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Credit as an option
I think of credit as not just a current period flow but also as an option; this is implicit in many of Fischer Black's pieces, including "Banking and Interest Rates in a World Without Money." If you lose the option to borrow that is a credit crunch too. As for the current financial crisis, my view of the data is that many borrowers have been drawing on their pre-existing lines of credit like crazy, for fear that their chances to borrow may be drying up. Banks have felt liquidity squeezed, in part because of pending CDS settlements, in part because so many borrowers are exercising their borrowing options, and in part because of potential insolvency. That liquidity scramble is why we have been seeing such a huge TED spread and near-zero nominal rates on T-Bills. Even now it remains unclear whether these options will be replenished and of course if they are not that means trouble.
The collapse of "borrowing as an option" shows up in market prices and it also shows up in many anecdotes, as chronicled at calculatedrisk.blogspot.com. It does not necessarily show up in current period credit flow data and in fact it may show up counterintuitively as a spike in borrowing.
I am puzzled by Alex's admission that there is a recession; no matter which way you assign the causality, doesn't that mean credit should be contracting? Working within the confines of his own view, shouldn't Alex be worried that credit flows remain so high?
I believe if we had an explicit series measuring the borrowing option. and its recent collapse, it would show the credit crisis very clearly. In the meantime that crisis does show up in other pieces of information.
Addendum: Here is comment from Mark Thoma and also Felix Salmon.
Posted by Tyler Cowen on October 24, 2008 at 07:53 AM in Economics | Permalink
Comments
Tyler,
I think you are touching on the fact that we commonly define the money supply in ways which are not directly relevant to the future (or next period) availability of means of settling transactions. The definition relevant to whether we really have a credit crunch (and to what we expect the level of prices to be in the next period) is the sum of the values all available classes of assets used in settlement of transactions with each class weighted by the likely number of occasions on which the average asset in that class will be used in settlement of transactions in the period in question. The contraction of the borrowing option is a radical fall in the sum of the value of that class of assets, a contraction likely to far outweigh the increase in the average use of the remiander of that class.
Posted by: David Heigham at Oct 24, 2008 8:12:47 AM
Alex seems to think that credit has increased because bank credit increased in September and early October. He hasn't noticed that the expansion in credit was unusually rapid and was mainly concentrated in real estate loans (including home equity) and "other" securities. Does Alex really think that real estate markets improved? Does he know what those other securities are? This is completely aside from what was happening to the rest of credit, as indeed banks are not the biggest lenders.
Posted by: Frank Howland at Oct 24, 2008 8:43:17 AM
“As for the current financial crisis, my view of the data is that many borrowers have been drawing on their pre-existing lines of credit like crazy, for fear that their chances to borrow may be drying up. “
So, your view of the data is that an increase in the amount of loans and credit available is a sign of a freezing of credit and an unwillingness for banks to lend. This is a very convenient position to take. A reduction of loans and credit is a sign of a credit crunch and an increase in loans and credit is also a sign of a credit crunch. This is like the game of flipping a coin where if you flip heads you win and if you flip tails I lose.
“Even now it remains unclear whether these options will be replenished and of course if they are not that means trouble.”
I see…so, we are not in trouble yet, but because in the future we might possibly have a reduction in loans and credit, that definitely means we are in a credit crunch now.
“It does not necessarily show up in current period credit flow data and in fact it may show up counterintuitively as a spike in borrowing.”
A spike in borrowing also means a spike in lending from the banks. But a credit crunch is where banks are unwilling to lend. Now, with new Orwellian double speak, a credit crunch is when banks are willing to lend to everyone and his brother. Some credit crunch.
“I am puzzled by Alex'a admission that there is a recession; no matter which way you assign the causality, doesn't that mean credit should be contracting?”
Causality does matter. If borrowers choose not to borrow this is not a credit crunch. A reduction in demand for loans due to a recession would not be considered a credit crunch. The credit crunch would have to originate on the supply side. Banks would have to be unwilling to lend to borrowers for there to be a credit crunch. A reduction in loans and credit is a necessary but not sufficient condition for there to be a credit crunch.
Posted by: tom at Oct 24, 2008 9:17:41 AM
Tom nails it.
Posted by: Alex Tabarrok at Oct 24, 2008 10:19:15 AM
...so does Caplan.
