On Tuesdays and Fridays I often drive produce to Lexington for Jerome Lange; the past couple of months the deliveries have included our own tomatoes and garlic and squash. I’m up at 4:30am and out the door by 4:50, to get to Jerome’s place by 5:15. He has already loaded the van the night before with boxes that don’t need refrigeration; we load stuff from the cooler into the van, and I’m usually on the road by 5:40. I arrive at Good Foods around 7:30, then take an hour or so to unload and deliver boxes to the produce department and the cafe kitchen. By 8:30 I’m usually on my way home, stopping to do whatever errands I need to run, getting home around lunchtime.
My first car came without a radio and I drove it for years before having one installed, so I’m quite used to driving in silence with only my thoughts to occupy me. Often I’ll make the trip to Lexington in silence. But it’s a long one, and sometimes I get tired of my interior monologue and turn on the radio. Lately I’ve done that a lot, since I am very interested in the news. Usually between 5am and 9am I’ll manage to catch most of NPR’s Morning Edition.
That’s what I did this morning, and I was delighted to hear two back-to-back segments that actually made some sense of the current crisis. The first one, Bank-To-Bank Loans Front Line Of Credit Crisis, was good enough that I took the trouble to transcribe it. Here is the text:
NPR’s Adam Davidson visited the front lines of the credit crisis.
Tradition Azel Securities has a massive trading floor, nearly a hundred men and a handful of women, sitting in front of computer screens. It’s in lower Manhattan, right near Ground Zero, and these guys like Will Aston Reese have no doubt about how important their jobs are:
Voice: “This is the pump right here. When you hear about priming the pump, money flows through the banking system.”
Reporter: “The pump of the U.S. Economy?”
Voice: “The pump of the U.S. Economy. The world economy.”
In normal times–meaning, before three weeks ago–these guys were the middlemen when one bank wanted to borrow from another. They called Tradition Securities and asked them to put the deal through. A billion dollar loan was routine. At this desk and a handful of others around Wall Street, trillions of dollars used to flow from one bank to another every day.
Voice: “Joe, count them up. Count them up. Give me a quick count.”
Will’s boss, Steve Merano, points out the board that lists the banks, all of them huge, famous banks, that are looking to borrow money.
Voice: “How many? Forty five.”
Reporter: “Forty-five banks have called you and said ‘We need money.'”
Voice: “Right. And how many do you see on the right?”
Voice: “So forty-five banks need money. Zero banks have money.”
That right there, on a whiteboard in an office four stories above Greenwich Avenue, that is the financial crisis. Forty-five banks can’t borrow money. That means forty-five banks can’t lend as much money to you or your boss or your corner store. That is how this crisis moves from Wall Street to your street.
Voice: “It’s hard to sit in the de facto temple of capitalism begging for a socialist solution to the problem.”
Aston Reese says these guys here, these traders, they are the last ones to want government help. But they need more. Nothing so far has worked. This interbank lending froze three weeks ago. The government guaranteed money markets to help out; that did nothing. Then the bailout finally passed; that did nothing. Then on Tuesday the Federal Reserve offered to directly buy short term loans; no help at all. Will and Steve can’t remember their last trade, it was at least three weeks ago. [….]
The second, Liquidity Crisis Hampers Financial Rebound, does a good job of describing current circumstances and also of explaining liquidity, but I think it makes a mistake in characterizing the current crisis as due to a lack of liquidity. Sources I trust, most notably Mike Shedlock, claim that the problem is not lack of liquidity but one of insolvency, i.e. firms are unable to transact business because most of them are in fact bankrupt, regardless of what their balance sheets claim. Here’s the second piece, with some comments.
One crucial element in understanding and fixing the financial crisis is liquidity. That waterfall of cash that has buoyed the global economy in recent years has gone dry. Getting capital flowing again is proving to be an enormous, and so far unsuccessful, challenge.
Liquidity basically refers to movement. Imagine a faucet: When it’s opened, water flows out to where it’s needed. The seizing up of the credit markets has basically dropped the water pressure for the whole economy. A lot of companies are opening their faucets — and nothing’s coming out.
Economy’s Pump Houses Tapped Out
“Money is like the tap water in the economy, and normally you have two different pump houses that supply it,” said Pete Kyle, an economist at the University of Maryland.
