Encouraging signs in a credit crunch

The economy's vital flow of short-term credit hasn't returned to normal, but a transition from fear to hope may be under way among professional investors.

This month a usually boring financial instrument, called commercial paper, has entered a crisis of confidence. A sizable amount of commercial paper represents borrowing by mortgage companies, and some of these debts were suddenly devalued by troubles in the housing industry. Now investors are scrambling to assess whether all mortgage-linked debts are toxic and whether other risks lurk unseen.

That crisis has had a chilling effect on an economy that is already cooling. If corporations have trouble borrowing through the issuance of commercial paper, the ripple effects can encompass everything from the ability of consumers to buy houses or cars to the ability of manufacturers to make big sales.

A key question for the economy is, how soon will short-term credit markets recover a semblance of normalcy?

Economists don't see clear evidence of that happening already, despite the Federal Reserve's effort to calm fears by expanding the flow of credit to banks. But some do see at least some tentative signs that a sense of panic may be on the wane.

"There are clear signs that it's easing. It doesn't mean it's over," says David Wyss, chief economist at Standard & Poor's, the New York credit-rating agency. "What's going on now is a good old-fashioned run on the bank. But in today's world, the bank is the short-term capital market."

Short-term credit provides important lubrication for economic activity. Jeff Werling, a University of Maryland economist, says it's like the circulatory system of the human body, bringing supplies to wherever they're needed.

A manufacturer, for example, will borrow to get materials or to extend credit to a customer. Automotive finance corporations issue commercial paper so that they can make car loans to consumers.

The biggest risk, Mr. Werling says: If the current problems with credit availability persist so long, they could deepen the current housing slump, adding to downward pressure on home prices and stock values. That could affect consumer spending.

He's hopeful it won't come to that. "In a month or so, we'll be past it," he predicts, as long as investors aren't surprised by another major bout of bad news.

Among the encouraging signs as trading drew to a close last week:

•"We've gotten through the end of the week without any serious blowups," says Lou Crandall, an economist at Wrightson ICAP, a firm that tracks short-term money markets. In this case, no news is big news.

•In a bid to ease the crunch, the Fed has lowered the discount rate it charges to banks for short-term credit. And last week it said it would accept asset-backed commercial paper – which has been at the center of the recent storm – as collateral for such loans.

•On Friday afternoon, the yield on three-month Treasury bills jumped to 4.22 percent, up from 3.7 percent earlier in the day, according to the Associated Press. Treasury yields had plunged earlier this month as debt investors fled toward ultrasafe paper issued by the government. The edge back toward normal terrain suggests a calmer attitude about market risks.

•"There was a community of investors that was extremely worried," says Carl Tannenbaum, chief economist at LaSalle Bank in Chicago. The rebound in Treasury yields "may be an initial sign that their comfort is being restored."

While all this provides a measure of hope, it's hardly an all-clear signal. "There is still a lack of normal function" in the short-term credit market, Mr. Tannenbaum says.

The challenge was starkly apparent in the Federal Reserve's most recent weekly report on commercial paper, released Aug. 24.

The amount of commercial paper outstanding fell by $90 billion, or about 4 percent, following a similar drop the previous week. Commercial paper includes debts coming due in as much as 270 days, but with 30 days the typical maturity.

In normal times, this weekly report by the Fed isn't a must-read by economists, let alone the general public. But the shift in the past two weeks represents an unusual and sudden freeze-up of activity.

"What's going on now is just pure fear" among investors, says Mr. Wyss.

Companies often need to roll over their short-term borrowing with new commercial paper from month to month, and now many can't do it.

The problem is most acute for financial companies and for firms that borrow using other receivables – such as mortgage loans they've made – as collateral. That segment of the market is called asset-backed commercial paper.

Companies that can't roll over their short-term debt in some cases are finding other means to finance themselves. Lincoln National, an insurance company, sold $300 million in five-year debt so that it could pay off commercial paper that's coming due soon, according to a report in The Philadelphia Inquirer.

The challenge affects some industrial companies as well. "It's going to have some impact" on manufacturing firms, says Brian Bethune, an economist at Global Insight, a forecasting firm in Lexington, Mass.

Some producers of heavy machinery, for example, may find it harder to extend financing to customers. That in turn could mean a modest slowdown in orders.

"If you're not a bank … then you have to fund yourself pretty much through the capital markets," relying on investors willing to extend credit by buying paper, Mr. Bethune explains.

So a key indicator to watch in the weeks ahead will be the Fed's weekly reports – whether the amount of commercial paper outstanding continues to fall at the same rate. "That would be an indication that there still is a severe credit crunch continuing," Bethune says, and that the Fed's move so far "is not getting the job done."