Banks lose confidence in each other

Analysis |

Despite the government's repeated attempts to calm financial markets, credit just keeps getting tighter.

That tightness makes bank loans for consumers and businesses expensive and tougher to get and could strangle the fragile economy.

On Monday, when Lehman Brothers filed for bankruptcy protection, the rate that banks charge one another for overnight loans spiked. It eased Tuesday, but only after the Federal Reserve pumped $70 billion into the financial system and made other moves to improve the money flow.

The fact the effective federal funds rate eased only after the Fed's moves means the credit system is not functioning normally, says Thomas Higgins, chief economist of Payden & Rygel. "I still don't think banks are lending to each other," he says.

The housing slump has made it difficult for banks to raise capital by selling or securitizing mortgages, so they have had to rely on one another for short-term financing.

Monday's spike was partly due to worries about the ability of counterparties to repay loans, after AIG, Merrill Lynch and Lehman Brothers buckled under the weight of bad debt.

Higgins sees conditions easing eventually, but not until banks regain confidence in each other and the system. "It's a key and critical market that has to keep functioning," he says.

Only then will consumer credit loosen. "Banks certainly need to be willing to lend to each other or they're certainly not going to lend to us," notes Liz Ann Sonders, chief investment strategist of Charles Schwab & Co.

In an encouraging sign, mortgage rates have come down. Investors have been flocking to safe 10-year Treasurys, pushing down yields. Those yields are the basis for 30-year mortgage rates.

But only borrowers with high credit scores are likely to be granted mortgages in the current environment, notes Global Insight economist Brian Bethune.