TOPICS > Economy

Firms’ Soaring Credit Debt Prompted Federal Rescue

September 23, 2008 at 6:30 PM EDT
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Unmanageable loans and debt of firms like Lehman Brothers, Fannie Mae, Freddie Mac and AIG led to declines in their credibility and the end of growth based on credit. Paul Solman explains how these giants lost control of their finances and why credit plays a central role.

GWEN IFILL: Next, a closer look at what triggered the dramatic credit crunch that prompted the government’s rescue effort. The NewsHour’s economics correspondent, Paul Solman, explains.

PAUL SOLMAN, NewsHour Economics Correspondent: Anxiously scanning the business pages of the other day, this headline: “Amid Potential Chaos, a Light-Hearted Break.”

For those who need a little bit of levity on a tense day, we present some mood music.

R.E.M., band (singing): It’s the end of the world as we know it…

PAUL SOLMAN: So is this the end of the world as we know it? Well, unfortunately, no one can answer that, not even Treasury Secretary Paulson or Federal Reserve Chairman Bernanke.

It does, however, seem to be the end of an era, an era driven by credit. And that may be the key to understanding what’s been happening, that this is a credit crisis.

The near-term fate of the financial system is being decided as we speak by global markets, made up of millions of investors, responding second by second to the latest word from Washington, sometimes stampeding in unison and driving down prices of stocks and other assets without meaning to by trying to sell before the other guy.

Loss of faith in bonds

But what triggered the recent stampede was not a loss of faith in stocks, but in bonds, the debts of firms like Lehman, Fannie, Freddie, and AIG.

Bonds are official IOUs issued by governments and corporations, and it can be interesting to see what they used to look like before they became digital blips. We featured this one in a story some years ago.

This IOU was issued in 1912 to build Russia's Kahetian Railway, with an absolute guarantee of repayment and 4.5 percent annual interest by the czarist government. On the back, you can see the first 12 interest coupons were clipped and redeemed. The 13th, dated August 1918, was clipped, too, but stapled back on to a now worthless bond, because of the Russian revolution, when the Bolsheviks renounced the debts of the czars.

Now, bonds are just a form of credit, but credit is just about the most important ingredient in an economy, any economy more sophisticated than, say, Robinson Crusoe's, which you can also find on your computer.

ROBINSON CRUSOE: At last, a food I know, a papaya!

PAUL SOLMAN: The point is, once you move past a one-man economy, you've got to trust other people, not just yourself. So a farmer gets money for seed corn that can't be paid back until harvest time on credit.

Growth based on credit

Firms, from railways to high-tech, pay for their equipment, offices, and workers as they try to grow on credit.

And with credit, we've grown, so that today the world economy is huge, rich, and bursting with debt, but not just debt to drive growth, debt on the assumption of growth, of endless growth.

You and I borrow via credit cards to consume, hoping our future earnings will grow at least enough to cover the interest. Governments borrow against their hopefully growing economies, as the U.S. Treasury does right here on its Web site. And they've been selling more and more of them lately.

The interest on the bonds is supposed to come from continued economic growth of which government's share is our taxes. And there's even credit built on credit, as we've tried to illustrate in the past with bargain-basement props, loans taken out against pools of domestic mortgages, commercial mortgages, credit card debts, even auto loans.

If you believe that growth will continue, and thus everyone will pretty much keep up with their payments, everything is hunky-dory. If not...

Harm from bad debt and loans

Look, as we've said before, credit comes from the Latin "credere," to believe, credence, credibility.

If the farmer loses credibility due to a failed crop, say, folks stop lending. Same for the high-tech entrepreneur whose product fizzles. Same for consumers who've piled on more debt than they can afford. Same for companies like Lehman, Fannie, Freddie, AIG, many of whom bought the loans of those consumers.

But these firms also need to borrow constantly to help pay off prior loans coming due, pay out insurance claims, pay employees, so they're always borrowing, by auctioning off their debt, their bonds, their so-called paper.

Now, although they had some bad loans, Fannie and Freddie were still making money on their mortgages, just as AIG was still making on its insurance policies, which they solicited with TV ads like this one.

But it was no laughing matter when AIG, sitting on bad loans and bad debts, suffered a loss of credibility and thus of its credit and was suddenly forced to pay higher and higher interest rates just to stay alive.

MOM: Did you have a nightmare?

BOY: No, I'm worried about this family's financial future.

PAUL SOLMAN: Would you have lent to AIG, even with their reassuring ads?

DAD: Buddy, we're with AIG.

BOY: Oh!

PAUL SOLMAN: But you probably wouldn't lend to AIG, or to Fannie or Freddie, for that matter, at any kind of reasonable price. And neither would anyone else. Credit, in short, was becoming unaffordable, frozen.

So right now, government is trying to figure out how to pump hundreds of billions of dollars into the economy. How exactly? To buy up the bad debts and restore credibility, in order to get credit back to reasonable rates and thus flowing once again.