Economic fallout explained

Much of the discussion around the recent attempt to bail out the American financial system bordered on the bizarre. That is, until I realized that the anger, recriminations, and ideological purity on display were really more frustration than informed opinion. Folks are surely frustrated over having to deal with this issue, and perhaps a little frustrated over not really knowing what they’re talking about.

There have been a few disingenuous people with access to the press who have tried to create a litmus test for Congress’ inaction, in effect saying, “See, I told you the world wouldn’t end if we voted down the bailout package.” And they’re right as far as it goes – the sun will rise with or without a package. But I do think that people aren’t grasping the central purpose for the bailout and what it needs to accomplish. Now once they understand it, I’m not sure it will move them to support a bailout or not, but they should at least be aware of the consequences of half-measures or inaction.

The principal problem right now in the financial system is the credit crunch. When the average Joe hears “credit crunch,” they immediately think of how it affects them, i.e. can I get a home loan, a small business loan, so forth and so on. But the credit crunch isn’t impacting that kind of credit. Individuals with good credit still have access to modest sums of money from community lenders. In fact, for some small lenders, business is booming.

The credit crunch involves corporate debt, specifically the short-term commercial paper that companies use to fund certain liabilities and operations, like inventory investment and payroll. For these needs, it is impractical and far too expensive to issue long-term bonds, so for most businesses in most cases, short-term paper is the only financing source available to meet the company’s day-to-day needs. After all, for rapidly growing businesses, or for companies with “lumpy” earnings – that is, irregular project schedules and invoices – they simply can’t function without the normal credit lines provided by the short-term commercial paper market. That’s not to mention the pressures exerted upon companies when their customers are late in paying their bills, which is apt to rise in a credit-crunch scenario, thus creating a vicious, negative feedback loop throughout the economy.

The reason the short-term commercial paper market is tanking is all the nastiness you’ve no doubt heard about in the press of late. The banking industry, collectively, made some massive and ill-conceived purchases of securitized debt, much of it originating in the mortgage industry. Once risk was revalued in the marketplace due to rising default rates, these instruments lost much of their value, and in turn the banks that had purchased a great deal of the stuff are now struggling to remain solvent. Several have failed, like Washington Mutual and Wachovia.

The connection here between short-term commercial paper and failing financial institutions rests in the overhang of securitized debt instruments still on the balance sheets of banks. Although belatedly, banks realized that these toxic debt cocktails were quickly losing value, but the market for these things had become illiquid. In other words, they couldn’t be sold – in effect, the banks were stuck with them. Further, they’re having a devilish time figuring out how much these cocktails are actually worth. With no market where the instruments are regularly bought and sold, there’s really no telling how much they’re worth.

The key point: until the banks can figure out how much these assets are worth, they simply cannot lend money…at all. Part of it involves the government-mandated capital requirements that all banks must meet, but more likely, the banks are just scared to death to resume normal lending for fear of what their accountants might tell them next week, next month, when the debt instruments they carry are priced lower than expected, tilting their institution into insolvency. The analogy here is dead reckoning – the banks are navigating a dangerous course without a compass and without charts and are extrapolating their current position based on their last known coordinates and speed.

The government bailout, primarily, is designed to buy a significant portion of these debt instruments, thereby setting a floor beneath the price of them. This would provide two benefits: one, it would give bankers the confidence to price their assets and know more or less definitively whether their banks are solvent or not, and two, it would take many of these assets off their hands and warehouse them until such time that a market can be made in them and they can be offloaded, hopefully at a profit (but don’t hold your breath). When and if these two things happen, then the short-term commercial paper market will begin to function again.

So, yes, the sun did in fact rise the morning after the bailout package failed to pass. But here’s the danger, and it can’t be measured in this week’s stock-market gyrations or “normal” business activity. According to an interview with bond trader Anthony Crescenzi published over at BusinessWeek, “It is critical that relief occur swiftly because most commercial paper matures in roughly 30 to 45 days, which means that vast portions of the entire market must be ‘rolled over,’ or reissued during this time.” This is why the average Joe hasn’t seen the effects of the bailout’s failure. Give it a couple of months. When ordinary businesses can’t roll over their short-term financing, there will be wrenching decisions to be made by corporate executives and business owners, and these are likely to involve downsizing, i.e., no economic growth, layoffs, and perhaps large-scale liquidations. This will send the markets south and working people scrambling for the unemployment line. It will also take much longer to dig out of a much deeper economic hole.

I’m not saying Treasury Secretary Paulson’s plan is the right one, but the alternative here cannot be inaction. I’ll try to post soon with some alternatives to consider.