Why This 'Credit Crisis' Hits Everyone

The stock market has grabbed the headlines, but it is the reeling credit markets that will get the most government attention in its bailout efforts. Understanding the problems in the credit markets can help you get a better handle on what is driving the current financial crisis.

These vast markets include everything from the trading of 30-year Treasury bonds to investing in securities tied to auto loans. In essence, the credit markets act as a vital lubricant throughout the nation's economy, helping businesses to operate and families to purchase a home or pay for college. For instance, mortgages are often packed together and resold.

But lately, credit markets have been hobbled as fearful investors back away from trading.

Blow to the Economy

When the credit markets falter, the economic impact can be quite swift and severe. Some of the ill effects are already noticeable. Auto financing is less available, one reason car sales have dropped sharply. Approvals for home mortgages have gotten much tougher. Credit-card interest rates have jumped. Indeed, the recent credit problems, if not resolved quickly, could drive the economy into recession.

A big part of the problem is that an enormous amount of borrowed money flowed into the credit markets over the past several years. For a time, this borrowed money amplified the profits that banks, securities firms and other investors earned in, say, mortgage-backed securities.

But when those strategies went awry -- such as when mortgage delinquencies led many mortgage securities to tumble in value -- the borrowed money acted like kerosene on a burning building, amplifying problems to the downside.

Many financial companies found themselves with insufficient capital to absorb their losses. What has followed is a run of failures and a sharp erosion in confidence among credit-market participants.

Credit markets essentially run on confidence. Buyers of debt are lenders and they expect to get paid back, with interest. When companies fail and debts go unpaid, lenders get nervous. In usual circumstances, the lenders will simply charge higher rates and set tougher conditions for loans. But today, there's a huge wariness about lending anything at all.

Like an engine with no oil, the credit markets are seizing up.

Adding to the lack of confidence: Nobody knows how bad things could get or how much bad debt remains in the system. Much of the trouble is in the opaque "credit derivatives" markets. Credit derivatives are investments derived from other credit-market instruments, like securities backed by mortgages.

While that sounds straightforward, financial engineers came up with multifarious ways to slice, dice and package these derivatives. Now people are having trouble figuring out what these investments are actually worth. (Hint: much less than they thought.)

Impact on Individuals

For individuals, the credit markets matter on several levels. Many investors, especially those close to retirement or in retirement, hold credit investments, usually in the form of Treasurys, corporate bonds or bond mutual funds. Treasurys are considered extremely safe, while corporate bonds range from pretty safe to frighteningly risky. Many corporate takeovers during the past several years were funded with borrowed money in the form of "junk" bonds. These corporate bonds sport a high yield but also a high risk of default.

Beyond investments, credit markets are essential to the economy. For instance, banks use credit markets to fund their day-to-day activities. The rates banks charge one another to borrow money for short-term needs have risen sharply, an indication that banks don't trust one another.

That translates into less money available for banks to lend to individuals or businesses, putting a squeeze on economic activity.

The most widely used bank-to-bank lending rate, the London interbank offered rate (Libor), which has risen sharply, is also used to calculate interest rates on credit cards and many adjustable-rate mortgages. That's more bad news that consumers and homeowners don't need.

Commercial-Paper Crunch

In another nook of the credit markets, banks and businesses actively use "commercial paper" to fund day-to-day business activities. Commercial paper represents short-term loans, sometimes as short as a day, and money-market mutual funds invest in this paper. But the credit crunch has even forced this usually routine market into crisis.

Some blue-chip companies report difficulty selling commercial paper, which means finding more expensive alternatives to fund business operations. Also, money-market funds, which historically are very safe, have gotten caught up in the commercial-paper crunch, with at least one fund seeing its price fall below the $1-a-share money funds almost always maintain. The government recently introduced an insurance program to backstop money funds.

A big part of the government bailout effort is aimed at restoring confidence in the credit markets by creating a "buyer of last resort," especially for the toxic credit derivatives that have heavily damaged the financial sector. Until the credit markets rebound, pressure on the economy will mount.

Write to Dave Kansas at dave.kansas@wsj.com