Where there's smoke . . .

This past week of spectacular autumn days somehow reminds me of September 11, 2001 and the jarring juxtaposition of that gorgeous Vermont autumn day against the terrible events occurring over the horizon and on our televisions.

A similar feeling of suspended animation has set in these past few months as we all watch the outlines of a growing international credit crisis. The feeling has intensified this past week with the sudden drama of the Bush Administration's proposed $700 billion credit market intervention.

The disjunction between beautiful benign Vermont weather and the threatening chaos of the larger world is unsettling in itself. As with 9/11, the dizzying flurry of public drama this past week flooding the media channels easily overwhelms our judgment. However, the disjunction offers some perspective as well. For myself, I require the low hum of a pre-dawn Vermont morning to arrange my thoughts and take stock.

What I see in the burgeoning credit crisis is both much worse and much less mysterious than the news frenzy would suggest.

First, the economic fundamentals involved are, I'm afraid, more dire than most the popular media seem able to grasp.

The bank failures and related government interventions are symptoms of a deeper, more profound credit crisis. The news cycle celebrates the symptoms without really addressing the underlying disease. Each intervention by the federal government is treated as a positive sign and the stock markets -- barometers of speculative investment rather than fundamental economic health -- leap as though the disease has been vanquished.

We are, instead, facing a crisis in confidence which, if allowed to become a panic, may well prove as traumatic and disruptive as the Great Depression.

Our economy and the world economy operate on relatively efficient credit flows. Individually, our decisions to spend are influenced by the availability of capital. Credit (mortgages, credit cards, car loans, etc.) expands the availability of capital beyond what our current assets would otherwise generate. Businesses and the business of banking are no different, though their ability to tap credit markets -- to leverage their assets -- is more sophisticated.

Extending credit is a matter of confidence: "Will the borrower be able to repay the loan?" There are certain well-established metrics to determine the lender's risk; credit history, job security, collateral. As debt instruments have become more complex and credit derivatives of all kinds have flourished, the question for lenders has increasingly become, "Can I sell the loan?," attenuating the risk of repayment by spreading the loan obligation among a number of different debt-derived securities which investors will buy.

The refinement of this secondary market for debt derivatives has fed an extraordinary period of credit expansion which has, in turn, fueled huge asset bubbles in the stock and housing markets. As long as prices continued upwards, confidence in further lending continued and the appetite to invest in debt-derived securities grew. To feed demand, lenders worked harder to drum up loans they could sell, loosening underwriting standards and terms based on what they could bundle and sell as debt-derived securities, rather than what the borrower could bear.

The fundamentals underlying the credit markets began to turn decisively in late-2005. Housing production began to fall well before lenders began to rein-in mortgage lending. Consumer spending has only recently begun to tail off despite unprecedented levels of consumer debt wholly disproportionate to prospects for offsetting increased wealth. A succession of subsidiary credit markets have shriveled, beginning with "sub-prime" mortgage-backed securities; the complete collapse of a $330 billion auction rate securities market last winter; and more recently, the bedrocks of the secondary mortgage market Fannie Mae/Freddie Mac and (via credit default swaps) AIG. Banks are hoarding what cash they can find to offset their growing lending losses rather than offer new loans. As these credit markets have constricted, they have rendered higher quality debt-derived securities more risky, giving impetus to a vicious cycle of credit contraction. Finally, with the public drama of Secretary Paulson's proposed intervention to purchase up to $700 billion in debt-derived securities, public confidence in the overall economy appears to have taken a turn.

It is that shift in public confidence which will determine whether we face a sharp recession or a prolonged economic depression.

Unfortunately, for all of us, neither our political nor our business leadership can afford to speak frankly on the matter until it's too late. To openly address the severity of the credit crisis would be to openly state that, inevitably, the vast majority of people will be less well-off over these next few years than they have been these past few. As people ask how much less, some will panic and panic is contagious. FDR's famous 1933 Inaugural Address quotation, "the only thing we have to fear is fear itself," is as true today as it was in the depths of the Great Depression. By the time FDR uttered these words, vast wealth had already disappeared in bank runs, stock market declines, and foreclosures; the political risk of admitting the emperor had no clothes had past.

