Credit crunch still threatens, Mr. Bernanke

“There is a girl in New York City, Who calls herself the human trampoline, And sometimes when I’m falling flying Or tumbling in turmoil I say Whoa so this is what she means.”

The Federal Reserve’s Open Market Committee meets in a little less than 2 weeks (on September 18) to consider what, if anything, it can do to stave off economic ruin in the wake of the real estate bust. I suspect right about now, Fed chairman Ben Bernanke is wandering the halls with Paul Simon’s Graceland album on his iPod wondering about that girl who calls herself the human trampoline. It’s an apt metaphor for the market these days, which seems to rise and fall with renewed volatility but a little less bounce each time.

Bernanke’s job isn’t to protect foolish mortgage lenders or ham-handed hedge fund managers, though. Rather, he’s supposed to be looking out for the greater good, keeping the economy on a path of sustainable growth without runaway inflation. He’d been able to blow off reacting to most of the summer’s bad news until things started spreading beyond subprime borrowers. Pretty much as soon as the commercial paper market took its biggest one-week dip since 9/11, Ben & Co. cut the Fed’s discount rate by half of a percentage point. Only banks can borrow at that rate and usually only do so in times of distress. The Fed also indicated that it would be happy to accept a potpourri of assets as collateral, a bid to firm up the market’s estimation of that kind of stuff. A few banks made token use of the capability but not many.

And there are continuing signs of tumbling in turmoil out in the real economy. Exhibit A, as I first mentioned two weeks ago, is the commercial paper market. Stats out from Bernanke’s analysts today revealed that the market for short-term borrowing shrunk for the fourth week in a row. Since the week ended August 8, almost $300 billion of borrowing has failed to roll over, a 13% drop. And the damage is mostly coming from the asset-backed side of the ledger, where outstanding commercial paper backed by stuff like mortgage loans has sunk to $967 billion, an 18% decline in the past four weeks. Rates for those still borrowing have jumped by almost a full percentage point, as well.

One alternative for those using CP is to simply issue longer-term debt. This may be more expensive in the short-run but it beats a liquidity-induced bankruptcy by a mile. And sure enough, corporation issued almost $72 billion of investment-grade bonds in August, the most ever for that month and the sixth-highest total for any month — ever. Nice. Then again, $72 billion is a drop in the bucket compared to the $300 billion of commercial paper that has evaporated in the past four weeks, which must also be some kind of record. And issuance of below-investment grade bonds, those from the very companies that may be most likely to issue asset-backed paper, actually shrunk to just $2.4 billion in August, approximately one-thirteenth the amount issued in June.

The question for Bernanke is what else can he do. The Fed could start cutting the more widely-used fed funds rate. That’s essentially what Bernanke’s predecessor and the original human trampoline, Alan Greenspan, did after the Internet bubble crashed. But in retrospect, Greenspan’s moves are at the root of the current lending bubble that expanded to mammoth proportions because rates were held so low for so long.

Bloomberg today quotes Diane Swonk, chief economist at Chicago-based Mesirow Financial Inc., warning of bigger repercussions ahead from the ever-shrinking commercial paper world. “This could be a much larger issue for currently solvent firms that have done nothing wrong if it does not correct itself,” she tells the wire service. Companies that are “currently solvent” may be a lot less so if their sources of capital all dry up. I don’t envy Bernanke much today.