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In 2009, An Economic Upturn Will Depend On Unlocking Credit

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By ERIC DASH and VIKAS BAJAJ

New York Times

Published: January 1, 2009

"Credit, the disposition of one man to trust another, is singularly varying," Walter Bagehot, the financial journalist, wrote 135 years ago. "In England, after a great calamity, everybody is suspicious of everybody; as soon as that calamity is forgotten, everybody again confides in everybody."

He might have been describing modern-day Wall Street, where trust - and credit - are in short supply.

The financial crisis began in the credit markets, and eventually it will end there. But as the financial industry rounds out one of the most wrenching years in its history, bankers and policymakers are struggling to see the way out of this mess. Despite triage by Washington and trillions of dollars of taxpayers' money, credit is not flowing nearly as much as many had hoped.

The problem, as Bagehot observed, is trust - or rather, the lack of it. Even after receiving millions, in some cases billions, of dollars from the government, banks are reluctant to lend money. Crucial parts of the financial system have stopped functioning. The exuberance of the boom, which led bankers to make loans to people who could not repay them, has given way to a seemingly intractable fear of making any loans at all.

How long this situation lasts will determine the immediate course of the nation's economic life. Will the recession, already a year old, drag on through 2009 - or even longer? Will the stock market revive soon or shrivel further? What of the beleaguered housing market?

The answers to those questions will depend on the availability of credit in all its forms - home mortgages, personal and business loans and bonds sold by corporations, states and municipalities.

For now, many banks are hoarding money rather than lending it. Their holdings of cash have nearly tripled to slightly more than $1 trillion in the past three months, according to Federal Reserve data.

In the capital markets, bond investors who embraced risk in good times have abandoned all but the safest of investments. Many have rushed to buy ultra-safe U.S. Treasury securities, driving the yields on those investments to historic lows. Once the credit markets stabilize, bankers hope, investors will start buying other types of debt, unlocking the flow of credit.

A big worry is the future of securitization, a key mechanism of modern banking that enables banks to bundle loans and bonds into securities for sale to investors. This crucial market is moribund now that many of its creations have plunged in value. Some question when, or if, certain areas of securitization will revive.

Securitization, which works like a shadow banking system, has radically changed banking and the credit markets in recent years. Three decades ago, banks supplied $3 out of every $4 of credit worldwide. Today, because of securitization, that share has dropped to about $1 in $3.

Unless financial companies can securitize debt - which, in turn, depends on investors' willingness to buy the bundled loans - credit will remain tight even if banks resume lending.

"What started in 2008, and is going on now, is the undoing of that shadow banking system," said Alex Roever, a short-term credit analyst at JP Morgan Securities.

The Federal Reserve and Treasury are trying to fill the void, at least in part.

Since late November, news that the government planned to acquire billions of dollars in mortgage securities issued by Fannie Mae and Freddie Mac, the two mortgage finance giants, has driven down home loan rates. The national average 30-year fixed mortgage rate has fallen a full percentage point, to just over 5 percent, setting off a huge refinancing boom.

The drop in mortgage rates, coupled with a steep decline in government bond yields, is prompting investors to reconsider riskier, albeit higher-yielding investment-grade corporate bonds. Since October, the difference between the yields on such bonds and comparable Treasuries - a measure of the risk investors perceive in corporate debt - has fallen to about 4.4 percent, from 5.7 percent.

That's a good sign.

"October was the peak, during which everybody shut down and stopped doing a lot of things," said Curtis D. Ishii, the senior investment officer for fixed income at CALPERS, the large California pension fund. "In December, things got a little better."

Still, many bond investors and analysts remain cautious. Despite the government interventions, and indeed even because of them, many investors are reluctant to act until they are sure of Washington's next step.

"Investors will regain their confidence when they are sure they understand the rules of the road," said Jaret Seiberg, a financial policy analyst at the Stanford Group, a research and consulting firm in Washington. "In the past 18 months, those rules have been rewritten so many times that nobody is sure when the government will intervene and when it won't."

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