Credit Markets Need A Dose Of Faith

In the current financial crisis, banks have no way of knowing which of the businesses they lend to are good for their debts. The term "counterparty risk" refers to the risk that someone you're doing business with won't be able to pay up. The new federal rescue measures are designed to restore faith with counterparties.

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STEVE INSKEEP, host:

As you may have notice, we've been trying to explain financial developments on this program. Developments that seemed to make no sense, and we often end up using financial terms that seemed to make no sense. So we've been trying to define them, terms like leverage and today's term, counterparty risk, that's the risk that someone involved in a business deal will not be able to make good on a loan. NPR's Chris Arnold tells us more.

CHRIS ARNOLD: Here's one way this counter-party risk issue is being described. It's like you're in a room full of a hundred people, and one of them has a fatal disease. If you touch them or do business with them, you're dead. So even though most of the people around you are fine, you can't risk touching anybody.

Mr. STEWART HOFFMAN (Chief Economist, PMC Financial Services Group): People have been frozen by fear and banks have been frozen, and they've stopped lending to one another.

ARNOLD: Stewart Hoffman is Chief Economist at a major regional bank based in Pittsburgh, PNC Financial Services Group. He explains that the government is now guaranteeing a big part of the lending between banks that keeps the economy chugging along - in effect, inoculating those who are willing to lend the bank's money.

Mr. HOFFMAN: What the government saying, look, if you just happen to come in contact with that one, we're going to cure you. We're going to make sure that their problems, their disease isn't transmitted to you, that you're not going to lend them money and not get paid back.

ARNOLD: It's a really big problem that this lending between banks and other big financial players is frozen up. As the banking system seizes, it's unable to pump money normally.

Prof. MATT SLAUGHTER (Dartmouth, Tuck's School of Business): And this is why we care about capital markets differently from a lot of other industries.

ARNOLD: Matt Slaughter is a Professor of Dartmouth's Tuck School of Business.

Prof. SLAUGHTER: When the borrowing and lending breaks down, that constrains the ability of automobile companies, restaurants, schools, local governments to fund their day to day operations of meeting payroll, paying their vendors, buying the new capital equipment.

ARNOLD: So schools don't get built, companies can't expand and hire more workers, unemployment rises, not good stuff when we're heading into a recession. And at least, some of that is due to this problem of counterparty risk. Nobody in banking knows if that other party, the counterparty is safe. That's why Sheila Bair, the head of the FDIC, moved to guarantee those loans made the banks.

Ms. SHEILA BAIR (Chairman, Federal Deposit Insurance Corporation): The overwhelming majority of banks are strong, safe and sound. But a lack of confidence is driving the current turmoil, and it is the lack of confidence that these guarantees are designed to address.

ARNOLD: But some think the moves may not go far enough to jumpstart the banking system.

Mr. WILL ASTON-REESE (Vice President, Tradition Asiel Securities): To be able to lend money, you have to have money.

ARNOLD: Will Aston-Reese is a vice president at Tradition Asiel Securities, which runs a trading desk that normally arranges billions of dollars in loans for major banks every day.

Mr. ASTON-REESE: One of the biggest sources of funding for the banks in terms of deposits are the money market funds.

ARNOLD: These are the funds that a lot of Americans park their money in, and they've got several trillion dollars to invest. But that source of funding has almost totally dried up for the banks, that's because of another perceived risk. Even though, the government has guaranteed money market funds, people still might panic and pull out their money. And if that happens, the money funds need cash to pay their customers back. So they're sitting on a mountain of cash and not lending it out. Gus Sauter is Chief Investment Officer for the giant mutual fund company Vanguard. He says there has been a tiny bit of improvement here but...

Mr. GUS SAUTER (Chief Investment Officer, Vanguard): The things there are still quite locked up. You do still have kind of a log jam.

ARNOLD: So Sauter thinks the government needs to take even more action.

Mr. SAUTER: The sooner the better, because what we're seeing now is that the financial market crisis is bleeding over into the real economy. And you know, that just continues to build every day.

ARNOLDS: Sauter says there's one thing that could help a lot. He says the government could make cash available if the money funds needed it. Then that mountain of cash that they're sitting on just in case could come off the sidelines and get back into the economy. Chris Arnold NPR News.

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