Drying up of short-term loans reverberates around world

Normally eager banks fearful of extending credit

By Casey Ross, Globe Staff  |  October 8, 2008

Companies are finding it harder than ever to borrow money for basic functions such as meeting their payrolls and funding operating costs. So how is this fueling a panic in financial markets around the world?

The answer lies in the economy's reliance on all kinds of credit, in particular short-term debts known as commercial paper. Companies use these inexpensive loans to finance the most routine operations of their business, such as stocking shelves and buying raw materials. Firms borrow on a short-term basis because sometimes they don't have the cash, or sometimes their cash is better used in other ways.

Normally, banks are eager to make these loans because they are profitable and seen as safe investments that companies pledge to repay within weeks or even hours. But both the banks that facilitate those loans and the investors who buy them fear the financial crisis gripping Wall Street will make it more difficult to get their money back. So they're raising interest rates, making it expensive for companies to borrow.

If short-term loans remain inaccessible, companies may curb spending to preserve cash or use reserves to meet their payrolls and daily costs. Once the reserves dry up, they may need to hold off on expansion or hiring, or even resort to layoffs. Such retrenchment, some of it already taking place, could cripple the US economy and set off a global recession.

That's why the current loan paralysis triggered an extraordinary maneuver by the Federal Reserve yesterday to create a special fund to buy commercial debt. The announcement had an immediate impact: Rates for overnight loans, a popular form of short-term debt, fell three-quarters of a percentage point, to 2.94 percent, according to Bloomberg.

However, the drop in rates came in the context of global financial turmoil that again triggered a sharp drop in the US stock market. That means banks and investors are likely to remain cautious, wary of taking risks on new debts until the economy stabilizes. No one seems to know when that will happen.

"If something doesn't break soon, people are going to start missing paychecks," said Robert MacIntosh, a vice president of investments for Eaton Vance.

The Federal Reserve intervened after the US government's $700 billion bailout failed to calm investors. The rescue plan was meant to stop the financial free fall by removing toxic debt from corporate balance sheets, but it's not known how much bad debt there is, or whether taxpayers' money is enough to keep institutions solvent.

Economists say the credit crunch - along with the broader turmoil - will remain until banks begin to see the plan's details. They want to know how the government is going to buy their assets, and at what price.

"Confidence will be restored when investors can see clearly the process of all of this being cleared up," said Tu Packard, senior economist at Moody's Economy.com. "It's not going to happen instantaneously. It's going to take some time to figure all of this out."

Casey Ross can be reached at cross@globe.com.