Wall Street's problems are quickly becoming Main Street's

McClatchy NewspapersSeptember 30, 2008 

WASHINGTON — Many Americans are nervously watching the wild swings on the New York Stock Exchange for signs of a Wall Street collapse, but it's the opaque credit markets that matter most right now to consumers and businesses alike.

These markets can be mind-numbing in their complexity, but they are vital to corporate America's ability to fund its daily cash flow, and to Main Street itself. And they're the reason why President Bush proposed the controversial $700 billion rescue plan.

Here are some answers to questions about the credit markets.

Q: What's the credit market?

A: It's not one but several interconnected markets. Some of these markets involve banks lending to each other at overnight rates, while others involve issuance of a variety of debt instruments such as bonds that carry a short lifespan.

Q: Why do banks need to provide each other overnight credit?

A: The Federal Reserve requires banks to keep a certain amount of cash in reserve on the premises or in one of the Fed's district banks. The amount is actually a ratio to the level of deposits the banks have. The required ratio of reserves-to-deposits goes up and down, so banks lend to each other to cover this ever-shifting target.

The Federal Reserve establishes a target for the rate that banks charge in overnight lending — called the Fed funds rate. This target is set through the Fed's rate-setting Federal Open Market Committee, which normally meets eight times a year. But the actual overnight lending rate is set by the banks themselves.

The Fed's target interest rate for overnight lending has been at 2 percent since April, but the market-set rate actually shot up to 7 percent Tuesday morning before tapering off to 3 percent. That's still a full point above the Fed's target, and it means that banks are hoarding cash and only willing to part with it for a high price. The result: They borrow less, and thus lend less.

Q: How does this translate to problems on Main Street?

A: Commercial banks take a cue from the Fed funds rate when they set the prime rate, which is the interest they charge on loans to customers with the best credit. The prime rate is usually 3 percentage points higher than the Fed funds rate, but banks do set this rate based on conditions on the ground. Changes in the Fed funds rate affect short-term interest rates, foreign exchange rates and indirectly the price of goods and services and even employment.

So overnight rates are a vivid, immediate expression of the confidence or lack thereof in credit markets. When nervous banks charge each other higher overnight rates, it ripples across all kinds of lending in the economy.

Q: How is this credit crunch affecting corporate America?

A: Corporations don't have piles of cash sitting in bank accounts to pay their bills. They issue IOU-like short-term notes, sometimes called commercial paper, that often mature in 30 days. In some cases, the collateral on these notes is a company's inventory or other assets, so these bonds are also called asset-backed commercial paper.

When these largely unregulated short-term notes mature, investors can cash in or roll them over for another 30 days. If there is the perception of more risk, the yield — or the interest paid to investors — rises.

When there's confidence in the markets, the yields are low, which means that borrowing costs for corporations are low. When fear is rampant, as it is now, investors are reluctant to hold these bonds, fearing a default. They demand a higher interest rate, or yield. As the yield rises, it becomes more costly to borrow to fund day-to-day operations.

Q: So what? These Wall Street fat cats deserve what's coming to them.

A: Maybe so, but remember that although the investors who buy these short-term debt instruments may be on Wall Street, the companies issuing this debt are corporations that employ millions of people in the U.S. and around the world. When their costs of borrowing go up substantially, they have to cut costs elsewhere, and that often translates into layoffs. That's how Wall Street problems quickly become Main Street problems.

Q: Any other examples?

A: Automobile dealerships. Carmakers don't just give them cars. Dealerships borrow money to purchase the cars that they will then sell to customers. When the cost of borrowing goes up for dealerships, they're forced to raise the price of the vehicles they sell at a time when there are already few buyers and when loan terms have tightened sharply for consumers.

"America's financial liquidity crisis, which was created by mortgage lending, is constraining the availability of auto credit, which is the lifeblood of both dealerships at the wholesale level and car buyers at the retail level," Annette Sykora, chairman of the National Automobile Dealers Association, said in a statement.

The credit crunch also hits developers and civil-engineering firms that build shopping malls, office buildings and public works projects. When funding for their projects dries up, construction workers are laid off.

Q: How are local communities hit by the credit crunch?

A: Many local governments rely on issuing debt, often in the form of municipal bonds, to fund road projects or other development in their region. They too are being squeezed as the cost of credit goes up. Local quality of life will suffer.

"I think it's going to limit (bond issuance) because it is going to be expensive to borrow. It's going to be tough on small communities," said Michael Long, the treasurer for Klamath County in Oregon, on California's northern border.

Not only is the cost of borrowing rising, but after a period of lax lending, investors are more closely examining the finances of issuers of municipal bonds.

"They're going to look closer to make sure they are going to get their money back," said Long, a past president of the National Association of County Collectors, Treasurers and Finance Officers.

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