickiest part of this formula. I would venture to say that lending standards at all US banks have been reviewed and modified since the middle of this year. Loans that were flying out the door as recent as last year are just not being made.

Over the years, I have seen credit crises and crunches bedevil the market many times. Often the cause is too many banks making too many loans that eventually go bad. I don't know why bankers do this over and over again, but they do. I recall back in the early 1990s that 6% of Citibank's (C) loan portfolio (to Latin American credits as I recall), when it went bad, destroyed the equivalent of 3 years of earnings. It seems the current write offs are small (but still growing??) relative to this. Citibank earned over $21 billion last year. Imagine if it would write off total $60 billion - ouch!

So, if lending standards have tightened, banks may be less willing to lend, even if demand rises and even if interest rates fall. Part of the Fed's motivation to ease is to keep the economy growing. But, if banks are (at the margin) unwilling to lend, regardless of demand and interest rates, all the easing in the world will not lead to more loans. Hence, the pushing on a string metaphor.

Lower rates did not spur the economy immediately following the tech bubble bursting because higher rates were not the cause of the contraction. This time too one could argue that higher rates was not the culprit, it was overly easy or aggressive lending practices. Will lower rates help? It is easy for this simple stock guy to submit that the answer may be "no," at least not in the near term.

Any thoughts?