Posted by: josh at Oct 24, 2008 11:14:16 AM
I agree with Tyler, existing credit lines are like an option to buy a good at a certain price. The price of that good (money) has risen significantly so everyone is using their option now and the amount of money lent has increased. Now the problem is that banks are no longer issuing new lines of credit and a stampede of people exercising their current options will only exacerbate the problem in the future.
Posted by: DRB at Oct 24, 2008 11:24:13 AM
I agree with Tyler, existing credit lines are like an option to buy a good at a certain price. The price of that good (money) has risen significantly so everyone is using their option now and the amount of money lent has increased. Now the problem is that banks are no longer issuing new lines of credit and a stampede of people exercising their current options will only exacerbate the problem in the future.
Posted by: DRB at Oct 24, 2008 11:26:31 AM
There is plenty of micro-evidence for tight credit. Some of Tom's point are simply not recognizing what a "line of credit" means. The others imply simply that the shock to the real economy will arrive with some lag. Surely that is true but I also would say the jolt now has arrived.
Posted by: Tyler Cowen at Oct 24, 2008 11:38:00 AM
Will you relax, Tyler? Geez. Stop fanning the flames of panic, this economy has essentially no fundamental problem whatsoever. As Alex has demonstrated, credit is rolling and the good times are soon to follow. Just like the Eagles now you got to "take it eaaaasay! Take it ea-eeeeee-a-heee-zay! DON'T LET THE SOUND OF YOUR OWN WHEELS-a-make you CRAY-A_ZAYYYYYYYYYYY-YAAAAH!"
Posted by: steve at Oct 24, 2008 12:36:43 PM
"A spike in borrowing also means a spike in lending from the banks."
Not necessarily.
Posted by: meter at Oct 24, 2008 12:41:04 PM
look at this another way: people know that if they pay off certain loans -- HELOC, credit card, whatever -- the bank is going to reduce their available credit. so, once they run up the debt, people aren't paying off things they normally would. looks like more borrowing, potential sign of health, actually a sign of sickness (because of burden on banks, you also have people paying big interest where they wouldn't normally)? that is, the loans presage hoarding of cash by the loanees, outflow of money from banks, etc.?
Posted by: dj superflat at Oct 24, 2008 12:59:49 PM
look at this another way: people know that if they pay off certain loans -- HELOC, credit card, whatever -- the bank is going to reduce their available credit. so, once they run up the debt, people aren't paying off things they normally would. looks like more borrowing, potential sign of health, actually a sign of sickness (because of burden on banks, you also have people paying big interest where they wouldn't normally)? that is, the loans presage hoarding of cash by the loanees, outflow of money from banks, etc.?
Posted by: dj superflat at Oct 24, 2008 1:01:12 PM
One of the things to keep in mind about all this is that bank loans are generally a lagging, not a leading indicator. As a matter of fact, real banks loans are one of the components of the lagging index.
Second, there has been a major trend in recent years for bank lending to decline in importance as firms became able to directly tap credit markets.
These two factors should be considered in evaluating what the recent bank lending data implies. It is obvious that firms are drawing on existing credit lines because their other sources of credit has been cut off or they are afraid it will be . Without making some estimate of how big an item this is it is just plain impossible to really tell what the recent growth in bank credit implies.
Early next month when we get the flow of funds data we should be able to resolve some of these unknowns.
Finally, the fact that Goldman and other have suddenly become banks may be distortion the data. Why isn't anyone that collects the data being asked about this. Could it be that too many people of all political persuasions are afraid to find out the true facts?
Posted by: spencer at Oct 24, 2008 1:25:32 PM
One of the things to keep in mind about all this is that bank loans are generally a lagging, not a leading indicator. As a matter of fact, real banks loans are one of the components of the lagging index.
Second, there has been a major trend in recent years for bank lending to decline in importance as firms became able to directly tap credit markets.
These two factors should be considered in evaluating what the recent bank lending data implies. It is obvious that firms are drawing on existing credit lines because their other sources of credit has been cut off or they are afraid it will be . Without making some estimate of how big an item this is it is just plain impossible to really tell what the recent growth in bank credit implies.
Early next month when we get the flow of funds data we should be able to resolve some of these unknowns.
