Why the credit market is tightening

NY Times:

Credit flowing to American companies is drying up at a pace not seen in decades, threatening the creation of jobs and the expansion of businesses, while intensifying worries that the economy may be headed for recession.

The combined value of two leading sources of credit — outstanding commercial and industrial bank loans, and short-term loans known as commercial paper — peaked at about $3.3 trillion in August, according to data from the Federal Reserve. By mid-November, such credit was down to $3 trillion, a drop of nearly 9 percent.

Not once in the years since the Fed began tracking such numbers in 1973 has this artery of finance constricted so rapidly. Smaller declines preceded three recessions going back to 1975; at other times such declines tended to occur in conjunction with an economic downturn.

Policy makers at the Federal Reserve are growing increasingly alarmed about the problem, which is an outgrowth of the woes of the housing and mortgage industries. Just yesterday, the Fed’s vice chairman, Donald L. Kohn, said that the latest market turbulence appeared to be reducing credit to businesses and consumers, hinting that the central bank, in response, was prepared to cut interest rates further.

Mr. Kohn’s unexpected pledge that the Fed would pursue “flexible and pragmatic policy making” that might help counter the trend and shore up the economy spurred a rally on Wall Street that sent stocks soaring. The Dow Jones industrial average jumped 331 points, to 13,289.45, while the broader Standard & Poor’s 500 index climbed 2.86 percent, to 1,469.02.

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Democrats are making proposals which will only worsen the situation. They have this irrational belief that the companies that are losing billions of dollars because of bad loans were engaged in "predatory" lending. It should be blindingly obvious that they did not make money off the loans that went bad, when they had to write off billions. But, Democrats want to turn trial lawyers loose on the not so deep pockets of lenders to punish them for making bad loans to people who defaulted.

Because of all the bad loans and the substantially losses incurred by the large financial institutions, they have less liquidity to make loans to begin with. In recent days Citi bank had to get an infusion of capitol from Abu Dhabi just to remain competitive for much of its business. Compounding the problems of the write offs is the natural tendency of business who have lost money to be more conservative in future lending to avoid future losses. This means some loans just will not be approved.

There is a reason why many of the large Houston banks will not loan money on drilling rigs. They are relatively high cost items whose scrape iron value is minimal if they are no longer needed for their intended purpose. Consequently, these deals are usually financed by people with a larger risk tolerance and an expectation of higher return. That same thing will probably happen on a lot of the deals that banks are not willing to do at this time.

This Washington Post story describes how the credit insurance business is having a ripple effect in the public finance sector.

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The municipal bond market has been squeezed by steep losses among bond insurance firms. Towns and cities with poorer credit ratings often rely on these insurers to back their bonds, enabling them to pay lower interest rates. But now bond insurers are facing massive write-downs because they promised to cover losses in the mortgage industry, leading some to stop insuring new projects.

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So far Congress has not accused the insurers of predatory insuring. But many of the loans that turned out to be bad were insured by these companies and the substantial losses they incurred make it difficult for them to insure new projects. The credit insurers made the same mistakes the lenders made by in effect investing in over valued real estate assets.