In January I promised in the next month’s column I would discuss where the credit crisis might take us. That was five months ago—a life time in the way our economy has been changing. Therefore, this month I will cover where we have been, what we have survived and where we are in the economic adjustment process.
We very nearly had a collapse of our financial markets. So near that had the Fed not acted in a most unusual manner we would have had a complete collapse of our credit markets. That would have meant that those of you who have good banking relations and have used Commercial Bank credit facilities regularly could have had your credit line terminated, not because you weren’t the same good risk you have always been, but because the bank would have had to terminate all its lending until it could raise new capital or contract its lending until it absorbed its loan losses. Either way, your company could have been put out of business for lack of cash to operate.
The trigger to the scenario described above was the near failure of Bear Sterns Investment Banking house. You are probably wondering what the failure of Bear Sterns has to do with your commercial bank. Until 1999 very little. In 1999 the Glass-Stegall act of 1933 prevented commercial banks from participating in investment banking. The amendment removed that barrier and commercial banks and investment banks became intertwined. The big commercial banks had become heavily invested in mortgages with their fair share of the sub-prime variety. Had Bear Sterns failed, there were two more of the large investment banks that almost surely would have followed suit. These failures would have produced a financial panic. In a panic, lenders freeze. They simply make no loans. It would take only a few days of a cut off of commercial lending to start a series of business failures among good solid businesses.
The Fed took advantage of emergency powers it possesses, but had never in its history used, to avoid a Bear Sterns bankruptcy. The Fed in effect combined the powers of the Federal Deposit Insurance Corporation and the Federal Reserve to arrange a sale of Bear Sterns to Morgan. Up to that point in the credit crisis, the Fed had only made shot term loan secured by collateral to the financial community. The Fed actually guaranteed 30 Billion of the Bear Stern worst portfolio in order to induce Morgan to close the deal that week end. In other words, the Fed risked 30 Billion of the public’s money. This should give you some feel of the Fed’s judgment of the risk to the nation’s economy represented by the Bear Sterns failure.
When a financial Institution suffers a loss on a loan, the amount of the loss comes out of its Capital. The amount a financial institution can lend is a ration of its Capital. Since in good times a financial institution is pretty much “loaned out”, that is it is lending as much as its Capital permits, loan losses are important beyond the money loss. As pointed out previously, loan losses force the institution to raise additional Equity or reduce their lending. You have witnesses the flurry of Equity raising by the financial institution during the past five months.
We are not at the end of the problems for the investment banks and the large commercial banks but I believe that we are past the risk of a “panic” in this area of the economy. We are just entering the problems for the smaller commercial banks. These banks have some serious problems with mortgages, but they also have the problem of over extended commercial loans during a slowing economy. Yes, the economy is slowing and is likely to slow further. The recovery is at least six to twelve months away and possibly a little longer.
NEXT MONTH I WILL DISCUSS THE ENERGY CRISIS AND THE RISK OF INFLATION