How a credit crunch may hurt the world economy

As troubles in the US housing market ripple across the global economy, the health of banks has become one of the biggest financial uncertainties for 2008.

By Mark Trumbull | Staff writer of The Christian Science Monitor

from the January 10, 2008 edition

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The old watchword in buying real estate is "location, location, location." But troubles in the US housing market have rippled outward to become a problem without borders.

Now the health of banks has become one of the biggest financial uncertainties for 2008. The risk: that a cutback in lending will restrain an already cooling world economy.

For now, economists say that no full-scale credit crunch has arrived. But the end of the US housing boom has caused billion-dollar losses for banks in places like New York, London, and Frankfurt, Germany.

That has consequences for borrowers. After years of relatively easy lending worldwide, the general trend now is toward tighter conditions: Loans are growing more expensive and harder to get. Here's a rundown on the credit challenge, and how it may play out this year:

How big is the credit squeeze?

Many borrowers are unaffected, but the credit problem goes beyond mortgage loans and beyond the United States. The biggest concern is, it could get worse. If loan losses surge, banks would become less able to lend, even to creditworthy customers.

"Credit conditions are tightening in Europe," says Tu Packard, a global economist at Moody's Economy.com in West Chester, Pa. "It's not as bad as here yet. [But] it's a very significant concern."

In part, what's happening is a reappraisal of the risk inherent in making loans. During an era of low interest rates and solid global growth, it was the potential rewards that captivated bankers, borrowers, and investors.

Now, banks face rising loan defaults and a possible recession in the US economy – an event that would have strong global ripple effects. So they are turning more cautious and reining in access to credit. It's not just mortgage loans that are going bad. Default rates are also rising for auto and credit card loans. Also at risk are loans to corporations making leveraged buyouts, and loans for commercial real estate.

Housing markets have weakened in Britain, Ireland, and Spain. But so far, the biggest problems are with investments tied to home loans in America.

"We know that around $700 billion in US mortgage debt has been [packaged into investments and] distributed abroad," says Desmond Lachman, a former International Monetary Fund official, in an e-mail interview. Add other loan troubles, and "this adds up to large likely losses to the global banking system."

What's 'SIV' got to do with it?

Don't know what a SIV is? The financial industry has grown ever more creative in recent years, and now one of the biggest challenges is sorting out the unknown risks of complicated products. Consider:

• Banks set up structured investment vehicles (SIVs), which derive income by making loans with borrowed money. Now, after other firms stopped lending to these SIVs, banks in effect are being forced to lend to themselves. They are bringing the SIV loans back onto their books – and marking down their value to reflect new realities. Europe's biggest bank, London-based HSBC, recently said it will absorb about $45 billion in SIV assets.

• Similarly, banks bundled a wide range of loans into so-called collateralized debt obligations (CDOs). These were designed to provide bond-like streams of income to investors. But as it turned out, credit-rating agencies failed to accurately gauge the risk of default. Some banks, having invested in their own CDO products, face huge losses here.

•Another burgeoning financial product line is called credit default swaps – contracts designed to insure against loan losses. But these contracts haven't been fully tested.

Since no one knows how all this will shake out, "the lack of transparency … makes banks very fearful of lending to one another," says Mr. Lachman, now a scholar at the conservative American Enterprise Institute in Washington. That's worrisome, because in normal times, daily interbank lending is a routine facet of the economy.

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