Today, our business and political leadership are scrambling to put band-aids on the credit markets and keep up a brave face. The federal intervention in the collapse and liquidation of Bear Stearns last March was considered an unprecedented intrusion into the markets by the Federal Reserve. Since then, the federal government has initiated an escalating series of unprecedented interventions, each more expensive and far-reaching than the last; each premised on the hope that it would be the last. In this context, Secretary Paulson's proposed $700 billion intervention in the mortgage debt derivative market should be recognized as simply another hopeful stopgap.

If you take a look at Secretary Paulson's original plan:

http://www.nytimes.com/2008/09/21/business/21draftcnd.html?ref=business

you'll notice he's seeking authority to purchase up to $700 billion in mortgaged-backed securities at any given time over the next two years. The hope appears to be that adding $700 billion to the mortgage debt market will allow banks and investors to sell off their distressed mortgage debt and use the cash from those sales to lend and reinvest. The concept is sound, but there's simply no guarantee $700 billion will be enough to encourage gun-shy lenders to open the credit taps once more; or to save the more distressed entities from worried investors. Moreover, the time period envisioned -- initially two years of continuing authority -- highlights the Treasury Department's expectation it will take an extended period of federal intervention to restore lender confidence.

Can any intervention at this point alter the fundamental shift in public confidence? While the stock markets may well leap at a signed intervention plan, the bread-and-butter of our economy will continue to languish with limited lending available while lenders sort out their balance sheets and borrowers bear the weight of existing debt in a recessionary economy. While Secretary Paulson and his successor are busy sorting out the mortgage-backed securities market, the credit-card-backed securities market, basic business loans, and mortgage payments on non-defaulting mortgages will all continue to deteriorate for all the same reasons the mortgage markets collapsed: a great deal of lending and borrowing occurred based on the appetite of investors to buy the debt, rather than traditional metrics for assessing the credit worthiness of the borrower.

Over-leveraged borrowers must reduce spending to cover debt expense. Consequently, business activity declines and lay-offs increase. Over-leveraged borrowers who lose their jobs will default on mortgage and credit card loans and the vicious cycle continues. Depositors begin to question the adequacy of bank reserves to cover swelling bad debt and begin to pull their money as we've seen recently with certain money market funds. If enough people run for the exits, panic ensues and all bets are off.

How do the federal interventions stay ahead of what is, ultimately, an untenable debt load throughout our economy? They don't. A lot of this debt must wash through the economy, depleting savings and sinking businesses in the process. The Paulson plan simply hopes to keep the major inter-bank lenders afloat while the economy "deleverages." If they can stave off a run on the banks, they can keep the credit taps open for those able to borrow. Eventually, confidence builds among consumers and they begin to borrow and spend once more.

The only thing I know for sure is that literally no one knows how this will all play out precisely because no one can know whether/when panic might set in. It is that fear, the fear that fuels economic panic, that we must now fear.

It's leadership we lack. The frank, courageous leadership to address the current crisis for what it is, confront the risk of panic up front, and outline a progressive multi-year plan to deleverage the economy which will mean pain for many but should avoid the irrational economic destruction of a panic for all.

Sadly, it may be the nature of the beast which makes such leadership rare. Those who claw to the top of the business and political worlds do so against ridiculous odds, fueled by an irrational optimism in both their own prospects and, I'm afraid, their own abilities. The few who reach the pinnacle are habituated to overcoming obstacles through that same optimism and sheer determination. You don't get to the top telling those below you to accept less.

(FDR's 1933 inaugural address, which employs much of the language and focus we sorely need today, was likely only possible after the horses were already out of the barn and the economic collapse an accepted fact: http://historymatters.gmu.edu/d/5057/ )