Understanding the impact of credit market problems on the macroeconomy

Banks' New Credit Austerity To Help Set Economy's Path, by David Wessel, WSJ:

The outlook for the U.S. economy turns on two factors: One is how much worse the nation's housing market gets. ... The other is how much of the continuing disturbance in financial markets infects the rest of the economy. ...

The key is what banks will do and how much impact it will have. There's irony in that because ... banks have become increasingly less important players.

In the old days, banks made loans carefully -- because they got burned if the borrower didn't repay. ... Today, banks make loans, turn many of them into securities, and sell them to investors, pocketing the fees. Someone else gets burned if the borrower defaults. ...

But, it turns out, banks may not have unloaded as much of the risk as they thought. And that's the rub.

Wall Street firms and commercial banks ... hold about $250 billion in bridge loans made to finance acquisitions -- loans they intended to lay off in markets that are no longer quite so interested in them. The banks may be stuck with those merger loans. ...

Then there's the mushrooming problem -- one hardly anyone saw coming -- of entities called structured investment vehicles and conduits. Many of them hold subprime mortgages and related securities, and counted on selling more than $1 trillion in short-term IOUs called commercial paper to finance their holdings. Investors no longer want that commercial paper.

So what do these entities do now? They turn to U.S. and European banks, some of which sponsored the conduits, and remind them of the commitments the banks made to provide credit if the commercial-paper market dried up. ...

Suddenly, banks find themselves with all sorts of unanticipated loans on their books. So what? In the antiseptic language of central bankers, Mr. Bernanke explained, "These banks" -- the ones stuck with merger loans they didn't intend to hold and those providing backup lines of credit to conduits -- "have become more protective of their liquidity and balance-sheet capacity." They are hoarding cash or buying short-term Treasurys, and that means making fewer new loans. ...

Saddled with loans to finance mergers or back-stop conduits that can't sell commercial paper, banks are likely to be less willing to lend to ordinary consumers and businesses or, at the very least, will be charging more for those loans. So, consumers and businesses are likely to borrow a little less -- and spend a little less -- and a financial disturbance could be transmitted through the banking system to the rest of the economy.

No wonder there's growing worry the U.S. is going to slide into recession. ...

As if that wasn't enough, there's another layer: Everyone knows banks have a lot of loans on their books that they'd like to sell, but can't -- or won't at today's prices. So some deep-pocketed speculators, the ones who buy when prices plummet and then help bring them back up, are waiting for prices to fall further. And that increases the risk of a prolonged period of financial market turmoil which, in turn, increases the risks to the rest of the economy which, in turn, makes bankers -- understandably -- a little more wary about lending.

The issue isn't whether all this is happening. It is. The issue is how big an impact banks' behavior will have on the economy. ...

No doubt it will be one of the big issues on the table when Mr. Bernanke and his colleagues meet next week to ponder how much to cut interest rates to offset the markets' tightening of the credit spigot.