Light Dawns on This Marblehead - Lenders, Fear, and Liquidity

The title of this post refers to an old Massachusetts put down of someone who suddenly grasps an idea - light dawns over Marblehead, which is a city on the north short of the state. And that's how I felt this morning, when looking at the latest problems with credit prices going higher.

I find that many financial stories, particularly those about the credit crunch, either assume that one understands the dynamics in advance, or assumes that the dynamics don't exist - that is, "And while I wave my hands, the credit markets seize up like an internal combustion engine running without oil." My flash of understanding was on the simple dynamic of what is happening at banks. The underlying driver is fear, as we keep hearing in the stories. But that fear does two things. One, is that the lenders are now afraid that because they've been making bad decisions for so long, any more reasonably drawn decision will be just as risky. So they price risk higher. For example, I received the following in an email from the Financial Times this morning:

Rising credit spreads meant AAA-rated General Electric paid a higher rate on a recent five year bond issue that it did for a comparable bond last May, according to Bloomberg calculations.

Alright, so it's the FT quoting Bloomberg. But consider the substance: GE is having to pay more for credit. It's not that the conglomerate is a worse credit risk. It's that the lenders have frayed nerves, and figure that since stupid decisions went wrong, then all decisions will go wrong.

Compounding that outlet of fear is another. Lenders have been caught having to restate financials to take into account unexpected losses. So they are taking cash and not only paying off the debts that came about from their ill-considered investments in the credit derivative markets, where essentially they create bonds and pay interest based on what they expect to get from payments on underlying assets like mortgages, but they are putting cash in reserves for future screw-ups. That means they lend a lot less of the money they have than they used to, and supply and demand then drives up the cost of interest.