The right eloquence needs no bell to call the people together and no constable to keep them. ~ Emerson

Friday, June 12, 2009

Giving Credit

A Serendipitous Turn of Events May Be the First Real Signal of Recovery

If you blinked anytime during the past several weeks, you may have missed the fact that the U.S. credit crisis is apparently over. Such is the case according to Jon Markman at MSN Money, who reports credit markets are “now on the path toward a real recovery.” If this catches you by surprise, you are not alone – as little as a month ago Markman was scoffing at the idea of the credit crisis ending as “not likely.”

However, Markman is not alone either. About seven weeks ago, Paul Monica, the Editor-at-Large for CNN Money cautiously noted, “The worst of the credit crunch may finally be behind us . . . The bond market is acting as if it's not as worried about a recession anymore.”

Nor is such optimism limited to here at home. Last week in Great Britain, the Independent fairly gushed with enthusiasm. “It is time to declare it – the credit crisis is over. The U.S. banking system, epicenter of the chaos, is returning to health; the outlook for the global economy, once seemingly completely black, is brightened by a dawn light.” It eventually calmed down sufficiently to amend, “The credit crunch cannot be declared finally over but this is perhaps the beginning of the end of it.”

This is a genuinely important sign. From the start, President Obama, Treasury Secretary Tim Geithner, and Federal Reserve Chairman Ben Bernanke made it clear that re-igniting frozen credit flows was critical to any recovery effort. The government poured billions of dollars of TARP funds into banks and other financial institutions, a program was unveiled to help repurchase toxic assets, and federal regulators conducted “stress tests” on the nation's nineteen largest banks to make certain they had sufficient capital to endure the worst economic times.

And, according to Markman, none of it made any difference. Instead, credit analysts are saying the turnaround came when U.S. automakers Chrysler and GM declared bankruptcy.

Chrysler’s debt holders initially assumed they would lose all legal claims at the expense of government favoritism toward the United Auto Workers. Despite loud complaints from several small investment houses, nearly ninety percent of Chrysler’s bondholders quickly accepted a deal to cancel $6.9 billion in secured loans in exchange for $2 billion in cash.

Likewise, when GM entered bankruptcy, the government wanted to give the UAW thirty-nine percent equity in the company and bondholders only ten percent. In the final deal, the union got only seventeen percent of the company, secured lenders received payment in full, and other bondholders accepted ten percent with warrants for fifteen percent more.

These deals represented what credit markets considered fair and convinced lenders for the first time that they would not be sacrificial lambs in any federal recovery efforts. This pleasant surprise triggered a loosening of frozen credit that quickly accelerated into what one credit analyst called “euphoric buying.” Others say they have never before seen a credit rally of such size and momentum.

This is good, albeit serendipitous, news for the Obama Administration, which has had nothing to trumpet about a perceived slowdown to the recession that was not both questionable and tertiary – fewer jobless claims than expected really does not cut it. Credit, on the other hand, is the engine driving our economy. Just as a downturn in credit markets proceeded widespread economic recession, so an upturn in credit is a real and significant leading indicator for the possibility of recovery.

However, the outlook is far from consistently rosy. The pessimists insist a second, far worse credit crunch is coming and its origin is overseas.

The U.S. Treasury plans to sell about $2 trillion in new debt this year to fund a $1.8 trillion fiscal deficit. Foreign investors, owners of a significant portion of the Treasury market, are steadily demanding higher yields and are likely to punish the U.S. for borrowing too much by refusing to buy debt until bond prices plunge to much cheaper levels. One of the harbingers of such a scenario is surging government bond yields, which optimists are citing as one of the signs of recovery.

The pessimists also point to the extraordinary amount of dollars pumped into the money supply by the Federal Reserve as inevitably leading to inflation as unemployment remains high. Reagan-era economist Arthur Laffer, writing in the Wall Street Journal, predicts, “We can expect rapidly rising prices and much, much higher interest rates over the next four or five years” that conceivably “could make the 1970s look benign.”

For now, the nod must go to the pessimists as the realists. Then again, both optimists and pessimists had trouble grasping the scope of the market downturn until walls were virtually crumbling around them. In the same way, perhaps we are all now too dour to believe in any upturn until it is already well in progress. We need to follow bondholder’s lead in giving credit.

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