Saturday, October 11, 2008

John Mauldin Warns that Another Credit Market Is Starting to Freeze Up

In John Mauldin's latest "Thoughts from the Frontline" letter ("Where Do We Go From Here?"), he writes that the letter of credit market is starting to freeze up, and that if this isn't dealt with, it will hamstring global trade:

Just as the business world is dependent upon commercial paper as its life blood, the world of global trade depends on letters of credit (LOC). Without LOCs, the world of trade quickly freezes up.

If you are a manufacturer of a product and want to sell to someone outside your borders, you typically require a letter of credit from the buyer before you load any cargo at a port. A letter of credit from a prime bank is considered to be proof of your ability to pay. It not only can be a source of ultimate payment, it can be a source of inventory financing while goods are in transit.

And if you are a business which is buying a product, you do not want to release money until you know the product is on the way. There are buyer's and seller's agents who make sure these things happen seamlessly, and world commerce had grown because of it.

Now we are starting to get anecdotal evidence that this extremely vital market is also freezing up. If you think the problems stemming from a meltdown with the commercial paper markets are threatening to the world economy, they are small potatoes when compared to a seizure in the letter of credit markets.

One piece of evidence for the freezing in letters of credit that Mauldin mentions is an anecdote about an shipper unable to get funding from Citibank using his letter of credit from BNP Paribas. Given the uncertainty that surrounds many large banks due to their exposure to distressed assets and opaque derivatives, I wonder if there might be an opening for smaller banks or even non-bank lenders to expand into letters of credit. Maybe not, but I'll bounce the idea off of a client who owns an non-bank lender.

Mauldin's letter covers more ground than this, including his take on the CDS market, the collapse of Lehman, the crisis in Iceland, and Mauldin's proposed solutions. It's worth reading the whole thing as a counterpoint to U. of Chicago Professor Casey Mulligan's more optimistic take on the state of the economy. I suspect the reality is somewhere in between.

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