29 September 2008

What the Credit Freeze Really Means

A number of people have commented to me that they didn't really understand what was meant by a credit freeze. They seemed to be having no trouble borrowing, even if their credit ratings weren't great.

First and foremost, the credit freeze is at the bank-to-bank level. You may think this is very odd (I know I'm still wrapping my head around it), but a lot of our economy is based on banks lending money to other banks! There's a constant swirl of loans that swirl around the banking industry. Quite a bit of this borrowing appears to be a case of borrwing from Peter to lend to Paul. No, I don't understand this yet, but when I do, I'll explain it!

At any rate, generally, the interest rate at which banks lend to each other is fixed by the Federal Reserve. When they talk about the Fed cutting or raising rates, this is often the rate they're talking about.

The current rate is 2%, but banks are ignoring that. They're demanding at least 4% from each other. So in other words, the credit is available, but it's expensive.

This means that banks are either balking at taking out such loans from one another, or passing the pain on to the people they, in turn, are lending to. So, for example, a business that should have been able to get a decent construction loan at (to pull a number out of thin air) 7% now will have to pay 9%.

This, in turn, may be more than that business (or individual, for that matter) feels they can pay. The rate of interest figures heavily into many borrowing decisions. Consider how many people started to buy homes as mortgage rates started to fall below 7%% a little over a decade ago (speaking as someone who bought into that wave).

So: it's not so much that nobody's lending. It's that nobody's lending cheaply, and many people who rely on credit as part of their capital model are finding the extra cost of borrowing too high.


earnan said...

One of the reasons banks loan each other money is that any federally insured bank (or perhaps any deposit financial institution) is required to have at least a percentage of the customers' deposits available as liquid money.

Assume the amount is 3%.

If a bank has taken in $100 in deposits, they must have at least $3 available in their accounts to return to the customer. This means they can only invest 97% of it in other things. If their investments happen to go above 97% of the customer deposits, they have to borrow money to cover up to the 3%.

This is what the Prime Rate is.

chesther said...

Two things...

The rates that the Fed sets are the rates that the Fed charges the banks for overnight loans. The bank-to-bank rates are, as you say, set by the market. An example of this is the LIBOR, the London Inter-Bank Overnight Rate, which is often referenced as a benchmark for mortgages, credit cards, and the like.

The real *fear* going on right now, and according to some it is actually happening, is that banks are, in fact, unwilling to lend to each other. In many cases those short-term loans are backed by collateral, and nobody wants mortgage-backed securities as collateral right now. In many cases, the lender is just afraid that the borrower will go bankrupt or get seized or bought out overnight and they won't get their money back (or at least not all of it and not in a timely fashion). Thus, what is so eloquently called a "liquidity crisis" and why the Fed has been printing money as fast as it can.

In the wise words of the esteemed Mr. Joker from the first Batman movie (i.e. the Jack Nicholson version): "This town needs an enema."