Credit Woes Heighten Risk of Recession

Big banks are trying to prevent a sell-off of assets in what may be a last chance to save the economy from going into reverse.

By Matthew Mogul, Associate Editor, The Kiplinger Letter

October 24, 2007

The likelihood of a sharp credit slowdown -- one that could bring on a recession -- is rising. Investors are growing concerned that borrowers will soon have a hard time repaying $400 billion in asset-backed commercial paper -- short-term debt tied to auto loans, credit card balances and home mortgages. A good portion of that will come due in the next few months.

Creditors holding commercial paper often roll over or extend their loans when the debt comes due, but the fear is that many of them will insist on cashing out this time around. Investors know that the rash of mortgage foreclosures nationwide has made it next to impossible to value the mortgage securities backing commercial paper, some of which may be worthless.

That raises the specter of a downward spiral: If creditors cash out en masse, borrowers issuing commercial paper will be forced to sell assets to pay their debts, prompting a fire sale for all kinds of debt securities. The massive losses that banks and their affiliates would be forced to write down under this scenario would shrink available capital everywhere and probably push the economy into recession.

Main Street businesses haven't been hurt yet. They still have access to capital, but there's no telling how long that will last. Record profits at banks for the past several years have so far given lenders a cushion to weather the credit crunch that gripped the markets in August. Commercial and industrial lending by banks recently recorded its fastest growth rate in more than three decades. Part of the rise stems from companies turning to banks instead of the debt markets to borrow because credit is getting more expensive to tap in the capital markets. Still, that won't last long if the predicted panic selling happens. So what's being done?

Emergency measures in the works are sketchy and risky. A privately financed bank credit rescue fund is being formed by Bank of America, Citigroup and JPMorgan Chase. The $75 billion-$100 billion fund will act as a buyer of last resort for highly rated mortgage assets (no subprime-backed paper) and thus snuff out any sign of a sell-off. The hope is that the mere creation of a big-bank-led backstop will give investors such a psychological boost of confidence that creditors will roll over their commercial paper debt as they've done in the past. The private sector solution is necessary in part because there's little sign that Congress is willing to step in with anything resembling a bailout.

So far, the bailout fund has received a lukewarm reception. Besides the three founders, Wachovia is the only big bank that has committed to back the fund. And news of the fund has done little to inspire investors, with many viewing it as a sign of weakness and an indication that the mortgage mess is worse than expected. Some cynics also see the fund as an elaborate scheme in which big banks are simply creating an off-the-books vehicle to absorb losses without having to tarnish their own balance sheets.

What happens if the fund fails? The shock waves will stretch from Wall Street to Main Street. "In that sort of worst case scenario we'd see a significant amount of tightening in the whole lending system, and that would hamstring banks of all sizes," says Gerard Cassidy, a bank analyst at RBC Capital Markets. And as a result, businesses would see their credit lines dry up and become much more expensive.

The Federal Reserve has made it clear that it will do what it must to keep credit flowing, meaning it's prepared to cut short-term interest rates further. Still, the central bank is limited. Deep rate cuts, for one, will weaken the dollar and push up inflation. And higher inflation will drive up long-term interest rates, slowing growth even more in an economy already hovering on the edge of recession.

For weekly updates on topics to improve your business decisionmaking, click here.