Credit squeeze's potential ripple effects

As lenders tighten standards, the possibility of a recession increases.

By Ron Scherer | Staff writer of The Christian Science Monitor

from the February 19, 2008 edition

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New York - Americans from Main Street to Wall Street may have to live with less debt.

Despite steeply lower short-term interest rates, banks and investors are now becoming much tougher when it comes to handing out credit cards, providing home-equity lines of credit, agreeing to lend money for corporate takeovers, and even providing money for student loans.

If this tougher scrutiny continues, economists see potential widespread ramifications for the economy:

•The tighter credit increases the possibility of a recession and makes any recovery less robust.

•If banks remain more selective in their lending, it could start to shift the roots of the economy from an emphasis on consumerism to savings.

•It may become more difficult for Americans to buy houses for investment purposes, tempering any recovery in the housing market.

•Access to higher education could become more restricted. The credit markets have already made it harder for students with a bad credit history to borrow.

"We are wringing out the excesses from the frenzied times," says Mark Zandi, chief economist at Moody's Economy.com. "All this is happening very quickly."

Last week, Federal Reserve Chairman Ben Bernanke told Congress that the central bank's most recent survey of senior loan officers at large banks found further tightening of loan standards. "Credit that is more expensive and less available is a restraint on our economic growth," stated Mr. Bernanke in his testimony before the Senate Banking Committee.

At the heart of the changes are the enormous housing-loan losses that are coursing their way through bank earnings, insurance company portfolios, and even individual investors' accounts. As of the end of January, bank write-downs were about $120 billion, according to The Wall Street Journal. Analysts are now talking about $400 billion in total losses, about twice the estimates from last August when the problems in subprime mortgages became known.

"We still don't know who owns all those … products," says Dirk Nitzsche, a senior lecturer at the Cass Business School in London. "It will probably take another six months to know where we stand and how much will have to be written off."

The uncertainty about the amount of bad debt is confounding even veterans of past credit crises. "I have been around a long time and been through all these credit situations in the last 50 years, and this is more opaque and more diverse and more global than any of these former difficulties," says Henry Kaufman, president of Henry Kaufman & Co. in New York. "At the moment it's too early to say if we have a structural change taking place or this is a cyclical development."

Mr. Kaufman, a former chief economist at Salomon Brothers, says he does not doubt that banks will have to be less aggressive in lending unless they can significantly replenish their balance sheets.

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