Crunch Time?

Much anxiety these days about the possibility of a "credit crunch" - a general tightening of lending standards. Their fingers burned by rising mortgage defaults and the attendant turmoil in markets for mortgage-related securities, the panicky, myopic herd otherwise known as Wall Street suddenly gets prudent. The troubles in the financial sector spill over to the general economy by making it harder to raise funds to finance investment and purchases of housing and durable goods. A credit crunch in the wake of the Savings and Loan crisis of the late 1980's may have been a contributing factor in the 1990-91 recession. In a column titled "Credit Market's Weight Puts Economy on Shaky Ground," the Washington Post's Steven Pearlstein discusses how financial "innovations" mean things may be different this time:

By one estimate, for example, more than half the loans used to finance corporate takeovers are now packaged with other loans and sold as "collateralized debt obligations." And among the big buyers of CDOs are investment banks that package them with other CDOs and sell them again. Those are called CDOs-squared.

One advantage of this packaging and repackaging of loans is that it spreads risk so widely among investors that any default by a borrower will have negligible impact on any one lender or investors. Over the past five years, this has added a good deal of stability to the financial system. And with stability has come lower interest rates.

But at the same time, this financial engineering has encouraged debt to be piled on debt, making the system more susceptible to a meltdown if credit suddenly becomes more expensive or unavailable. And that's precisely what's been developing over the past several weeks.

A credit crunch means not only an increase in risk premiums - the extra interest paid by risky borrowers - but that some deals won't get done at any price. Reuters columnist James Saft says "It'll be a cold day before debt markets reopen":

Hopes that debt markets will reopen for leveraged borrowers after a pleasant summer holiday will be dashed, leaving mergers and buyouts and the stocks which depend upon them very exposed.

The riskier parts of the debt markets, especially leveraged loans, have all but shut up shop. Hedge funds generally can't get credit from their bank lenders and structured finance isn't buying either.

And it's not just that investors could have a long wait before the debt-powered private equity pipeline starts flowing again, it's also possible that a liquidity crisis prompts defaults and wider economic fallout.

He goes on to quote my old boss: "'It's going to take longer than September for the market to fully reopen,' said Meredith Coffey, an analyst with Reuters Loan Pricing Corporation in New York." As I remember well, the only thing more exciting in the Loan Pricing newsroom than big leveraged deals were big leveraged deals in trouble. At times like these, its much better to write about banking than to do it.

Meredith was characteristically cautious, but The Economist is positively sanguine. In their leader (as the Brits call an editorial), they say tighter credit conditions are just what the markets need:

BANKERS and investors might not agree, but the recent sell-off in financial markets is good news. It may, at last, have brought people to their senses. For the past few years, too much money has been lent too cheaply and too easily to too many people, whether it was speculators trying to make a fast buck in Miami condominiums or private-equity groups financing their latest multi-billion-dollar takeover. This wake-up call came too late to save the American housing market from frenzy and subsequent bust. But it may have arrived in time to stop the takeover boom getting out of control—and when the world economy is strong enough to cope with the consequences.

Update: Willem Buiter of the LSE has a proposal on what the Fed should do