Traditional lending by banks is one pump house, Kyle said; the other is what’s called the “commercial paper market.” Companies use that to go straight to investors and borrow money outside the banking system.
“Today, you’re seeing that that commercial paper market, that extra supply of liquidity, is just not available.”
Comment: Shedlock would say that this is not due to a lack of money in the system, but because the lenders do not want to lend what money they have to insolvent borrowers.
With that pump house down, banks are in a tough spot. And that is not good for the economy: “I’m predicting a pretty severe recession,” Kyle said.
Case Study: Marriott Hotels
As an example of how it all fits together, take the Marriott hotel company. It’s a good, solid business. Marriott Chief Financial Officer Arne Sorenson explains that in a normal month, the firm would borrow about $900 million through that commercial paper market.
“You could think about that as being, you know, $30 to $45 million a day that would come due. And we’d go into the markets and we would, in effect, renew that — we’d roll it over,” Sorenson said.
Comment: you have to ask yourself why they don’t simply avoid the cost of borrowing by slowing down a bit, saving up that money, then running on a cash basis.
Marriott uses that money to pay employees, contractors who are building new hotels and so on. Then, three weeks ago, Lehman Brothers failed. That spooked investors in money market funds, which have several trillion dollars to invest. They usually buy a ton of commercial paper — in effect, lending money to big companies like Marriott. But money market funds stopped doing that.
“During that week, the commercial paper markets seized up,” Sorenson said. And losing that source of liquidity has taken a toll on Marriott’s business.
“In at least two hotels under construction and getting near opening in 2009, construction has stopped,” Sorenson said.
Plans for other hotels have been scrapped in recent months because of the situation in the credit markets, he said — including a 2,000-room hotel in San Diego that now will not be built.
Comment: this strikes me as disingenuous. Hotels are notoriously overbuilt. It’s awfully convenient to blame this change in plans on a frozen credit market.
“There probably are already tens of thousands of those jobs that would have been created that probably have been lost,” he said.
It’s not a life-threatening problem for Marriott. The firm had a backup line of credit with a bank, so it can keep making payroll — and it’s in good shape, Sorenson said. The biggest corporations usually have more options.
Banks ‘Hoarding Water’
But back to the tap-water analogy: Companies like Marriott suddenly need billions of dollars in extra liquidity from regular banks. Many of those banks are already short of cash because of losses in the housing bust, so they’re a lot less willing to lend money to everybody else.
“The banks are hoarding water because they are afraid people are going to come and demand water from them,” economist Pete Kyle said. “So they keep as much in supply as they can.”
Comment: this is probably true. But it is also true that commercial construction projects are now very high risk, with builders going bust with increasing frequency.
And in an environment like this, “The people that need the money the most will get it the least,” said Bob Froehlich, vice chairman of the mutual fund arm of Deutsche Bank.
He says liquidity is so scarce right now that things could get much worse very quickly. He thinks many small- and medium-size companies could start falling apart and laying off a lot of people.
“Companies that are solid companies do not have the cash flow to be able to meet payroll — that’s the magnitude of the crisis we’re facing,” Froehlich said. “There has never ever ever been anything like this in the 33 years I’ve been in the business.”
Fed Sends In Tanker Trucks
That’s why Treasury Secretary Henry Paulson looks like he hasn’t slept in weeks. The government is scrambling to fix this liquidity crisis before the fallout gets worse.
It has been lending to banks and is now lending directly to all kinds of companies to meet that demand for liquidity.
“The Fed is saying, ‘We’re gonna be the firemen here and we’re gonna put our hoses into the system and start pumping water out of our trucks, or out of our reserve system,’ ” said Kyle, who has been watching all this closely.
Comment: the most telling evidence that this is not a liquidity crisis is that the Fed and the Treasury have already pumped trillions of dollars into the system since the credit markets froze, and none of it has helped. This makes no sense if the problem is liquidity. This makes perfect sense if the problem is insolvency, i.e. lenders no longer have confidence that borrowers are financially sound enough to repay a loan.
He says the Great Depression happened in part because the government didn’t respond quickly enough to a credit and liquidity crisis. But he just can’t see that happening again. He thinks the credit markets will soon get back under control. He thinks we’re headed for a tough recession, with unemployment rising above 8 percent, but nothing really cataclysmic.