Credit Crisis

There is so much fear wrapped up in this financial crisis that government leaders are willing to support anything, even if this means the bailout bill was concocted mostly between Henry Paulson and his former colleagues as Goldman Sachs.

It is true that action is needed to contain the financial crisis. Many of the most gifted economists--Paul Krugman, Lawrence Summers, and Joseph Stiglitz, for instance-are now in favor of a bailout. Stiglitz, a Nobel Laureate, is the pioneer of "moral hazard" theory, so it's hard to argue that this group doesn't understand the dangers of public largesse.

A group of 166 economists from around the country wrote a letter protesting the $700bn bailout plan. They say it is unfair to help risk-taking financial firms and not mortgage holders, unclear on what terms toxic assets will transfer from private institutions to the state, and that the bailout will damage the long run health of the financial system.

The letter offers no explicit alternatives, but implies that a better plan would have more support for mortgage holders, clearly define the contracts between the Treasury and private firms, and not abandon the free market principles that anchor the U.S. financial system.

Snapshot asks, what would their vision for the bailout plan look like?

The credit crisis is not over, and banks are holding back their lending in order to keep cash on their balance sheets. The value of credit held by banks in the second quarter shrank by $154bn, the largest three-month contraction since 1948. Some expect further bank lending to contract by some $600bn to $700bn.

Small businesses are being disproportionately affected. Fifty-two percent of banks reported tightening lending standards for firms with annual revenues below 50 million. Small businesses comprise of over half of the U.S. labor market and their lack of access to credit could further damage unemployment and consumer spending.

Snapshot asks, does a credit contraction have a disproportionate impact on small business and therefore the labor market?

Wall Street Journal - Businesses Feel Pinch of Tighter Lending
Investors Insight - $1.6 Trillion in Losses and Counting
Reuters - Credit Seen Drying up for Small Business
Market Watch - Small Business Funding Alternatives Sought

Bond insurers are in trouble again, and banks will be forced to look for more capital. But the sovereign funds that bailed out investment banks in the winter may have lost their appetite for financials. A recent short-list of potential investors for Washington Mutual was absent of eight sovereign wealth funds the bank approached earlier. Merrill Lynch overcame investor reluctance in its last round of capital raising by agreeing to strict restrictions on subsequent share offerings.

Snapshot asks, as banks face further write-downs and seek to raise capital, will better deals lure sovereign wealth funds back into financials?

Federal Reserve Vice Chairman Donald Kohn says conditions in the credit markets are improving. Equities prices have rallied, spreads on high-grade corporate bonds have fallen considerably, and firms have not had trouble raising funds in credit markets. These positive signs are the result of the Fed's efforts to boost liquidity, ability of financial institutions to raise capital, and better than expected economic data.

Despite some positive signs, credit conditions are not optimal. Many investors remain skeptical of credit quality and the securitization market of mortgages has fallen dramatically. Because the market for securitized loans has deteriorated, banks cannot bundle and sell loans and other assets. As credit conditions deteriorate and the risk of default increases, financial institutions have had to de-leverage their balance sheets.

Snapshot asks, are credit markets improving or have we only begun to see a drawn out process of de-leveraging?

Federal Reserve Bank of New York - May You Live in Interesting Times: The Sequel
Don Kohn - May 20th Speech
Financial Times - Fears of Prolonged Credit Crisis Hit Wall Street

Since November, sovereign wealth funds have injected $41 billion of a total of $105 billion into struggling financial institutions. Since the purchases, the weighted average of those investments is down 40%. Many sovereign wealth funds are somewhat protected by buying mandatory convertible bonds, which pay large dividends to their holders before paying out to those with common stock. Still, sovereign funds were hasty in their investments and have spent the last couple months licking their wounds.

Snapshot asks, when will sovereign wealth funds move back into financials?

Reuters - Gulf Arabs put brakes on buying spree, await bargains
Wall Street Journal - SWF Losses
Bloomberg - Bear Stearns's Ruin Will Shake Sovereign Funds
IMF (Box 1.2) - Global Financial Stability Report

The Libor (London inter bank offered rate), or the interest rate that banks lend to other banks, has been called under question as a reliable indicator of banks' access to credit. Because of the tightening of credit conditions worldwide and hesitance to reveal the sting of the credit crunch, banks may not be reporting the actual rates at which they are able to borrow from other banks. The repercussions for the unreliability of Libor are catastrophic. Interest rates on home loans, auto loans, and student loans worldwide depend on the Libor rate. Citigroup's Scott Peng believes that Libor could be underestimated by as much as .3 percent, causing all banks to lend money cheaper than they should.

Snapshot asks, if Libor is underestimated, how much more pressure will it put on banks?

Wall Street Journal - Bankers Cast Doubt on Key Rate Amid Crisis
Wall Street Journal - Bank Group Expedites Libor Probe
Financial Times - Lenders examine Libor alternatives
Bank of International Settlements - Interbank rate fixings during the recent turmoil

It's all we hear about these days: The U.S. subprime mortgage bubble -- created by poor and at times predatory lending practices and lax banking regulation and creative investment products -- has burst. Of the approximately 7.7 million subprime loans outstanding, over 2 million are at risk of foreclosure and 600,000 borrowers are expected to lose their homes this year. The majority of us are left in shock as we watch the devastation unfold, the bubbles aftermath wreaking havoc on the U.S. (and increasingly global) economy, ensuing fears of recession and economic pain to come, and leaving politicians, economists, and regulators all scrambling to pick up the pieces.
However, in the meantime, the 2006 Nobel Peace Prize winner on Tuesday proudly hailed microfinance -- the innovation of providing small loans to poor, traditionally financial excluded individuals, mainly women -- as "sub sub sub subprime" lending. That means that globally, more than 3300 microfinance institutions provide such "super-subprime" loans to over 100 million clients and growing. Just to be clear: I'm a huge fan of microfinance. However, I'm left perplexed by this dichotomy: How can a lending practice that is almost singlehandedly dragging the whole of the U.S. economy in to a hole simultaneously and sustainably end third world poverty?

It has lately become fashionable for conservative pundits (Larry Kudlow, George Will) and disgruntled ex-bankers (Vernon Hill, for example, in his March 7 American Banker editorial) to blame the current credit crisis on the Community Reinvestment Act. This is patent nonsense. The sub-prime debacle has many causes, including greed, lack of and ineffective regulation, failures of risk assessment and management, and misplaced optimism. But CRA is not to blame.

First, the timing is all wrong. CRA was enacted in 1977, its companion disclosure statute, the Home Mortgage Disclosure Act (HMDA) in 1975. While many of us warned against bad subprime lending before the turn of the millennium, the massive breakdown of underwriting and extension of risky products far down the income scale-without bothering to even check on income-was primarily a post-2003 phenomenon. To blame a statute enacted in 1977 for something that happened 25 years later takes a fair amount of chutzpah.