Credit as an option

I think of credit as not just a current period flow but also as an option; this is implicit in many of Fischer Black’s pieces, including "Banking and Interest Rates in a World Without Money."  If you lose the option to borrow that is a credit crunch too.  As for the current financial crisis, my view of the data is that many borrowers have been drawing on their pre-existing lines of credit like crazy, for fear that their chances to borrow may be drying up.  Banks have felt liquidity squeezed, in part because of pending CDS settlements, in part because so many borrowers are exercising their borrowing options, and in part because of potential insolvency.  That liquidity scramble is why we have been seeing such a huge TED spread and near-zero nominal rates on T-Bills.  Even now it remains unclear whether these options will be replenished and of course if they are not that means trouble.

The collapse of "borrowing as an option" shows up in market prices and it also shows up in many anecdotes, as chronicled at calculatedrisk.blogspot.com.  It does not necessarily show up in current period credit flow data and in fact it may show up counterintuitively as a spike in borrowing.

I am puzzled by Alex’s admission that there is a recession; no matter which way you assign the causality, doesn’t that mean credit should be contracting?  Working within the confines of his own view, shouldn’t Alex be worried that credit flows remain so high?

I believe if we had an explicit series measuring the borrowing option. and its recent collapse, it would show the credit crisis very clearly.  In the meantime that crisis does show up in other pieces of information.

Addendum: Here is comment from Mark Thoma and also Felix Salmon.

Comments

Tyler,

I think you are touching on the fact that we commonly define the money supply in ways which are not directly relevant to the future (or next period) availability of means of settling transactions. The definition relevant to whether we really have a credit crunch (and to what we expect the level of prices to be in the next period) is the sum of the values all available classes of assets used in settlement of transactions with each class weighted by the likely number of occasions on which the average asset in that class will be used in settlement of transactions in the period in question. The contraction of the borrowing option is a radical fall in the sum of the value of that class of assets, a contraction likely to far outweigh the increase in the average use of the remiander of that class.

“As for the current financial crisis, my view of the data is that many borrowers have been drawing on their pre-existing lines of credit like crazy, for fear that their chances to borrow may be drying up. “

So, your view of the data is that an increase in the amount of loans and credit available is a sign of a freezing of credit and an unwillingness for banks to lend. This is a very convenient position to take. A reduction of loans and credit is a sign of a credit crunch and an increase in loans and credit is also a sign of a credit crunch. This is like the game of flipping a coin where if you flip heads you win and if you flip tails I lose.

“Even now it remains unclear whether these options will be replenished and of course if they are not that means trouble.†

I see†¦so, we are not in trouble yet, but because in the future we might possibly have a reduction in loans and credit, that definitely means we are in a credit crunch now.

“It does not necessarily show up in current period credit flow data and in fact it may show up counterintuitively as a spike in borrowing.†

A spike in borrowing also means a spike in lending from the banks. But a credit crunch is where banks are unwilling to lend. Now, with new Orwellian double speak, a credit crunch is when banks are willing to lend to everyone and his brother. Some credit crunch.

“I am puzzled by Alex'a admission that there is a recession; no matter which way you assign the causality, doesn't that mean credit should be contracting?†

Causality does matter. If borrowers choose not to borrow this is not a credit crunch. A reduction in demand for loans due to a recession would not be considered a credit crunch. The credit crunch would have to originate on the supply side. Banks would have to be unwilling to lend to borrowers for there to be a credit crunch. A reduction in loans and credit is a necessary but not sufficient condition for there to be a credit crunch.

...so does Caplan.

I agree with Tyler, existing credit lines are like an option to buy a good at a certain price. The price of that good (money) has risen significantly so everyone is using their option now and the amount of money lent has increased. Now the problem is that banks are no longer issuing new lines of credit and a stampede of people exercising their current options will only exacerbate the problem in the future.

Will you relax, Tyler? Geez. Stop fanning the flames of panic, this economy has essentially no fundamental problem whatsoever. As Alex has demonstrated, credit is rolling and the good times are soon to follow. Just like the Eagles now you got to "take it eaaaasay! Take it ea-eeeeee-a-heee-zay! DON'T LET THE SOUND OF YOUR OWN WHEELS-a-make you CRAY-A_ZAYYYYYYYYYYY-YAAAAH!"

look at this another way: people know that if they pay off certain loans -- HELOC, credit card, whatever -- the bank is going to reduce their available credit. so, once they run up the debt, people aren't paying off things they normally would. looks like more borrowing, potential sign of health, actually a sign of sickness (because of burden on banks, you also have people paying big interest where they wouldn't normally)? that is, the loans presage hoarding of cash by the loanees, outflow of money from banks, etc.?

One of the things to keep in mind about all this is that bank loans are generally a lagging, not a leading indicator. As a matter of fact, real banks loans are one of the components of the lagging index.

Second, there has been a major trend in recent years for bank lending to decline in importance as firms became able to directly tap credit markets.

These two factors should be considered in evaluating what the recent bank lending data implies. It is obvious that firms are drawing on existing credit lines because their other sources of credit has been cut off or they are afraid it will be . Without making some estimate of how big an item this is it is just plain impossible to really tell what the recent growth in bank credit implies.

Early next month when we get the flow of funds data we should be able to resolve some of these unknowns.

Finally, the fact that Goldman and other have suddenly become banks may be distortion the data. Why isn't anyone that collects the data being asked about this. Could it be that too many people of all political persuasions are afraid to find out the true facts?

GREAT PIECE!

HELOC is a decent example of a borrowing option, but I don't know where you find these in aggregate fed statistics.

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