Credit Crisis 101 - Re-Powering America by Getting Capital Investments Flowing Again

See Also Part 1, Part 2

This is the third part of a three part series on how the credit crisis started, where it has left us, and how we can start re-powering our economy starting today.

Companies Remain out in the Cold with respect to Credit

While inter-bank lending rates are finally starting to thaw following the central banks nearly $4trln liquidity injection over the past two weeks, the credit markets continue to remain out in the cold. 

The auto sector is clearly on the front lines of the credit crisis with GM now effectively borrowing 5yr money at a whopping 48% per year. This rate of interest is implying that the markets expect GM to default on its debts inside of two years if things remain as they are.

The energy sector, which is the third largest consumer of capital after the banks and the federal government, is also under a great deal of strain from the lack of funding available in the credit markets. Higher borrowing costs, lower energy price expectations, short-term demand uncertainties, and tumbling stock valuations have forced the energy sector as a whole to hold more cash and dramatically reduce the amount of capital available for future investments.

Examples of how this is playing out in the energy sector are as follows:

• Coal plant developers are being faced with higher funding costs and lower short-term demand growth, which are likely to keep most new build proposals on the drawing board. Investor owned utilities have been particularly hard hit given the fact that almost all of their deals require investors to buy a substantial amount of equity like debt to secure their financing. These credit based problems are all in addition to the fact that coal prices have climbed so high relative to natural gas prices that building a natural gas plant is now a cheaper alternative to a new coal-fired power plant, even without pricing in the carbon risk.
• Exploration and Production companies have seen borrowing costs rise substantially over the past few months, as many of their current large-scale projects they invested in are no longer economically viable. Investors who wanted to "Drill, baby Drill" with oil at $145/barrel this summer are now left with nothing to do but cry, baby cry for those investments. 
• Pipeline developers were expected to invest over $50bln in pipeline infrastructure project over the next three years, but with oil and natural gas falling well below market price expectations, many of these new pipeline plays will now be put on hold.
• Renewable companies, who have seen their stocks' plummet over the past few months, are now expected to be constrained in their ability to take on new capital intensive growth opportunities due to their high level of capital intensity and lower stock valuations.  This is especially the case for wind as the PTC credits are of limited value as no one is making profits.

Priming the Credit Pump

Indeed, while the governments' action to protect consumer deposits has helped slow the de-leveraging process by the banks somewhat, this loosening of borrowing standards is unlikely to benefit corporate or other borrowers anytime soon. The shift currently taking place from super easy to super tight credit is now sending shockwaves through the system. These shockwaves are already starting to have a severe impact on the US economy in terms of job growth, lower expected tax revenues, and reduced energy security as America gets further behind on its domestic energy investments. And things are only expected to get worse if nothing is done to get the credit pump primed once again and soon.

Congress is currently working on a second stimulus package which will hopefully help provide some fresh capital into the markets but as I mentioned in my last post See Part 2, Japan spent nearly $1trln on economic stimulus packages over ten years and it did very little good to reverse the effects of their credit crisis due to its lack of focus. I am not arguing that economic stimulus packages can't effectively be used to build bridges, but I would caution that we need to make sure those bridges are built to take us to a place to where we actually want to go.

What we need is a way to direct committed capital to industries starting today that can create jobs and give us back our competitive edge as a global technology innovator. This must not simply be a public initiative but one done in concert with private capital, understanding the banks will need to have cash flows or collateral on the table that can justify their capital commitments at a reasonable rate of interest. 

This new program that I am referring is one that would establish tradable limits on total carbon emissions, investing some of the resulting proceeds into a new energy economy during the early years before returning the bulk of these revenues from the carbon market back to households. This program, known as "cap, invest, and dividend", would create revenues through trading of carbon permits but be structured to pay the economy back by investing the money to create new jobs in new industries like wind and solar, increase energy efficiency efforts at the state level, and improve fuel economy standards by helping to re-tool the auto industry to allow them to better compete in a energy constrained world.

Show me the Money

You might ask, how would passing a law that wouldn't go into effect for years help get capital flowing back into these industries today? Let me explain. Once a cap and invest program has been put into place, allowances from the carbon emission auctions can be set up in such a way as to guarantee a minimum auction value for the allowances during the programs early years. These allowances would then have an agreed upon cash value guaranteed by the federal government that could then be used as form of collateral for investment. Collateral that could then be pledged to the banks as future cash flows for various low carbon investment initiatives.

To give a concrete example of how this would work, let's look at how a cap and invest policy would affect GM.  As I mentioned previously, GM is currently borrowing at such high interest rates that even with the 30% government guarantee on loans passed by Congress this month, their effective borrowing rate would still be above 35%, interest making any additional investment in energy efficient vehicles next to impossible to justify. 

With the introduction of a cap and invest program, however, GMs chances to recover improve greatly. GM would be able to tap the re-tooling incentives in the cap and invest bill by pledging their carbon credits to the banks in exchange for better funding terms. The banks would be able to use these future carbon credits as collateral for specific re-tooling investments and allow GM to fully utilize their government guarantees to build energy efficient vehicles. This would allow GM to invest in these new vehicles at more affordable interest rates and would hopefully help turn around the company's fortunes by making their cars cleaner and more attractive to buyers.

Bringing Forward Stalled Energy Investments

This type of collateral based funding would also work to help jump start energy sector investments as follows:

• Coal plant developers and operators will be able to mitigate their carbon risk by investing in the deployment of an important export technology known as carbon capture and storage (CCS). These investment flows will also help Exploration and Production (E&P) companies take advantage of a multi-trillion dollar opportunity to use this cheap source of CO2 from coal plants to recover stranded domestic oil through a process called enhanced oil recovery (EOR) with CO2.  
• Pipeline developers will be able to pursue more domestic natural gas and oil pipeline opportunities as enhanced oil recovery efforts are scaled up, making investments in not only pipeline infrastructure but also scaled up transmission infrastructure projects for solar and wind more economically viable.
• Renewable companies will benefit tremendously from the trued up cost equalization that comes from putting a price on carbon. This ability to become more competitive as an energy provider will give these players a stronger case when tapping the banks for financing to pursue new technologies that can be utilized at home and exported overseas.
• Scaled up energy efficiency investment would also benefit as needed investment capital would be made available to create the millions of jobs described in Van Jones' new book The Green Collar Economy: How One Solution Can Fix Our Two Biggest Problems.

In addition, the same could apply to a program that would spend now pay back later on public sector investments. These programs could use carbon revenues guaranteed by the Treasury to get people working today on directed energy initiatives without increasing our Federal debt burden.

Listening to Buffet

Warren Buffet's investment philosophy that a wise investor "attempts to be fearful when others are greedy and to be greedy when others are fearful" has important application to our situation as the credit crisis continues to unfold. The US has an opportunity to be greedy while others are fearful in today's credit constrained world. By passing a "cap, invest, and dividend" program we would be securing a long-term investment plan that would help us bridge the credit gap and get directed capital investments flowing again. Capital that would then be invested in new industries that will create millions of jobs, improve our energy security, and reduce the harmful effects of climate change.

The current credit crisis is unlikely to be resolved with half-measures as Japan's "lost decade" has shown us. The US needs a directed policy to regain our economic and moral leadership in the world at a time when others have lost their focus. As Mark Fulton, Deutsche Bank Asset Management's Global Head of Climate Change Investment Research stated in a recent report, "the current crisis is making the necessity of tackling climate change an opportunity to stimulate growth through investment opportunities." Cap, invest, and dividend is a way to provide that stimulus and help ensure this crisis is as short lived as possible.