With banks in miser mode, credit markets tightening

Stocks are rebounding and a new bailout package could be coming soon, but the credit markets – where day-to-day borrowing occurs to keep the gears of the economy turning – are still stuck.

Even relatively healthy businesses are out in the cold.

Randall Stephenson, the CEO of AT&T, said Tuesday that when the telecommunications company tried to get short-term cash last week by selling corporate debt known as commercial paper, no one was willing to lend anything for longer than overnight.

The crunch is being felt by others, too. Many small businesses can't get funding for supplies and in some cases are falling behind on their payrolls, said John Castellani, president of Business Roundtable, an association of CEOs of companies that employ more than 10 million people.

Castellani said the credit problems have been going on for several months but have accelerated in recent weeks as lending tightens further and consumer spending wanes.

“It feeds into itself,” Castellani said. “It just continues to spiral down.”

The key bank-to-bank lending rate, the London Interbank Offered Rate, or LIBOR, rose to 4.05 percent Tuesday from 3.88 percent for 3-month dollar loans, and to 6.88 percent from 2.57 percent for overnight dollar loans – the highest level since the British Bankers Association began tracking that rate in 2001.

That's especially worrisome because normally, overnight LIBOR is just slightly above the Federal Reserve's target fed funds rates, another overnight interbank lending rate.

Now, it is more than 4 percentage points above the target rate of 2 percent. That has troubling implications for other lending rates tied to LIBOR, including homeowners' adjustable rate mortgages.

For Americans already worried about their nest eggs, mortgages, and fuel, food and medical costs, the prospect of an even deeper economic downturn is troubling – especially since it's so hard to understand how we got here.

In simple terms, banks made bets on the housing market when it was booming, and didn't cash out in time. When people started defaulting on their mortgages last year, banks' investments went bust. As banks' losses started piling up, they pulled back on lending and started stockpiling cash.

Already cash-strapped banks got stingier this week, after the House rejected the Bush administration's $700 billion bank rescue package.

Renewed hopes for a revised plan to buy banks' souring mortgage-backed assets gave the stock market a big lift Tuesday, but the future remains uncertain for the credit markets.

“There's too much fear in the market,” said Kim Rupert, managing director of global fixed income analysis at Action Economics. “Everybody is hoarding their cash.”

This is a problem because companies – even big, hearty ones – borrow money to operate and grow, especially when the economy is weak.

In recent decades, large companies have borrowed money by selling short-term and long-term bonds in the credit markets. This means they take a loan from an outside investor, and promise to pay it back with interest after a certain amount of time. The investor agrees to the deal because they trust the company will pay them back.

That trust, however, has been slammed by the downfall of big names like Lehman Brothers Holdings and American International Group.

Most companies right now cannot sell commercial paper for longer than overnight or a couple days, said Steve Traum, a former portfolio manager, as opposed to more typical period of one to two months.

A main factor behind the reluctance is that money market funds, the biggest buyers of commercial paper, are extremely cautious. “They don't know where the next problem is going to arise,” Traum said.

As a result, most money market funds are pouring their money into Treasury bills, considered the safest short-term investment around.

Companies in search of cash can go directly to their bank. But most major banks have their own problems with capital, so a company has about as much luck as a person trying to get a mortgage: Those with clean credit histories will likely get loans, but at high rates, and those with spottier credit histories might not get loans at all.

“In a good-case scenario, the economy is slow,” said Axel Merk, portfolio manager at Merk Funds. “In a bad-case scenario, there are massive bankruptcies.”