Wednesday, November 28, 2007

Krugman's Calculation of Credit Crunchiness

In addition to affecting consumer spending, the problems in the housing sector may be contributing to a credit crunch (see earlier post). In a column titled "Banks Gone Wild," Paul Krugman writes:

But bad housing investments are crippling financial institutions that play a crucial role in providing credit, by wiping out much of their capital. In a recent report, Goldman Sachs suggested that housing-related losses could force banks and other players to cut lending by as much as $2 trillion — enough to trigger a nasty recession, if it happens quickly.

Beyond that, there’s a pervasive loss of trust, which is like sand thrown in the gears of the financial system. The crisis of confidence is plainly visible in the market data: there’s an almost unprecedented spread between the very low interest rates investors are willing to accept on U.S. government debt — which is still considered safe — and the much higher interest rates at which banks are willing to lend to each other.

He explained further on his blog:

Anyway, what I’m talking about is the spread between Libor — the London Interbank Offer Rate, which is the rate at which banks lend to each other — and the yields on Treasuries of the same maturity.

Normally, there’s just a small difference. For example, in February 3-month Treasuries yielded 5.03%, while 3-month Libor was 5.36%.

Right now, however, 3-month Treasuries are yielding only 3.18%, while 3-month Libor is 5.02%. That’s a big spread, suggesting that investors are very nervous about banks’ finances.

That nervousness is, in part, because it is hard to tell how much trouble the banks are in. One expert put it this way:

I fancy that the great New York (banking) institutions have more skeletons in their cupboards than anyone yet knows about for certain, and that their concealed anxieties cramp their action more than is admitted.
That's John Maynard Keynes, in 1930 (via EconoSpeak).

One reason Libor matters is that most corporate bank loans are priced at a spread over Libor - that is, the interest rate is "floating" and rises and falls with Libor; so this is directly affecting the cost of credit to corporations.

Some of our trading partners see the financial turmoil as a buying opportunity - Abu Dhabi is buying a $7.5 billion stake in Citigroup.

At Vox, Columbia's Charles Calomiris offers a more optimistic view of the situation.

Update (11/28): The NY Times reports "Lenders' Belt-Tightening Stifles Growth in the Economy."

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