updated 2/10/2009 8:32:54 PM ET 2009-02-11T01:32:54

Since the start of the financial meltdown, government officials have faced a chicken-and-egg question: Will healthy credit markets fix the economy or does a healthy economy fix the credit markets?

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The answer, problematically, is both. Credit markets must work well for an economy to rebound, but the big players in the economy — consumers, homeowners and businesses — must show signs of strength, too, for investors and banks to really want to lend to them.

It's a conundrum plaguing market participants, too, who are worried the government is throwing money at symptoms instead of the disease. The Treasury Department on Tuesday, having already injected banks with capital, said it will now aim to remove $500 billion in toxic assets from banks' balance sheets and boost lending to consumers and businesses.

"Fixing the credit markets is just stabilizing the situation, rather than reviving growth," said Edward Yardeni, an independent market analyst, as the Dow Jones industrial average tumbled 382 points and investors flocked into Treasurys.

Over the past several weeks the credit markets — where companies and other investors go to buy and sell debt — have started to heal. Many key rates have fallen. Corporate bond issuance is up. It hasn't felt like a victory, though. The freeze in the credit markets may have brought the economy to a halt, but thawing them won't necessarily bring it back to life.

The credit markets provide companies with loans, and determine interest rates for individuals. But as important as they are, an economy needs hearty, confident consumers, economists say. And right now, they are borrowing less and saving more as the job market worsens and home values keep dropping. If the economy were a house, the credit markets would be the plumbing: Repairing broken plumbing is essential, but it doesn't clean up the damage from the clogs and flooding.

"The assumption that we had — solve the credit crunch, and happy days return — was a false one," said Howard Simons, strategist with Bianco Research in Chicago.

The credit markets are far from robust, of course. But by most measures, rates are markedly improved from where they were after Lehman Brothers collapsed in mid-September, thanks to multi-billion-dollar efforts by the Federal Reserve, Federal Deposit Insurance Corp. and Treasury Department to buy and guarantee debt:

  • The London Interbank Offered Rate, or Libor, for three-month loans between banks is now 1.22 percent. In October, it was 4.82 percent.
  • The difference between the three-month Treasury bill yield and the fed funds rate turned positive last week for the first time since 2006 — a sign panic has eased. After Lehman went bankrupt, fed funds rate was nearly three percentage points above the three-month T-bill yield.
  • The difference between investment-grade corporate bond rates and Treasury rates has fallen to 4.61 percentage points, while the spread between junk bond rates and Treasurys has dropped to 13.79 percentage points, Standard & Poor's said. A little over a month ago, these spreads were at 5.43 points and 16.75 points, respectively.
  • The 30-year mortgage rate, though up from a record low of 4.96 percent a few weeks ago, is 5.25 percent. Last fall, it was well above 6 percent.
  • Rates on commercial paper — short-term debt companies sell to money market funds and other investors — have tumbled. The rate on 30-day paper sold by highly-rated financial companies was 0.42 percent last week, compared to over 4 percent late last year.

However, the improvement in these rates has not been felt in the real economy, and banks are still wary about lending.

"As it turns out, improving spreads were a necessary condition, but not a sufficient one," said Lou Crandall, chief economist at Wrightson ICAP.

No matter how low rates get at the wholesale level, Crandall said, banks are not likely to drastically loosen underwriting standards anytime soon. The Treasury has lent banks capital, and said Tuesday it plans to get the toxic assets off their books; but there are not many creditworthy borrowers now because the economic outlook is so uncertain.

Meanwhile, although corporate bonds are easier to sell now, companies won't suddenly ramp up their hiring — jobs, unfortunately, tend to be the last thing that come back in an economic turnaround.

And while investors' appetite for risk may improve, it won't bounce back to the levels reached two years ago. Private investors do more U.S. lending than banks do, according to Federal Reserve Board data. But the securitization market, where loans are bundled into bonds and sold to investors, is dormant. The Treasury Department's new plan to incentivize private investors to buy the distressed securities, if it works, could help revive trading, but what cannot be changed is that the price of the assets underlying these securities — houses — were overvalued, and loan defaults are still on the rise.

Somewhere along the line — at the bank, investor, or taxpayer level — losses will need to be taken, analysts say.

"The problem is we have overpriced assets," Simons said. "These long-term structural problems have a tragic inevitability to them."

Moreover, while the government tries to rouse market activity, there are "behavioral and structural changes taking place — a massive deleveraging process that will take years to complete, and a whole new attitude towards risk," said Carmine J. Grigoli, chief investment strategist at Mizuho Securities.

Deleveraging, the process of getting out of debt and into cash, is occurring among consumers as well as investors. Demand for loans is down because people already have enough debt and feel poor. The savings rate for 2008 was 1.7 percent, three times the rate in 2007.

The government recognizes that focusing solely on market rates can't solve the nation's economic woes. In addition to slashing benchmark rates, lending banks capital, buying mortgage-backed securities, and guaranteeing bonds, the government is spending hundreds of billions of dollars to cut taxes and spend on projects aimed at creating jobs.

Ed Lincoln, economics professor at New York University's Stern School of Business and director of the Center of Japan-U.S. Business and Economic Studies, said the rescue plans, because they've been put together quickly, should help the United States avoid a protracted economic stagnancy like Japan's after its asset price bubble burst in the late 1980s.

But Yardeni said a Japan-like malaise is a possibility for the U.S. He said what the government's plans lack is very basic: money that goes directly toward refinancing mortgages. The housing market must recover for the rest of the economy to do so, too, he said.

"We're spending an enormous amount of money to buy time," Yardeni said.

Copyright 2009 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.


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