Loans are not soybeans. Keep that in mind when digesting news of a much ballyhooed “credit crunch.” Market forces of supply and demand drive household and business lending, but not in the simple way introductory econ students learn.
Soybeans are a “homogeneous product.” They fall into standardized USDA grades. A ton of No. 2 soybeans from Minnesota is a near perfect substitute for a ton of No. 2 beans from Alabama or Brazil. A world market for soybeans centers on trades made in Chicago. Prices vary around the world but only by differences in transport costs to or from Chicago or major ports.
On any given day, anyone can buy or sell soybeans at the market price. If the buyer has cash, the seller does not worry about anything else. Nobody has to fill out any application to buy. Once payment and delivery happen, the buyer and seller never need see each other again.
Loans are as far from homogeneous as you can get. There are car loans, home mortgages, credit card debt, student loans, farm operating loans, small business loans, loans to buy stock on credit, multinational bank loans to Fortune 500 corporations, investment bank loans to hedge funds.
A loan is a service – the provision of money – that takes place over time. There is always risk that the loan won’t be repaid as scheduled. Lender and borrower are locked in a symbiotic relationship for months or years.
There is not just one price. Not only are there different prices for different types of loans, but different borrowers pay different interest rates for the same kind of loan. The rate depends on their credit worthiness.
Despite all this talk of a credit crunch, many interest rates have not changed much. The fed funds rate targeted by the Federal Reserve has been 5.25 percent for more than a year. Home mortgages remain in the same general band. The prime rate, the interest rate charged by large commercial banks to their most creditworthy business borrowers, is not rising sharply. So just what’s the crunch?
The answer is that while posted interest rates have not changed much, lenders are not making nearly as many loans at those rates. Home buyers who easily could get a low rate a year ago may not find a willing lender if their credit scores are not great. Retailers who could finance Christmas season inventory cheaply last year may find their lender is not willing to advance as much this year. Hedge funds that had to beat eager investment bankers away from the door in 2005 may find that no one returns their phone calls in 2007.
What should the Fed do? Very little, unless financial markets approach meltdown. Tighter credit is a healthy, though painful, adjustment away from too-easy money.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.