The Credit Market Freeze — How It Works And How It Affects You
October 7, 2008 by Miranda Marquit
Filed under Finance
At first, when I heard that the government is considering to buy so-called “commercial paper,” my reaction was rage. But I’ve calmed down and thought things through a little bit. This might be a needed action on the part of the Fed.
But first, a brief tutorial:
Commercial paper is basically an unsecured loan that businesses make to each other. It’s like when you get out the credit card toward the end of the month to smooth things out as they get a little tighter. Basically, a company says, “I need $500 million to make payroll this week, but income has been a bit down. I don’t have $500 million in ready cash.” Then the company goes to another company, that has a surplus, and says, “I’ll give you this I.O.U. for $600 million if you front me $500 million to get me through the week.”
This isn’t happening anymore. The liquidity isn’t there. Banks aren’t lending to each other, and the $700 billion bailout hasn’t done anything to thaw the credit market freeze. That is why the Fed is stepping in. Supposedly, Fed actions aren’t going to really use our taxpayer dollars, because the Fed can do things to create its own “money.” It will either buy the unsecured debt outright, or issue emergency short term loans. In either case, liquidity theoretically will be increased, easing the credit market situation. It will probably result in inflation as well. (For an interesting argument on the necessity of inflation to get our economy on track, read this post on Stock Trading to Go.)
What does a credit freeze mean for you?
More dangerous than a stock market crash, a credit freeze has direct consequences for the reast of us “regular” folks. Most of us see it in terms of personal credit:
- Car loans.
- Private student loans.
- Mortgage loans.
- Credit cards.
- HELOCs are being frozen.
- Interest rates go up in some cases, especially on mortgage loans.
In some cases, this might be a good thing. It means that we have to re-evaluate our priorities and figure out what we want to spend our money on.
There are indirect effects as well, though.
Many universities, hospitals, large government contruction projects (like roads and other infrastructure) and other organizations rely on bond funding. In the last two weeks, interest rates on this sort of bet have skyrocketed — from below 3% to above 7%. This means that some projects will have to be cancelled, because they have become too expensive. For hospitals, non-profits and other institutions, it means staff cuts and service cuts. That means that the jobless rate is likely to continue to rise. And if you make use of some public service…
The effects on small businesses, the true engines of our economy, are also going to be great. If the big guys can’t get loans, small businesses don’t have a prayer. This credit freeze means further job losses from small businesses, as well as probably cuts to benefits. All of this coming on the heels of decreased revenue, since people can’t spend.
It is a sad fact, but a fact nonetheless: Our entire economy runs on credit. And if we don’t have the liquidity to keep it going, things could get really ugly.
What do you think of the economy?
I have heard stories of students and parents that are getting calls from the universities they are attending.. They are saying that their student loans have bounced and that to start the school year they need to come up with cash to make up the difference.
Yikes! Yes, this credit market freeze is wiggling its way in everywhere. Credit that has been extended is being pulled on many fronts.
Thanks for the plug, appreciate the support!
With the credit freeze, there are ways right now the federal government can open up credit. Sometimes i think the whole government has no clue whats going on. Its sad kids will be denied an education due to the credit freeze.
You make a good point, Brian. Sometimes I wonder if the government knows what it’s doing as well. It feels like they keep focusing on a “trickle down” solution, when maybe they should start with helping the middle class and move from there.
I work at a private professional school, and I’ve heard of similar stories of student loan money “drying up.” That means fewer students in school, which means they will start looking for jobs and increase the ranks of the unemployed. We think we are more sophisticated than in the 1920s and 1930s. We’re just more complex, but no smarter.
An interesting insight, Jean. I guess the more things change, the more things stay the same.
Perhaps the government should take over all lending?? Sounds a bit commie but it might be the only way to get us out of this crisis in the short term.
An interesting thought, Uncommomadvice. After all, we’ve already moved rather far down the socialist path…
With the 700 point plunge in the market, I think the credit freeze is going to be remembered as the straw that broke the camel’s back. What remains to be seen now is whether the younger Bush will emulate his senior and freeze trading on the market to give a ‘cooling off’ period to the economy; or just let it slide into the abyss. I guess the old Chinese curse is true: may you live in interesting times indeed!
Thank you for your insight, Edward. They’ve already manipulated the markets so much, that there’s no reason not to. At any rate, Bush Jr. has done little in terms of following Bush Sr.’s (often) wiser courses of action. I’m not sure that this is any different.
Today I’m hearing cheers about the 1,000 point rally. I think people are still missing the point. All this indicates is the market is volatile place right now. Suppose we have a six or seven hundred drop tomorrow? Which is not only possible; but likely considering that no one in this market seems to understand what the “Fair Market” price stocks is. Only that millionaires can be made from trading on the right day. Even if we get full liquidity on the part of the banks; we still don’t know how much bad paper is out there. Plus the morgage crisis is still not going away. How many Americans are going to be spending on Christmas like they used to? The fragility of this economy (particulary when we have SO MUCH debt) is still very much in question.
I agree completely. It’s nice that Dow had such a nice day, but who knows how it will be tomorrow. You cannot tell. And debt is still a big problem, especially since none of our leaders feel that addressing debt is a priority.