Credit Tightening: Reply to Bob Higgs

by Liberty and Power

In a comment on my October 11 post about "Interest on Bank Reserves," Bob posed the following question:

"You refer twice in this post to a tightening of credit last week. I am wondering about what evidence of such tightening you have in mind. . . . Consulting the Fed's website, I see that issuances of commercial paper increased last week from roughly $179 billion on Monday and Tuesday to roughly $205 billion on Thursday and Friday. This 14 percent increase would not seem to comport with a situation of 'credit tightening.'"

Given the subject's import, I've decided to make my reply to Bob a separate post:

Bob: I agree with you entirely that current reports about credit markets"freezing up" and"melting down" are grossly exaggerated. Which is why I used the term" credit tightening," which can encompass fairly minor changes in the credit markets, including your scenario of risky borrowers having more difficulty finding lenders. The credit tightening that had been bothering the Fed over the past year was the increase in the Treasury-Eurodollar (TED) spread and the LIBOR-OIS (overnight index swap rate) spread. The first reflects a market shift from riskier to less risky assets and the second reflects a shift from intermediate maturity lending between banks (one to three months) to overnight lending. Then on September 18, the increasing demand for liquidity caused the T-bill rate to go temporarily negative, which is when Bernanke and Paulson hit the panic button. T-bill rates can only go negative so far before it pays to flee into base money.

Last week's concern over commercial paper was not with respect to total volume. It was over the enormous increase in the spread between A2/P2 and AA thirty-day nonfinancial commercial paper, reported here. In other words, lenders were shying away from the riskier commercial paper. As a result, the total volume of A2/P2 paper outstanding fell by over one-third from August to October. While an A2/P2 rating is not the highest, in order for firms to get it and be able to issue commercial paper that sells on a secondary market at all, they must be fairly well qualified. (In short, it is nowhere near analogous to a subprime rating on a mortgage.) You also saw the drying up of issues maturing in 80 days or more (remember that commercial paper can legally have a maturity of up 270 days) and the bunching of maturities at the shorter end. (See this Fed chart, particularly the monthly averages for A2/P2 non-financial and AA-financial paper.) Borrowers could only issue shorter term paper than they would have liked. All that this reflects, of course, is not any total interruption of the flow of savings, but a redirecting of savings into different channels, causing a re-pricing of financial assets. This certainly does not qualify as the catastrophe that newspapers were screaming about. But it does result in some economic stringency for the firms affected, and therefore I think the mild phrase" credit tightening" is not inappropriate.

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Jeffrey Rogers Hummel - 10/16/2008

Thanks for your comment, Bill. I found it insightful, and it helped clarify a few things in my own mind. I agree with you totally about government-mandated capital requirements. They are the only way to reduce the moral hazard problem from deposit insurance and yet they have exacerbated the current situation in several significant ways. In addition to the factor you mention, capital requirements have created all the difficulties resulting from mark-to-market accounting. In short, the financial system will never achieve full long-run stability until government deposit insurance is utterly abolished.

By the way, I intend to reply to your comment about outside money made to my previous post, but I'm not sure when I will get around to it. Just to clarify, I am NOT claiming that all inside money must pay interest. Just that outside money cannot. Think about the present value of an interest-bearing debt, in which the interest is only paid in more interest-bearing debt, and I think you'll understand why.

Jeffrey Rogers Hummel - 10/16/2008

Ah, yes! I thought it might be a take off from "Say it ain't so, Joe."

Robert Higgs - 10/16/2008

Roy Hobbs (aka "the natural"), the protagonist of Bernard Malamud's 1952 book, played by Robert Redford in the 1984 film adaptation. "Say it ain't true, Roy" is a telling line in the story. I know you're not Roy, Jeff. You're a better man: you'd never throw the decisive game to collect a bribe.

Jeffrey Rogers Hummel - 10/16/2008

Thanks Bob. I agree completely with your first two paragraphs. But in the third, who is Roy?

Bill Woolsey - 10/16/2008

The AA nonfinancial firms aren't having problems with credit. They have been paying less.

It is the A2 firms. They are now paying more than the prime interest rate on average, and the new issues are shrinking. (The outstanding volume statistics I can find don't distinguish between credit ratings.)

