Friday, September 14, 2007

Waiting for the Fed, and Hoping

Published: September 14, 2007

That there is a financial crisis is clear. What is not so clear is whether the medicine in Dr. Ben Bernanke’s bag can do much good.

Next week, the Federal Reserve is expected to make the first cut of the Bernanke era in the federal funds rate. The Wall Street debate is over whether that cut will be just a quarter percentage point, or whether the Fed will show its determination to act by cutting the rate by twice that amount.

That the debate has gotten this far is evidence that the economy now seems much weaker than it did when Mr. Bernanke was testifying to Congress in July, just as the credit squeeze was getting under way. Then, he seemed to think there was no need for any cut at all, despite the crumbling housing market and the growing subprime problems.

A new poll of corporate chief financial officers, taken by Duke University and CFO Magazine, shows a surge in pessimism. Nearly a third of the financial bosses say their companies have been hurt by the credit market turmoil. And few see much benefit from Fed action. Nearly half think a cut of half a percentage point would not help their companies at all, and most of the rest see only a small benefit from such a move.

For many companies, the immediate credit issue is not price, but availability. Can they borrow enough money to get by?

The next part of the crisis may come from a company that is unable to borrow enough money to pay off maturing commercial paper. The Fed can help there, with gentle urging to banks not to be overly tight in their lending standards, and there is reason to hope that the immediate problem will pass with banks taking on a lot more loans.

But even if it does pass, there is the question of where companies will borrow in the future, whether to finance expansions or acquisitions, or just to raise capital if and when their business turns down. The credit markets were wide open just three months ago. Now they are all but shut to companies with speculative-grade ratings.

In the second quarter, the total volume of new junk bonds and leveraged loans averaged $88 billion a month. In August, the figure was $6.6 billion. That is a 93 percent decline.

“For the first time in years the loan market is all but gridlocked,” Standard & Poor’s said this week in its leveraged company commentary. “Demand has withered, forcing arrangers to put the massive calendar of underwritten deals on ice.”

That has happened, it may be noted, with virtually no defaults on corporate loans. But the majority of such loans were financed through securitizations, in which the risk was sliced and diced in ways that enabled most of the money to be put up by investors who bought securities rated AAA, the highest possible rating.

Sometimes those ratings were a bit off. Three weeks ago, one such security still had AAA ratings. But since then Moody’s has cut it twice, and it is now in the nether regions of junk, rated Caa2, with Moody’s warning it could go lower. It’s sort of like going from class valedictorian to remedial reading failure.

That fall is unusual, but instructive. The security in question, called a variable leveraged super senior certificate, was sure to be safe unless the market value of a bunch of AA-rated securities collapsed. Those securities are still rated AA, Moody’s tells me, but their market values have plunged.

“Liquidity in asset-backed markets has dried up,” Merwyn King, the governor of the Bank of England, told Parliament this week, and banks will have to return to their historic roles as financial intermediaries. “That process,” he added, “is likely to be temporary, but it may not be smooth.”

Eventually, perhaps, a safer and more cautious securitization market will develop. In the meantime, banks, and perhaps some institutional investors, will be called upon to finance corporate loans directly. Until some part of that happens, the credit squeeze is on.

Lowering the fed funds rate — the rate at which banks lend to one another — will not hurt. It will make it cheaper for high-quality borrowers to raise money, and some of that will filter down. But it will not address the issues that have caused credit to tighten.

Nor will it get us closer to learning just where prices will settle — whether for homes or companies — in an era when risky loans are no longer easy to come by. This week’s stock market euphoria at the prospect of Fed easing is likely to be temporary.


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