The downside of credit liquidity

Robert Samuelson:

There is a vast gap of perception between the real economy of production and jobs and the financial economy of loans and investments. The real economy, though weakening, is hardly in a state of collapse. In 2007, it has grown about 2 percent; payroll jobs are up by 1.3 million. Even economists who expect a recession generally think it will be mild. Meanwhile, financial markets are described hysterically as being "in turmoil"; there is a "credit crisis."

This contrast reflects fear of the unknown. Since 1980, America's financial system has changed dramatically in ways that are now arousing widespread anxieties. Many loans once made directly by banks are "securitized": packaged into bondlike securities and sold to investors (pension funds, investment houses, hedge funds and banks themselves). There's been an explosion of bewildering financial instruments -- currency swaps, interest-rate swaps and other "derivatives" -- that are used for hedging and speculative trading.

Until recently, the transformation seemed a splendid success. Credit markets had broadened; risk was being spread to a larger spectrum of investors. So it was said. This was an illusion. The securities containing "subprime" mortgages -- loans to weaker borrowers -- have experienced unexpected defaults, rating downgrades and losses. The unpleasant surprises have ignited fears among bankers and investment managers over how the new financial system operates.

Credit and financial markets subsist on trust and confidence. The subprime crisis has corroded both. Estimated losses range upward from $50 billion. Because trading in subprime mortgage securities is thin, how can they be accurately valued? Who holds them? Banks and investors have reacted to these uncertainties. For example, banks now find the "interbank market" -- banks lending to each other -- riskier than before, because they don't know which banks are most exposed. The three-month LIBOR (London Interbank Offered Rate) jumped to more than two percentage points above U.S. Treasury bills, triple the historic "spread" of 0.6 percentage points.

The subprime debacle also posed a question: What if it's not the only problem? Consider "credit default swaps" (CDS) as a possible sequel. CDS's are, in effect, insurance contracts on loans or bonds: The seller receives a payment and, in return, agrees to pay the buyer some or all of the amount of a designated loan or bond if the borrowing company (say, General Motors or IBM) defaults. But note, neither party to the CDS has to be the underlying lender or borrower. They usually are outsiders. They are simply betting on the creditworthiness of different borrowers.

Since 2004, the volume of CDS's has increased about sevenfold....

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What ultimately matters is the connection between the financial economy and the real economy. In housing, that's clear. Subprime losses reduced mortgage lending, housing construction, sales and prices. But not all credit cutbacks are so damaging. If too many junk bonds were sold at foolishly low interest rates to finance "private equity" deals -- buyouts of companies -- the process had to reverse someday through higher rates and fewer bonds being sold. That's not turmoil so much as the distasteful reality of retreating from dubious investments.

Despite all the bluster, evidence of a widespread credit crunch is so far scant....

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Credit enhancements preceded the "securitized" credit markets. Insurance conglomerates would guarantee payment of an issuers debt for a fee that was less than the saving the borrower got from issuing his debt at a lower rate. Because of the number of defaults in some of these loans these guarantors no longer have the ability to guarantee as many debt instruments which drives up the cost of borrowing for some. The biggest problem right now is that by securitizing credit instruments lenders lost control of the decision making process on the credit worthiness of the borrowers and the decision was being made by mortgage brokers with an incentive to make loans and not worry about their repayment. This turned out to be a disaster for the lenders and many of the borrowers.