Tuesday, October 7, 2008

Credit Crisis

Best explanation I've heard of why the credit crisis is wreaking such havoc on the economy, on This American Life, of all things.

Companies don't like to keep a lot of cash on hand -- if you have cash sitting in the bank, it's not invested in your business earning money. So each day, the company treasurer tots up the company's income and expenses and determines whether the company has extra cash or needs some cash. If it needs cash, it goes to the commercial paper market and borrows the money for a very short time -- perhaps just overnight. That's what commercial paper is: very short term borrowing by companies.

But for the last couple of weeks, there's been no money to borrow or lend in the commercial paper market, because money-market funds, which are big investors in commercial paper, are going crazy because one of them "broke the buck" -- it lost money -- because it had too much invested in Lehman Brothers commercial paper. So lots of people are trying to get out of money market funds, to the point where the government had to guarantee them. And then another fund broke the buck, and then money market fund managers decided to stop lending in the commercial paper market and just buy government bonds instead.

So there's no money to lend. Companies from small businesses to General Electric are having trouble borrowing money, even short term.

The whole economy runs on credit. People deliver the goods and settle up at the end of the month. If you can't do that, it's a crisis.

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