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Thoughts on the credit crisis and the bailout

2008-09-24

I was recently writing a reply on a different blog that crystallized my thoughts on the investment banking crisis.

Financial companies like investment banks don’t just hold investments. Every day, there are millions — literally millions — of business-to-business and business-to-consumer transactions brokered by investment banks.

What kind of transactions? Well, short term loans like commercial paper. When a business needs money (for example, to pay for a shipment of raw materials or to make payroll), they may technically have ample cash spread among various accounts and business units, but getting all that cash consolidated could take days or weeks. So they get a short-term loan from an investment bank, usually made up of cash supplied by other companies and banks in chunks of $500000, $1 million, $5 million, whatever. These are commercial paper loans.

When a factory in Germany puts cars on a ship bound for the US, they don’t wait for the ships to arrive before getting paid. They can’t wait weeks for the ship to get there. So they sell the cars to an investment bank, who uses the free cash of other companies and banks to buy the shipment, and then the bank sells them to German Company of North America, skimming a very little bit off the top. That’s called a banker’s acceptance.

When a business plans to buy a piece of equipment from Japan, they’ll buy a forward contract on Yen, paying some number of USD now for the privilege of some number of Yen in the future, to hedge against the risk of fluctuating currency markets. Who writes these contracts, issues the letter of credit to the Japanese manufacturer guaranteeing payment and delivers the Yen on time? Investment banks!

Those are three examples. There are hundreds, perhaps thousands, of financial instruments and contracts like this, all aimed at different industries and different in the details, which bind up cash for a few days or weeks or months at a time. For the week ending Sept. 17, there were $1.68 trillion (TRILLION!) in commercial paper loans (short term B2B loans, the first type listed above) extant. And that’s the lowest it’s been in 26 years. And that’s just one kind of credit instrument.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aw990wjDl_1c&refer=home

That is the crisis that sent Bernanke and Paulson to the negotiating table. The credit crisis has spread to extremely short-term money market transactions, and if those transactions are slowed or stopped, businesses in the US are in big trouble.

Where does the cash come from for these transactions? Some comes from direct investment by corporations, but a lot of it comes from you and me, in the form of our money market savings accounts. This is how banks get the 2% or 3% that they pay on your savings.

You can see why the Feds are so scared. If several large investment banks fail and all the employees are sent home, what happens to all of these transactions? Who pays the computer guys to get the data? Who contacts the principals to tell them, “Sorry, we’re not going to pay the Yen to your Japanese supplier next month. Here’s you’re money back.”

Who is going to explain to a few hundred workers that the paper mill is idled for a few weeks because the company can’t get a commercial loan to pay for timber?

Who is going to tell Ma and Pa Kettle that they can’t withdraw their money from their savings account because it was invested in highly liquid short-term loan contracts, and the folks that administrate those contracts are currently on the street looking for jobs and nobody knows how to get the data back because the IT guys were laid off, and the FTC sent in some guys to try and get the info off backup tapes but it could take months so the money is in limbo? No new tractor for you, Mr. Kettle. I guess there won’t be a harvest next season.

I’m not saying that Paulson and Bernanke are doing the right thing. But as finance people, they are doing the only thing they know how. The fact that it rewards risk-takers and punishes responsible businesspeople is unfortunate indeed.

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