The trust crunch

Because commercial-paper loans are short-term and are made only to companies with sterling credit ratings, they’ve always been assumed to be practically riskless, and lenders (most notably money-market funds) have been willing to lend at low interest rates. But the past year has called into question the very idea of a low-risk loan.

Lehman Brothers, after all, still had an A2 credit rating when it went under, taking down with it billions in commercial paper. Since its failure, lenders have adopted a gimlet-eyed approach to everyone, making it hard for key companies to perform basic transactions, and thereby exacerbating the market panic. A company like AT&T. is hardly likely to go bankrupt in the foreseeable future, but, after Lehman’s collapse, lenders were so skittish that AT&T couldn’t get commercial-paper loans that lasted longer than overnight.

The fear that has overpowered lenders is not just about the current market chaos. It also reflects their lack of faith in the models and systems that they rely on to evaluate risk. For Morgan, that process of evaluation was all about relationships. In the modern financial system, by contrast, risk evaluation involves two things: impersonality and outsourcing.

Personal judgments about the reliability of a borrower — the sort of judgment that Morgan, or a small-town banker, would make before issuing a loan — have been replaced by mathematical models. And lenders have delegated much of the responsibility for evaluating borrowers to other players, such as credit-rating agencies. In many cases, an AA rating was all a company needed to get a loan.

There’s no doubt that this system has had huge benefits. It has made it easier for money to connect lenders and borrowers. It has removed the kinds of personal bias that kept capital in the hands of people whom men like J. P. Morgan approved of. And it has vastly expanded the amount of lending as well. But all those benefits have come at an exorbitant price.

The problem with an impersonal system is that when the models fail, and when companies’ ratings become suspect, everything is called into question. Lenders can’t fall back on their own judgments of a specific company or individual, because such judgments aren’t part of their typical decision-making process.

Instead, they’ve adopted a deep-seated distrust of all borrowers, even financially secure ones. If the Fed is now taking corporate I.O.U.s, it’s because everyone else is acting according to that old motto: In God we trust — all others pay cash. 

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