Sunday, January 4, 2009

Tearing the Cartilage of Trust

When I first saw blood flowing in the streets of the credit markets during late September, I knew the financial system had taken a turn for the worse. My immediate fear was the sharp collapse of corporate bond prices would prevent companies from borrowing and force a broad contraction in business activity. For more, see the charts in this posting.

And right I was. To me, the broad shutdown of the market for corporate bonds and asset-backed securities remains the biggest problem facing the economy now. The reason is that this is where companies and consumers get their money. Companies always have different kinds of debt to refinance, whether it consists of debt coming due, or bank debt (working capital) that needs to be "termed out." (When companies build a factory or buy inventory they plan to convert into products, they usually borrow the money in the short term using bank lines. They then often sell longer-term bonds to pay off these bank loans.)
If companies cannot sell new bonds, they are forced to rely more on short-term debt, which is dangerous. Most of the time they respond by reducing costs, which means they order less inventory and shed jobs. (Sound familiar??) As this collapse of confidence spreads through the business community, companies grow less willing to extend credit to each other. Under normal circumstances, they might wait say 90 days for payment. They record this IOU as an "Account Recievable," and consider it an asset more or less akin to cash.

When things are contracting, like now, companies demand payment sooner and are less willing to trust each other in general. This results in a decline of Accounts Recievables, which is shown in the chart above.

I called it "Trust Broken" because it illustrates what's really going on in the economy. The word credit, after all, derives from the Latin word for "believe" ... You believe you're going to get paid back. I have described this as the cartilage that holds the body of the economy together. Companies and customers are like bones and muscle.. they do the work. But without credit, they can't work together.
While it might sound like an abstract concept, like everything else, it has a price. When a single market exists to provide that price, it will inevitably set the levels for everyone else.
Accounts Recievables contract during all recessions, but what is interesting about this one is the sheer speed. It had been growing at 1-2.4% of GDP over the previous six quarters, but suddenly dropped to -1.8% of GDP. That represents a swing of 4.26 percentage points of GDP, the sharpest contraction since at least 1952, when the Fed data begins.
The other noteworthy thing is that corporate bond issuance plunged and bank lending increased. This shows how companies, unable to sell bonds or issue short-term commercial paper, increasingly rely on backstop bank loans.
We're likely to see an outright contraction in corporate bond sales in the fourth quarter, which would be another first in the data. The really key issue is whether it will rebound going forward. If it doesn't, the economy and stock prices will be in serious trouble.
In the last few months, yields have fallen as the authorities muscle borrowing costs lower. This is clearly good news for some savvy investors who bought the bonds at the most panicked moments in October. But it won't help the broader economy until we see a follow-through of real bond issuance. Until we see big numbers on the volume front, it won't help to restore credit to the economy.
I am skeptical of Bernanke & Co. because they have managed to force borrowing costs lower, but there is less and less lending going on. Everyone is hopeful the new Administration will stimulate the economy... My biggest fear is that the high expectations will undermine business confidence because it gives decision makers a reason to wait before doing anything. I personally think that creating high expectations and then being unable to deliver is much more damaging that not creating any expectations at all. Let's hope it doesn't wind up what former Supreme Court Justice John Marshall would call a "splendid bauble..."
This January's pipeline of new corporate bond offerings will be extremely important to watch. Will people bid for new deals, or will they demand huge concessions, pushing yields back to record high levels? Those are the key things to watch in coming weeks, and will be a good barometer on the health of the credit market.

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