Finally, the fact that Goldman and other have suddenly become banks may be distortion the data. Why isn't anyone that collects the data being asked about this. Could it be that too many people of all political persuasions are afraid to find out the true facts?
Posted by: spencer at Oct 24, 2008 1:26:36 PM
GREAT PIECE!
HELOC is a decent example of a borrowing option, but I don't know where you find these in aggregate fed statistics.
Posted by: Alex at Oct 24, 2008 3:53:14 PM
The Federal Reserve data on interbank lending, the actual federal funds rate (not the target), and bank lending to businesses, consumers, and for real estate _debunks_ claims that credit is "frozen" or that banks will not lend to one another. Or that
banks aren't making any loans.
No one has used this data to claim that nothing has happened in credit markets. Or that there is "no problem."
It is rather that people who pretend to know what they are talking about should stop saying that credit is frozen and that banks refuse to lend to one aother. Or claim that banks are not lending to anyone.
They should come up with new ways to describe the problem that are consistent with increases in bank lending, below target actual federal funds rates, etc.
They might say that credit is more expensive for relatively poor credit risks. Or that some _some_ firms (and _some_ banks) cannot borrow at all, or only at extemely high interest rates. (The interest rates I pay are tied to prime, and I am paying less. During the hight of the crises, I borrowed $1000 more by making an entry in my computer.)
With a more careful look at the data (say, looking at the decreases in the volumes of nonfiancial commercial paper, loans by finance companies, etc, and comparing that to the expansion in bank lending, we might see that total credit is less. Maybe.
But that wouldn't be that banks aren't lending. In fact, it would be that banks are lending more. They just aren't increasing their lending enough to make up for decreases in other sources of credit finance.
The notion that relatively poor credit risks had been able to bypass commercial banks and pay interest rates only a little higher
than the T-bill rate, but that now, they must go to banks and pay higher rates, isn't necessarily a problem.
If the result is less borrowing and expenditure by relatively poor credit risks, this isn't a problem if this is offset by an increase in borrowing and expenditure by good credit risks. This may require a decrease in interest rates overall.
But the notion that the resources going into relatively risky ventures must be maintained assumes that it was optimal before.
For example, it is apparent that there were people investing in money market mutuals funds who thought they were more or less riskless (break the dollar? never.) And the money market mutual funds were investing in AB commercial paper. Well, there is a risk. So, maybe the people who had invested in money market mutual funds would prefer to accept a lower interest rate and instead keep money in money market accounts at banks. They don't like the risk of indirectly holding AB commercial paper. They would rather have the protection of the commercial banks capital.
And, then, those firms that had been selling AB commerical paper to mutura funds at remarkably low interest rates, have to go to banks and pay more.
Some banks, the largest and most famous ones, are paying really high interest rates for temporary funding. That doesn't mean that no bank will lend to another bank. It is just no one, banks included, consider the big name money center banks hearly as safe as the U.S. government. Given these high rates, the firms that had been borrowing from these banks can't. Or only at very high interest rates.
Well, then they need to find new banks. The ones with funds to lend. Can the thousands of banks who have funds to lend (pehaps funds they are no longer lending to the money center banks) expand fast enough?
Again, they are lending more. But maybe the increase is insufficient.
Personally, it is hard to see the talk of "credit is frozen" "banks won't lend to one another," as being much more than special pleading by and for the large money center banks.
But, then, stick to the truth. The large money center banks are in financial difficulty. There are banks that currently aren't having problems and are lending more. But they cannot expand lending fast enough to offest the shrinkage of our troubled large banks. So, we must bail out these large banks..
Important borrowers who deal with the money center banks cannot switch banks. The banks that are lending are too small..
Borrowing a little here and a little there is impossible.
Or, important borrowers can't borrow from the smaller banks. That is because they are high credit risks. Only the large money center banks had been willing to overlook their problems. The large money center banks are more confident that Ford will not go bankrupt or that California will not default due to conflict amongst its politicians.
But to repeat again and again that the top 20 money center banks in the world are paying way more than the U.S. government.. well, so what?
If they continued to be the best credit risk and everyone else was paying even more, then the TED might be a proxy for a credit crunch. But as it is, it is just saying that the government is paying less, and the large money center banks are paying a lot more.
Posted by: Bill Woolsey at Oct 25, 2008 11:04:55 AM
