The Credit Crunch Spreads to Business

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Downward Spiral

Until now the business sector has kept the economy aloft even as consumers have cut back. But if the credit crunch shuts down borrowing, businesses will begin to ax jobs, cease investment, and default on their debts in larger numbers. If rising defaults cause banks to tighten credit even more, there will be a downward spiral. William Verhelle, founder and CEO of First American Equipment Finance, says his lease-financing business has been insulated from the credit crunch until recently, partly because his bank funding partners have remained solid. But he fears his sector won't be spared. "I feel much more nervous now than I have at any point in this process," he says.

Businesses rely on a healthy banking system, but at the moment it's on life support from the Fed. Banks are stashing their money in U.S. Treasury bills instead of extending credit to one another or to stretched customers. "It's like strangling the corporation," says Anthony Clemente, CEO of Canaras Capital Management, which buys pieces of syndicated loans and bundles them into collateralized debt obligations. "If you do it for only a few seconds and you let go, they are dizzy, but they recover. If you do it for a minute or any prolonged period of time, they are going to pass out and die." Banks that do manage to borrow in the interbank market can rarely secure loans for longer than overnight. Says one central banker: "If all you can do is borrow every night, then every day the firm faces a life-or-death situation."

The clearest sign of bank cash hoarding occurred on Sept. 30 when the overnight London Interbank Offered Rate—the interest rate on interbank loans in dollars—soared to 6.88%, far above the 2% federal funds rate it normally tracks. LIBOR is a benchmark rate for everything from home mortgages to corporate bonds. Says Lena Komileva, Group G7 economist at money broker Tullett Prebon: "These markets were dysfunctional for the past year, but in recent weeks they have become virtually nonexistent." The Sept. 30 spike in LIBOR occurred just one day after the Federal Reserve announced an unprecedented injection of an additional $630 billion into the global financial system, which ordinarily would have driven dollar-borrowing rates to near zero.

The latest vicious circle: Banks are being squeezed for cash because nonfinancial companies, worried they'll be cut off from other sources, are suddenly drawing on their lines of credit. Gannett (GCI), Goodyear Tire & Rubber (GT), General Motors (GM), and ServiceMaster are among the companies that withdrew billions of dollars from banks in late September and early October. Even Duke Energy (DUK), a huge, financially stable utility, chose to draw down $1 billion from $3.2 billion in credit lines. The looming question is whether banks will be able to meet all of their commitments to provide credit. If companies grab their cash preemptively, "the prevailing mayhem could lead to a funding blitzkrieg…upon bank lenders," wrote research service CreditSights.

Skeptics point to the increase in lending to Duke Energy and others as evidence that there is no credit crisis. Alan Reynolds of the libertarian Cato Institute calls talk of a credit freeze "hysterical chatter," noting that all types of lending have risen over the past year. But much of the increased lending is involuntary. Banks are being forced to take assets back onto their balance sheets and keep loans they once would have shed. "That's actually the crux of the problem," says Lou Crandall, chief economist of Wrightson ICAP, a Jersey City (N.J.) research firm.

Building a Firewall

Under these conditions, the government bailout plan seems like weak medicine. The Senate bill takes a further step toward protecting the banking system by raising the limit on FDIC-insured deposits to $250,000 from $100,000. But that may not go far enough. Some economists say the U.S. should build a firewall against panic by at least temporarily emulating Ireland, which on Sept. 30 said it would insure all debts of its six biggest financial institutions. James Galbraith, an economist at the University of Texas Lyndon B. Johnson School of Public Affairs, is among those who favor that approach.

That's not the only possible solution to the crisis. But it's clear something has to be done—soon—to keep a dysfunctional banking system from wrecking the global economy.

Coy is is the economics editor for BusinessWeek. With David Henry and Mara Der Hovanesian in New York, Carol Matlack in Paris, and Nanette Byrnes in Chapel Hill, N.C.