How the credit crisis hits home

It’s been difficult for people to figure out how the big liquidity crisis in the financial markets affects them.  That, along with justifiable outrage for the underpriced risks that the large investment banks took during the credit boom over the past four years, has led many to loudly protest the huge Wall Street and bank bailout which will be taken up again by the US Congress this evening.

I thought it would be helpful to briefly walk through how and why this credit crisis affects everyone in this country. 

At its simplest, the whole financial system in the United States depends on banks lending each other money, so that they can provide credit to consumers and small businesses to buy cars and equipment, homes and office space, or to stock up on holiday merchandise or even to meet payroll.  When that credit dries up, the whole economic system from consumers to producers starts to contract, which means jobs get cut, home prices continue to shrink, and companies cut back on investment.  That’s what’s happening today – let’s talk about why that is in a few simple steps:

1. In normal times, when there is “liquidity” in the credit markets, major investors (banks, pension funds, sovereign wealth funds, etc.) routinely transfer money between each other and to corporations so that they have the money they need when they need it.
2. Banks in particular lend to each other at very low rates (this is the source of the LIBOR interest rate a lot of consumer and corporate debt is tied to – the London interbank offer rate).  However, this isn’t happening currently, for 2 reasons:  banks have a lot of capital tied up in bad mortgage-based assets, so they need to hang onto their cash, and they are worried about other banks not paying failing and not paying the money back.  So the overnight rates on this type of interbank lending are at all time highs, and even then the banks are reluctant to provide the money.  This is why the Federal Reserve and other government central banks are pushing huge amounts of cash into the system.
3. Since banks still don’t have much money to lend, and they want to avoid more bad loans in an uncertain market, money isn’t made available to homebuyers or businesses.  As I mentioned, businesses frequently use short-term borrowing to support production costs or even payroll.
4. These pressures quickly ripple throughout the economy, which can affect you in the form of:  stock losses (your 401k), job losses, more declines in home prices, tougher credit terms to buy or lease a car, higher credit card rates, etc.

Fixing this credit crisis, however it’s done, is essential to avoiding a much more severe downturn.  It won’t cause an economic boom, but at least it will help get the financial system back off the ground.