Faith in credit fading during crunch
- Until recently, Federal Reserve Chairman Ben S. Bernanke was talking about a “global savings glut” that was pushing down interest rates and pushing up the value of assets like houses.
Now, suddenly, all talk of a glut has been replaced by its bone-chilling opposite -- a dangerous evaporation of credit that could bring down companies and conceivably shove the country into recession.
This about-face comes at a time when nothing seems to be going terribly wrong with the day-to-day functioning of the economy. “What we seem to have is a financial crisis with nothing bad happening to the flow of production and distribution to the economy,” said J. Bradford DeLong, a UC Berkeley economic historian who served as a Treasury official in the Clinton administration.
The current crisis has little to do with the stuff making and stock trading that are the focus of attention in normal times. Instead, it has to do with the payments system -- the credit that lubricates the economy by keeping goods and services moving and the compensation for those goods and services flowing back to their providers.
Substantial parts of the payment system have frozen up, because people are now unwilling to accept credit that was once considered legitimate compensation. That has caused its value -- and the value of what it was intended to pay for -- to vanish.
“It’s absolutely like black magic that somebody can come along and destroy hundreds of billions of dollars of value just like that,” said Karl E. Case, a Wellesley College economist and co-creator of the Case-Shiller index, which is extensively used to measure changes in home values. “That’s because value depends on what people are willing to pay or accept as payment, and right now many people are walking away from many kinds of payment -- especially those involving mortgage-backed securities.”
The current credit crisis differs from those of the past in that it is spread out across hundreds, perhaps thousands, of firms that sold mortgages, bundled individual loans in packages, and sold off shares to investors around the world. Contributors to the crisis are from occupations as diverse as home appraisers and financial analysts at securities rating agencies.
“In all the credit crunches I have dealt with, there was a central place where the problem was located,” said veteran Wall Street economist Albert Wojnilower, who with Henry Kaufman earned the titles “Dr. Doom” and “Dr. Gloom” for predicting the bulging deficits and titanic interest rates from the Reagan tax cuts and defense buildup of the 1980s.
“The central bank could go there and deal with it,” he said. “Now, if you and I were advising Bernanke and we were supposed to tell him where to put a chunk of money to stop the bleeding, we wouldn’t know -- because we don’t know where the problem is.”
The Fed on Thursday injected $17 billion in reserves into the economy -- $5 billion in a form that will make it available for 14 days and the rest just for one day. Like the much larger reserve injections of last week, the aim was to maintain the Fed-set federal funds rate -- the rate at which banks make short-term loans to each other -- at the Fed’s decided-upon level of 5.25%. The money is generally available for banks lending to companies or others that need the funds, but is not specifically targeted at borrowers or lenders currently in trouble.
The Fed is in the peculiar position of not being able to depend on what once were its key tools in case of crisis: deposit insurance and reserve requirements. That’s because the institutions at the center of the current credit trouble -- mortgage brokers and investment houses that package and resell housing loans -- are not eligible for either.
Even if the current trouble had taken a more traditional form, however, there is still a problem with credit crises that make them particularly difficult to deal with: Unlike the cash in your pocket, credit is in more than one place at a time. The act of giving or accepting it is almost entirely an act of faith.
The quality is illustrated in a famous line from Frank Capra’s “It’s a Wonderful Life” in which banker George Bailey (played by Jimmy Stewart) confronts an angry customer demanding his money, saying it is in Bailey’s bank.
“Your money’s not in the bank,” Bailey replies. “It’s in Mr. Smith’s house.”
“There isn’t enough money in the world to finance every transaction that occurs in a day, so you have to have faith or confidence you’ll be paid when you’re told you’ll be paid,” said author and financial markets expert Peter L. Bernstein.
That is precisely the faith that a growing number of people do not seem to have in the type of credit at the center of the current trouble: securities backed by mortgages, especially those backed by sub-prime mortgages (lent to people with less than strong credit histories).
Hundreds of people crowded offices of Calabasas-based Countrywide Financial Corp., the biggest U.S. mortgage company, in Laguna Niguel, Pasadena and West Los Angeles on Thursday, seeking to withdraw their deposits from Countrywide-run banks.
Meanwhile, issuers of commercial paper -- the unsecured promissory notes used by corporations in need of short-term loans -- retreated from lending to some mortgage companies, reducing the amount of U.S. commercial paper outstanding by its largest weekly amount since the Sept. 11, 2001, terror attacks. The commercial paper total declined $91.1 billion, or 4.1%, to a seasonally adjusted $2.13 trillion in the week ended Wednesday.
The decline was driven by a 4.3% fall in asset-backed commercial paper, which represents about half the market and has been used to finance sub-prime mortgages. Commercial paper is purchased by money market funds and mutual funds and serves as the lifeblood for corporate America.
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