The outanding issues data shows that the total outanding for domestic nonfinancial firms dropped about $15 billion during September. Bank credit, however, has expanded by nearly $500 billion. Of that, about $70 billion is commercial and industrial loans.

If most of that loss in nonfinancial commercial paper was A2, there still seems to be plenty of new bank credit relative to the financing on the commercial paper market.

The reason A2 (and AA) firms weren't using banks to begin with, is that if the loans are on the books of the banks, the banks must finance the loan with 10% capital

If a bank issues a CD and uses the funds to make a loan to a business, the bank is guaranteeing the loan (and FDIC is as well, depending on the rapidly changing policies about whether there remain uninsured deposits) Regulations requires that on average, these loans must be financed 10% with stockholders money.

By cutting out the bank, the person who would have bought the CD can get a better return. And the borrower can pay less.

So, for much of last year, CD rates at the best banks were just about at the Federal Funds Rate and A2 paper was paying about .5% more. The prime interest rate is 3% above the Federal Funds rate. So investors were getting .5% more and borrowers were paying something like 2.5% less. (Well, we don't really know that these borrowers would pay prime.)

Of course, the risk is on the holder of the commercial paper.

If people who were willing to buy commercial paper now shift to banks, depositing money there, the borrowers must also go to banks to get the funds.

The firms borrowing will now pay more, and presumably, those depositing in banks will earn less.

(The secondary market on CD's is paying over 4%, but looking at things like bankrate.com suggests that newly issued CDs are paying less.)

Now the A2 commercial paper rate is more than 5%, (which was the prime intresest rate a few weeks ago, but the prime is now 4.5%)

So, one can imagine that there are complaints among borrowers.

Rather than borrowing directly from borrowers at 2% (which would be .5% above the current federal funds rate,) they can at best hope to pay prime, which is now 4.5%, about 2% points more than they paid a month ago.

I suspect that loudest complaints are among dealers in commericial paper who are losing busines to banks.

Aside from the special interest of commercial paper dealers and the shift in the flow of funds from direct finance to bank finance, are there any problems?

Banks need to expand deposits and lending in this scenario. And that means that banks need more capital. They have to get more funds from stockholders.

The figures for Sept. show commercial banks expanding lending, deposits and reserves.

Capital appears to be fluctuating at around 1.25 trillion. (Be mindful that bank capital was less than 1.2 trillion last year, and less the year before, etc.)

And so, banks may not be willing to lend, because they are having trouble raising capital.

Purchases of newly issued bank stock by the government solves this problem.

I think this is why many economists advocated government purchases of bank stock and consider this a more appropriate solution than buying up mortgage backed securities.

The market solution is for banks to issue more stock to take advantage of the increase in business.

Like required reserve ratios, I am inclined to think required capital ratios to be counterproductive. I am sure that requried reserve ratios are foolish. The point of holding reserves is to use them when needed. Maintaining reserve ratios when reserves are needed means that there was no point to the reserves.

Capital ratios are a bit different. In my view, bank capital is the most sensible thing for depositos and others lending to banks to have confidence. Still, the who point is for this "buffer" to be used when banks suffer losses. One way to rebuild capital is through profitable operations.

But with expanding deposit insurance, the reason for capital ratios is to protect the taxpayer (since insured depositors are protected by the taxpayer.) Having government buy stock in the banks puts those taxpapers are equal risk. Why not just reduce capital requirements?

Robert Higgs - 10/16/2008

Very well expressed, Jeff. And I don't dispute any of it. I simply continue to insist, as I have in regard to various sorts of financial data I've discussed in recent weeks, that this sort of development in the markets in no way justifies the pell-mell stampede to financial fascism that we are now witnessing.

Many of us bemoan, say, the New Deal, but we do not deny that SOMETHING SERIOUS underlay the Roosevelt administration's actions from 1933 to 1938. In the present case, in constrast, we are witnessing a government response that is, at best, stupendously disproportionate to the actual underlying problem, if any of a systemic character exists at all.

At times I find myself attracted to the outrageous hypothesis that this whole sorry business is nothing more than a cosmically audacious robbery for the benefit of the Friends of Hank. Say it ain't true, Roy.