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Thursday, December 06, 2007

Can Policymakers Keep Credit Markets from Freezing Up?

This helps to highlight that while the Bush/Paulson plan to freeze the interest rate on some subprime loans may help some homeowners, subprime loan defaults are not the primary problem for the economy. The main worry is that banks and other lenders will pull back on loans of all type and cause a slowdown of investment and economic activity:

America's Grand Deleveraging, by David Wessel, WSJ: ...The ... market for credit, the lifeblood of a modern economy, isn't functioning well.

Just a few weeks ago, a lot of folks were arguing that the worst was behind us. Housing was still ailing. But after a big wallop, markets for credit seemed to be moving toward normalcy. The Federal Reserve ended its Oct. 31 meeting declaring that the "upside risks to inflation roughly balance the downside risks to growth." If Fed officials truly believed that then, they no longer do. They'll likely cut interest rates again... Only the most optimistic observers expect the U.S. economy to rebound quickly from its fourth-quarter slump. The argument now is between those forecasters who expect growth to be so slow in early 2008 that the unemployment rate climbs a little, and those who see a recession in which it climbs more.

In ordinary times, this would be unpleasant, but not so frightening. The Fed knows how to treat this condition: cut interest rates. ... But these aren't ordinary times.

For years, banks and investors lent freely. They took big risks for surprisingly little reward (known as "low risk premiums"...). Now, they're shunning risk. Big banks are reluctant to lend even to each other for more than a few days, and are hoarding cash. In a symptom that the financial fever hasn't broken, interest rates for one- and three-month loans among banks are up sharply. The Fed and the European Central Bank are now forced to consider the economic equivalent of alternative medicine. ...

The problem goes beyond mortgages. Rising delinquencies for credit cards and home-equity and auto loans are bound to make banks, credit-card issuers and other lenders wary. "Banks are having to eat into their capital base in order to reserve for growing losses," Mr. Mauldin says. "And that means they have less money to lend."

The Fed's weekly numbers show that bank lending is still increasing. But a lot of that is unwilling lending. Some banks are making loans under old promises to finance customers if they couldn't access financial markets. Others are taking on to their books loans made through complicated off-balance-sheet entities, and now have to set aside capital as a result. At a time when they'd rather reduce their portfolios of loans, that unwilling lending seems certain to lead them to pull back, if they haven't already, on lending to consumers and businesses. ...

Getting liquidity to the choke points, many of which are outside the traditional banking system, is a tough problem for the Fed to solve since most of its tools operate within the traditional banking system. It has been creative, e.g. changing collateral rules so that banks could act as intermediaries between mortgage lenders and the discount window, but there are limits to what it can do within the existing regulatory structure.

    Posted by on Thursday, December 6, 2007 at 02:52 AM in Economics, Financial System, Monetary Policy | Permalink  TrackBack (0)  Comments (15)

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