Was the Credit Freeze Real?

Now that the financial rescue package has passed, it's time to answer the obvious question. Was the credit freeze real? In a word, yes.

Unfortunately, like the financial rescue package, it is not a simple thing to explain.

Probably the most accessible way to understand it is to compare it to a mortgage. Without the ability to borrow money for a home, most people could not afford to own one. With the median cost of a US home just over $210 thousand, most of us would be renters if mortgage loans weren't available. To some extent, the same thing is true for business.

Publicly owned companies raise money through the stock market. They publish information about their business, and investors buy a portion of that business through purchase of stock in its initial public offering. After investment bankers take their fees, the company uses that money for a variety of purposes, including expansion, research and development, facilities and equipment. In addition, such companies often borrow money for a period of time through the credit markets. The total of its outstanding stock and borrowings is called the company's capitalization.

Long term borrowing is facilitated through the sale of bonds, and shorter term cash needs, through more expensive commercial loans, or very short term commercial paper. These borrowing mechanisms allow companies to weather short term cash requirements caused by seasonality, economic slow-downs and a myriad of other reasons.

Most businesses have some degree of debt. The reason for that is, again, easiest to explain by comparing it to a mortgage. Let's say you buy a $350 thousand home with 20% ($70 thousand) down. Seven years later, you sell the home for $430 thousand. After paying off your mortgage (now $255 thousand), you will receive about $175 thousand.

• Original price - $350,000 - $70,000 = $280,000
• 7 years reduction in loan balance = $ 25,000
• Loan balance after seven years = $255,000
• Sales price = $430,000
• Less loan balance = $255,000
• Gross profit = $175,000
• Original investment = $ 70,000
• Return on investment 14%

If you had not borrowed any money, and bought your house for $350 thousand in cash and sold it seven years later for $430 thousand, you would have made $80 thousand on an investment of $350 thousand, or 3% annual return.

This borrowing, or "leverage" as it is referred to in business, increased the return on the sale of this home by 11% per year over seven years. Businesses use borrowing, or leverage, for the same reason - to increase the return on investment for their shareholders.

Conservative business analysts usually recommend no more than a 30% debt ratio (total debt as a percentage of debt plus stock) for a business.

Again, this 30% debt ratio is similar to that recommended for comparing housing costs to gross income when considering lending money to a person for a home loan. That allows for a sufficient "cushion" for most people to continue making their loan payments without difficulty. Some leverage is good. Too much debt, though, is bad. That is true for both businesses and people.

Borrowing is an important part of the economy. For people, and businesses that need shorter term loans, it's made possible by commercial banks by taking in deposits and loaning out a percentage of those deposits to borrowers. Their assets are loans.

Over the last few years, in addition to loans, many banks held securities on their books that contained hundreds of mortgage loans that were sliced up into pieces and sold. As everyone who hasn't been under a rock for the last year knows, many of these loans were made to people who couldn't afford them. Most are good, but some are not. So, until we know just how many are bad, these securities that are made up of these loans are hard to sell. What are they worth? How many of the loans they contain are bad?

Nobody knows. So, banks had assets on their books to which they couldn't assign a price. And, when your assets are loans, and you are in the business of making loans, selling those loans, getting money from that sale to make more loans . . . well, you get the picture. So, to shore up their balance sheets, banks hung on to their cash. Need a loan? No lenders. Everybody's holding on to their money, so the FDIC won't force a "marriage" of their bank that has assets that can't be priced, with a bigger bank (at a fire sale price).

Businesses, like car dealers, furniture sellers, clothiers, etc., who rely on banks for financing their inventories were about to face the prospect of being unable to borrow because no lenders were lending. And, their customers couldn't get credit for their purchases either.

We saw automobile manufacturers close their leasing operations. Credit had already begun to dry up. There was a crisis of confidence.

The entire financial system is based upon belief. Money is a symbol. It's not worth anything if the belief is suspended. It can be as small as bankers reducing the available amount on your credit card if they don't believe you'll pay them back, to as large as banks not lending money to each other because they don't know how many sub-prime loans are in their mortgage backed securities. If we all stop believing, the economy grinds to a halt. Jobs are cut. Those of us whose jobs aren't cut stop spending because we believe our jobs may be cut.

We've talked about how the Treasury is buying $700 billion of mortgage backed securities that are on the books of our banks to get the economy rolling again. http://www.bizcovering.com/Investing/700-Billion-Bailout-What-It-Means.280179

That money is the shot in the arm that banks need to get lending again. Like it is when we come to a full stop on the freeway, we won't be at full speed immediately. But this will get us moving again, slowly at first; then back to full speed.

There was a liquidity crisis. But, to put this into perspective, the US economy continues to be the most resilient in the world, and though this problem is severe, we will weather this as we have many other financial crises.

A bet against the US economy has always been, and continues to be unwise. This, too, shall pass.