Credit crisis has Main Street watching Wall Street

The current upheaval in financial markets is hitting some highly specialized lenders and investors the hardest, but it hasn't stopped there: It has big implications for the whole economy.

The stock market has become much more volatile in the past few weeks. Borrowing has become tougher for home buyers and some businesses.

These effects come as ordinary Americans have greater financial wealth but also more debt than ever before. It also coincides with financial industries becoming increasingly complicated and global in scope.

Behind all this lies a big question: If the turmoil on Wall Street gets worse, how large an effect will it have on Main Street – in communities where consumers are already burdened by high gas prices and falling home values?

It is that concern – not a desire to bail out tottering mortgage firms – that prompted the Federal Reserve to step in last week as a provider of cash and confidence. That helped the Dow index post a small gain for a roller-coaster week. "We have a financial sector which is in many ways different than it used to be," says Saul Hymans, a University of Michigan economist in Ann Arbor. "It's not a matter of whether it's going to ripple into the rest of the economy, but the degree."

Most forecasters say a recession is not on the immediate horizon, especially now that the Fed has sent a "We're here to help" signal to stressed markets. But the consensus view is for a 26 percent chance of recession in the next 12 months, says the August release of the widely watched Blue Chip Economic Indicators survey. That's up from 23 percent in July.

A summary of economists' opinions added: "Should credit markets remain stressed, further weakness on Wall Street could migrate to Main Street, resulting in a softer economy than now anticipated."

Financial conditions have always been intertwined with the production of goods and services in the broader economy. When one side lands in some trouble, the other feels it, too.

The financial sector is on much sounder footing now than it was in the 1930s, when the lack of federal deposit insurance prompted a wave of bank failures as customers rushed to pull their money out. But dramatic changes over the past 20 years created new uncertainties as well as resilience:

• Derivatives – contracts whose value derives from assets like currency or stock – have become a dramatically larger presence in the investment universe. The popularity of mortgage derivatives helped fuel the recent housing boom in the US. The current credit turbulence arose as investors were forced to make huge markdowns on the value of derivatives linked to subprime mortgages (home loans to high-risk borrowers).

• Financial firms are more global. Markets worldwide were shaken last week, and central banks stepped in after a French bank revealed large losses related to subprime US lending. German banks, among others, got caught up in the storm.

• Leverage has grown as investors such as hedge funds and private buyout firms borrow to make their deals. Among the implications: Investors may need to sell even high-quality holdings to cover bets in other areas.

• Ordinary households are touched by financial trends in larger ways. The rise of 401(k) retirement plans has expanded the realm of stock ownership. If employers promise a fixed pension, the funds are likely to be players in hedge fund investing. Borrowing has also increased, with 18 percent of American homeowners' disposable income spent on housing and auto payments, up from 15 percent two decades ago.

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