There was been a lot of drama over the last week, which we have certainly contributed to, about the stress tests. It was all very exciting, finally seeing numbers purporting to show how healthy or unhealthy each bank was. But let’s recall what the point of this whole exercise was.

Depending on your perspective, the goal is either to restore confidence in the health of the financial system, or to ensure the health of the financial system, which are obviously closely related. We care about the health of the financial system because the financial system is critical for the health of the economy as a whole: without banks that are willing to lend money for people to buy houses, cars, and consumer goods, or for businesses to invest in real estate, factories, inventory, software, etc., none of these things will happen. So the ultimate goal is to ensure the availability of credit.

There are ways to measure the availability of credit directly. One of them is the Fed’s quarterly survey on bank lending practices, which was released earlier this week (hat tip Calculated Risk, as usual). For a quick overview, I recommend the charts. The charts show you, for each quarter, the change in supply of or demand for credit in that quarter – in other words, they are you showing you the first derivative. 

The quick summary is that lending practices tightened for every category of loans for the seventh straight quarter (in some categories, tightening has been going on even longer). In most categories, the rate of tightening – the difference between the number of banks who say they have tightened credit and the number who have loosened it – is lower than the peak in the October survey. But this just tells us that the second derivative is positive, which was to be expected, since the October peak was the highest ever recorded in every category, when virtually every bank was tightening credit. The first derivative is still negative, which means it is still getting harder to get a loan across all major categories. 

Note that the latest survey was taken in April, which is after the banks’ spectacular first quarter results. So despite the major banks’ insistence that they are healthy and they can earn their way out of their troubles – which appears to be the government’s strategy as well – it is still getting harder to get a loan. Now, it may actually be true that the banks can earn their way out, if you look at the second figure, which shows that virtually all banks have been increasing their spreads on commercial and industrial loans every quarter for the past year. As money gets cheaper, competition dies off, and lending standards get tighter, profits go up. 

At some point, increasing bank profitability – if it can be sustained – should translate into increased competition, lower spreads, and increased availability of credit. But we are a long way from that point. 

The other thing the charts show is that demand for credit has been negative for several quarters in every category, with the exception of prime residential mortgages, which turned positive in the April survey – almost certainly due to refinancing at historically low rates.  So even though we saw increased consumer spending in Q1, it was with lower borrowing. This reflects the expected shift in consumer behavior away from debt and toward saving.

By James Kwak

A few weeks ago, three economists at the Federal Reserve Bank of Minneapolis set off a debate among Internet-addicted economists by claiming that, in essence, lending to the real economy was just fine and anyone who said there was a credit crisis was wrong. (See my initial reaction, as well as links to the original paper and several perspectives.) Now we have been treated by four economists at the Federal Reserve Bank of Boston, who argue that there was, in fact, a credit crisis. In particular, they say:

• “the aggregate figures in [the original paper] do not reveal the weakening in new lending”
• lumping together AA and A2/P2 commercial paper hides the problems for A2/P2 issuers
• lumping together all durations hides the fact that commercial paper shifted from longer durations to shorter durations
• even though most corporate lending is via bonds, not direct bank lending, households and small businesses rely heavily on banks

and similar points. Take a look; some of the charts are fascinating.

Every week, it seems, we see a new high-water mark for government intervention in the financial sector, culminating (?) in today’s announcement that the government is buying $125 billion of preferred stock in nine banks, with another $125 billion available for others. The recapitalization, loan guarantees, and expanded deposit insurance are the most aggressive steps taken yet in the U.S. and were all on on our list of recommendations.

I think it is highly likely that today’s actions will boost confidence in the banking sector. First, the banks involved have fresh capital; second, they can raise new debt more easily thanks to the loan guarantees; and third, because the U.S. government is now a major shareholder, it is even less likely that the government will let one of them fail. I could be wrong, but I think worries about bank defaults, at least for participating banks, will start to recede.

The next question, however, is what the impact will be on lending to the real economy, and here the outlook is less certain. In a press conference today, Paulson said, “The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it.” However, it’s not clear that he has the tools to compel the banks to increase lending. The terms of the investment are relatively favorable to the banks – 5% dividend, no conversion to common, no voting rights (unless the dividends are not paid for several consecutive quarters). So the self-interested thing for banks to do may be to take the cash and pay down higher-yielding debt on their books. Hopefully as the financial system returns to normal banks will go back to doing what they usually do, which is lend money.

All that said, I think we’re still in better shape than two days ago.

Some people have asked me how you can tell if the bailout, or anything else the government is trying, is working, since the stock market is largely noise. I’m no expert here, so I’ll point you to a couple of other measures of the credit market that people have recommended. One is the TED spread (3-month LIBOR minus 3-month T-bills; explanation here), a measure of banks’ willingness to lend to each other as opposed to buying Treasury bills, which came down today (which is good). The blog Calculated Risk also recommends a few metrics you can look at.

One week ago, the House rejected the bailout bill and the Dow fell more than 700 points. That fall was a major reason why public opinion shifted from heavily against the bailout to confused, and why the bill passed on Friday. On Friday, though, the Dow fell another 150 points, and today at 1 pm Eastern it’s down another 500 or so.

Before panicking, though, we have to consider what this means. Broadly speaking, we are faced with two related crises, each of which is approximately represented by a different market. The first is a global economic slowdown that people have been talking about for months. The second is the acute credit crunch that hit after Lehman went bankrupt on September 15.

Fears of a global economic slowdown are reflected in the stock market. Stocks are claims on the future cash flow of companies, and companies do better during economic growth periods than during recessions. When sentiment shifts from the belief that we will see a short, mild recession to the belief that we will see a long, harsh recession, the stock market goes down. By contrast, the acute credit crunch is reflected in the credit market in the record-high prices that banks are charging to lend to each other and to ordinary companies.

Although you and I and most people with investments have more money in the stock market than in the credit market, the stock market is more a gauge of sentiment than an independent force in the economy. Lower stock prices make it more expensive for companies to raise equity capital, but most companies raise more money by issuing debt than by issuing stock. And when people’s investments go down, they tend to spend less, but only a little; if their 401(k) goes down by $10,000, they don’t cut back on spending by $10,000. The credit markets, by contrast, have direct and immediate effects on how companies behave; in an extreme case, no credit can mean no cash with which to make payroll. (See the posts tagged “real economy” for a couple examples of this.)

Now the credit and stock markets are related, because when the credit market freezes up, people’s expectations about the future turn downward, and hence stock prices fall. Ironically, all the attention the credit crisis has gotten over the last three weeks has undoubtedly hurt stock prices because of all the talk about potential dire consequences. (As Simon advised me, if you write a post entitled “your money is not going to go poof,” as I did, 20% of your readers won’t see the “not.”)

So in this context, what does the fall in the stock market mean? Probably two things. First, people are only beginning to realize that Europe is in big trouble – given its difficulty in coming up with coordinated economic policy, perhaps bigger trouble than the U.S. Because U.S. companies operate in a global economy, that will hurt all companies. Second, it means that more people are realizing that the Paulson plan is only a partial solution, which is something we (along with many other people) have been saying for a while.

As long as the credit market remains tight, fears of recession will remain high, and stock prices will suffer. The important question is when the credit market will loosen up. Right now it looks like there are still enough open issues with the Paulson plan (what price, which securities, how fast) that lenders are still waiting and seeing. In the long term, though, the stock market will only turn up when people believe there is a credible plan for fighting the recession in the real economy.