'True Indicators Of Doom?'

Filed under: Questions from You

Shaun Parker and several other readers have asked about the intimidating world of interest rates, credit markets, commercial paper and what it all means for them and the economy. Parker writes:

"I was wondering why we are judging the impending doom of the financial world (at least via the media) only by the stock market. It seems that the real worry is the paper that isn't being issued and the soaring interest rate being charged between the banks lending to each other? If those are the true indicators of doom, why isn't the media following those more closely (or at all)?"

It's an interesting question, and not just for us financial nerds here at Planet Money. Drops in the stock market are important, of course. But the big problem for the financial markets remains the credit crunch.

Credit is the lubricant of the entire economy. When loans don't happen, business don't expand, factories slow down and workers don't get hired -- or worse. A short-term economic bump in the road can quickly become a deep recession if it continues unabated.

The main problem today is that the Kryptonite-laden balance sheets of so many large U.S. financial institutions has made many traditional lenders afraid or unable to lend money. In fact, many are either charging very high borrowing costs or not lending at all.

As Shaun points out, that means many companies are having a harder time borrowing money to meet short term cash needs like paying the rent or their employees' paychecks.

Consider this stat: the amount of outstanding commercial paper -- essentially a short-term loan for companies -- fell to $1.7 billion on Sept. 24, a drop of 3.5% from the previous week, according to Federal Reserve data. That was before Lehman Brothers, one of the largest commercial paper dealers, declared bankruptcy, the Fed forced a handful of national banks into fire sales and Congress spiked its bailout plan.

All that hasn't been kind to interest rates. Lately, the globally accepted benchmark interest rate known as the London Interbank Offered Rate (or LIBOR) is climbing to worrisome highs. In theory, LIBOR (pronounced LYE-bor) is simply a rate set in London each morning that large institutions charge each other to loan short-term cash.

In practice, however, student loans, equity lines, credit cards and most adjustable rate mortgages (to the tune of up to $360 trillion) are based off the LIBOR rate. And that means everyone's interest payments are climbing or about to climb very soon.

After the rejection of the bailout bill by the House of Representatives, banks hoarded cash, driving LIBOR up to 6.88 percent. A week ago, LIBOR was at 2.95 percent.

Worse, the spread between the LIBOR rate and the federal funds rate is growing. That's bad.

Typically the two trade a few hundredths of a percentage point apart, because they essentially monitor similar things. Now, they're moving apart now because lending banks worry that the borrowing banks may not be in business long enough to pay them back. The "spread" (called the TED spread just in case you hear about it elsewhere in the news) could undercut one of few remaining tools the Federal Reserve has to stimulate the economy.

Even if the Fed decided to make another cut to its target for the federal funds rate -- surplus reserves that banks lend to each other overnight -- the difference in rate between government and commercial bank lending means we might not see much of a boost because so many loans would be based on significantly higher rates.

Another last worrisome possibility of all this: as the credit market continues to weaken, it could lead to more layoffs and foreclosures and then the credit crunch might get much worse before it gets better.

Maybe it's not "indicators of doom" Sean mentions, but it's all scary stuff at the moment.

Daniel Costello

3:40 PM ET | 09-30-2008 | permalink

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