The current turmoil in the nation's capital markets reflects more than the usual tight money during a credit crisis. One by one, the major sources of the capital that lubricates the economy are breaking down. t
A credit crisis is normally a short-lived but exciting event. Stern warnings by government officials produce visions of financial apocalypse in the borrowers who previously thought that abundant and low-cost credit was their birthright. Few things are as exciting to observe as other people's financial calamities, and a good credit crisis produces some spectacular bankruptcies. After labor and business become frightened enough to curtail inflation for awhile, the credit crisis ends and everyone goes back to business as usual.
But when the current credit crisis ends, the stock market is unlikely to go back to business as usual. The stock market is not just a nationwide casino for the diversion of investors without the time for a trip to Las Vegas, but a vital source of new funds for promising companies. It was a fertile source of new funds during the 1960s, but it never recovered from the recessions of 1970 and 1973-75. Today, it is active only in trading existing securities; low prices and investor apathy make it marginal as a source of new funds to industrial companies. A spectacularly successful semiconductor company like Intel, which began operations only a decade ago, probably could not raise the equity capital to begin operations today.
When the stock market dried up as a source of new funds in the 1970s, the bond market took over the burden. Now even the bond market is closing to all but a few high-quality companies willing to pay the high interest rates. t
Bond buyers went on strike after the administration released its fiscal 1981 budget. At first, even cynical investors could not believe that any administration would stimulate the economy into double-digit inflation and then propose another stimulative budget. Few administration officials have practical experience in the financial markets, so there is great potential for miscalculating their reaction. When administration officials described the now-repudiated budget as "tight as a tick" investors took that to mean that the budget had been prepared by creatures depicted on a can of Raid. The bond market promptly dropped a record 15 percent.
American capital markets once were almost unique in the world in trusting the government enough for a long-term bond market to exist, but today's bond buyers are converting to the cynical European view that their own government is out to fleece them by debasing the currency. If the nation's capital markets were created from scratch today, the long-term bond market would not exist. Just as the stock market died as a major source of new funds in the 1970s, the bond market is dying of acute inflation in the 1980s.
The same fate may be in store for savings and loan associations in their present form. S&Ls borrow short-term money from depositors to fund long-term mortgages on homes. The major risk in borrowing short and lending long is that inflation and a credit crisis will drive short-term interest rates paid to a level above the average returns received on long-term mortgages. That risk is reality today, and most of the nation's S&Ls are losing money or soon will be. The losses get worse with each passing month as certificates of deposit issued when interest rates were lower roll over at today's high rates. An updated version of Shakespeare's advice to S&L officials might be: "Neither a short-term borrower or a long-term lender be." o
Now that the other sources of finance are in trouble, the banking system stands alone as the last reasonably healthy source of fresh funds to the economy. Since they both borrow and lend short-term funds, banks have not been hurt by rapidly rising interest rates as S&Ls have. The only real threat to the banking system lies in the possibility that a wave of bankruptcies by foreign and domestic borrowers will erode the banking system's equity capital so badly that it will be unable to provide new funds to the rest of the economy. Bankers view loan losses in the same way they view bees -- annoying in the singular but devastating in swarms.
Without deliberate malice, bankers are acting to cause the very wave of loan losses they fear. They currently charge their prime borrowers 20 percent interest, which is far above the 10 to 12 percent that the typical industrial company earns on its assets. Most corporate borrowers will go bankrupt in time if they continue to borrow at today's interest rates, but they are so dependent on debt that they have no choice. Chrysler is only one of many companies so desperate for funds that the decision to borrow is based on short-term survival, not long-term profitability.
Normally, a bank absorbs loan losses with a strong equity capital position, but large banks today have weak capital positions by past standards. For a generation, large banks increased their loans faster than their equity capital, a decision that many bankers now regret.
Banks prefer to loan money to borrowers in such good financial condition that they really do not need the money. When a bank needs to raise money to improve its own capital position, however, it faces a stock market that imposes the same Catch-22: the only banks able to raise equity capital in the stock market today are a tiny minority in such good condition that they do not need the money. The banks with weak capital positions and low profitability need more equity capital, but are unable to sell new stock because their current stock prices are low and investors avoid them.
Even when the financial fireworks of the current credit crisis fade away, the nation's capital markets are unlikely to go back to business as usual. At the very least, many promising new companies will be unable to begin operations, and existing companies will be unable to expand them. After the coming recession ends, the following economic recovery may be weak and insipid because the capital markets are unable to finance it.
Like the proverbial dragon in the cave who is most fearsome when he lurks in the drakness and snarls, a financial crisis usually is most terrifying in contemplation. When the dragon actually steps into the light of day, he often turns out to be smaller and less formidable then feared, just as all the financial crises since World War II proved to be milder in the experience than in the expectation. About once in a lifetime, however, the dragon that emerges from darkness is even larger and more powerful than expected, and the capital markets collapse as they did in the early 1930s. The size of the dragon that emerges from the current credit squeeze is yet to be determined, but present indications are that he will be larger than normal.