Why did the market fall 777 points yesterday?
A quote from today’s Business Week captures the prevailing logic:
“Credit is the lubricant for the U.S. economic engine. If loans don't get made, businesses don't expand, orders don't get placed, workers don't get hired. A garden-variety economic slowdown can turn into a deep recession.”
OK, I get that. When the cost of capital goes up, growth becomes more expensive. And if the real cost of capital has shifted upward, valuations will shift downward, and who knows where that all ends? But did the world change so much just because Congress failed to make a one-time injection of $700B into the credit markets (some of which it will inject anyway through other means) that the long-term cost of capital changed? Or are we really worried about something else?
The same article stated: “If companies can't get funding in the commercial paper market, they won't be able to take care of basics, such as meeting their payrolls.” I’ve been hearing statements like this a lot the last few days. The experts seem to be saying that unless the short-term credit markets “unfreeze,” consumers and businesses alike will not be able to meet their day-to-day obligations. I don’t know about you, but I don’t rely on credit to meet my day-to-day obligations. And I’m not aware of many healthy businesses that do either. Sure, longer-term capital projects may be postponed in the current financing environment, but payroll? Are we really worried about consumers and businesses (other than over-leveraged financial institutions) facing bankruptcy because they can’t borrow more money? Were we all playing this kind of financial kiting scheme as part of some mass illusion of prosperity?
Yes, we are facing tough economic times. Yes, we will see real economic growth slow as we digest the excesses of the past few years. Yes, we will need to adjust to a world where spending bears a more prudent relationship to income and home prices are set by the demand of those who can actually afford them. Yes, these adjustments will mean corporate revenues, and thus earnings, will fall. Yes, as growth and earnings fall, so will jobs. But we knew all that before Congress voted yesterday.
So why did the market fall 777 points yesterday? Because we were hoping we would be allowed to ignore a bit longer what we all already knew. As a society, we have been living beyond our means. Being the sensible people we are, Americans told Congress yesterday it was time to stop. Even the stock market seems to understand that now. It’s time to go back to work and build real value. Nothing has changed in our fundamental ability to do that. S&P 500 is up 4% and climbing.
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1. Posted by fedgovernor on September 30, 2008 @ 13:11 | Permalink
"If loans don't get made ..."
You know, when I read this I popped on over to the London Interbank to see if they were loaning money today, and lo and behold ... guess what I found?
They were loaning money!
Any bank can borrow money from any other bank for 300 basis points.
That's certainly not the historically low rate banks usually extend to each other, but then again, historically, banks weren't allowed to own securities now were they!
Since banks are now allowed to own securities, they are, inherently, riskier borrowers and nobody knows that better than another bank.
But to suggest that loans aren't being made is asinine. Of course loans are being made.
2. Posted by fedgovernor on September 30, 2008 @ 13:14 | Permalink
"As a society, we have been living beyond our means."
It's actually worse than that David. As a society, we've been forcing banks to lend money to people who have proven they are incapable of playing by the rules and paying it back.
That's what the Community Reinvestment Act does. It forced, under threat of sanction, community banks to lend money to people who are not going to pay it back.
So, it's not just that as a society we're nebulously living beyond our means.
Our government has written into the law that we are required to do so.
3. Posted by Elizabeth Brown on September 30, 2008 @ 13:28 | Permalink
The market is going back up because everyone is betting that Congress will come back on Thursday and pass some sort of bailout plan. Either the Democrats will go it alone and put in all the provisions that they left out to appease the Republicans or enough Republicans will be chastised given the reaction to their "no" vote that they will vote "yes" on the next version. If Congress again fails to pass any bailout bill, the market will plunge back down.
As for your questions about how businesses and consumers operate, many consumers routinely charge almost all of their daily expenses (groceries, gas, etc.). A majority of them do not pay it off at the end of every month. The credit crunch will mean that they will pay higher interest rates on their outstanding balances, have higher minimum payments, and may find their credit limits reduced in the future. As a result, they will have less ability to buy things in future. As for businesses, many businesses, particularly seasonal businesses, certainly use short term borrowing to cover expenses like payroll. Seasonal businesses are ones that make the vast majority of their revenues in a single quarter or period.
4. Posted by Elizabeth Brown on September 30, 2008 @ 13:33 | Permalink
Fedgovernor, The Community Reinvestment Act did NOT cause this crisis. It has been around for 30 years. This crisis is a result of lax regulation and new, unregulated hybrid financial products that have existed only for the past decade. The American Prospect has an article that debunks the idea that this crisis is the result of the CRA. See http://www.prospect.org/cs/articles?article=did_liberals_cause_the_subprime_crisis
5. Posted by Lori Ringhand on September 30, 2008 @ 14:11 | Permalink
I have assumed that the "making payroll" point is referring to businesses that have a great deal of variance in their short-term cash flow (construction or seasonal business may be examples), not to businesses that are surviving only because of continuous deficit spending. But that is just an assumption - I would appreciate a better informed answer from those who know these types of things.
6. Posted by Randy on September 30, 2008 @ 14:12 | Permalink
Certainly many businesses do operate that way. I was recently the interim GC at a manufacturing company with record levels of EBITDA, but with expensive raw materials, a 30 day collection period on A/R, a small cap ex program and occasional large payments for things like taxes, you need a loan facility to manage cash flow (as a result of a spin-off they no longer had a large cash cushion built up). Not focusing on cash flow on a daily basis frees management to think about growth and operating the business instead of watching the bank accounts like analysts watching the Dow.
7. Posted by dave hoffman on September 30, 2008 @ 15:19 | Permalink
With respect, this is boosterism. I agree with Randy & Elizabeth: access to credit is necessary for the economy to run. Look at LIBOR's reaction not the equity markets. Banks can't survive at that rate, and neither can any large company (for very long).
8. Posted by fedgovernor on September 30, 2008 @ 15:36 | Permalink
"Banks can't survive at that rate, and neither can any large company (for very long)."
Banks most certainly can survive at that rate. They merely will adjust their pricing to reflect their new cost basis. (Companies will do the same.)
This will lead to higher inflation. The Fed will fight that inflation by raising interest rates. This will in turn increase foreclosures as people are priced out of their adjustable rate mortgages (mine, for example, is based on LIBOR). Banks will respond to this new threat to their bottom lines by seeking more government handouts. Not finding any, they will increase the rate of interest they charge for the risk they take lending to other banks.
9. Posted by Karl Okamoto on September 30, 2008 @ 15:42 | Permalink
I don't disagree (and don't I believe said anything different). Yes, long-term credit contraction will cause pain. I'm less clear why we need to panic over short-term illiquidity. Where is the real Main Street impact that is cataclysmic?
10. Posted by Greg Schliesmann on September 30, 2008 @ 18:40 | Permalink
I'm a mortgage broker in Milwaukee, and it's obvious there is still liquidity in this market. Yes, lending requirements are more strict, but isn't that what the government wanted? If there wasn't enough money in the market, how would rates be so low? See Current Milwaukee mortgage rates online