Credit squeeze's potential ripple effects

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

from the February 19, 2008 edition

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"For marginal borrowers, it means it will be more difficult to get credit. And even those who are creditworthy, relatively speaking, they are going to be paying more than under earlier circumstances," he says.

The potential effect of this credit squeeze, says Kaufman, is that even if there is no recession, "the economic recovery will be modest and moderate rather than dynamic." This slow growth period, he predicts, will "dampen" the financial markets for some time.

Mr. Zandi thinks the implications of the credit problems could be even larger. Since the 1980s, the consumer share of the gross domestic product (GDP) has been about 70 percent. "Over the next few decades, that will decline and go back to about 63 percent, which is where it was from World War II to the early 1980s."

Some signs are already emerging that some consumers are having trouble getting credit cards, says Bill Hardekopf, CEO of LowCards.com, a consumer resource center on credit cards. "We are seeing a tightening of approvals, and they are no longer granting approvals to people with marginal credit," he says.

The tightening is extending to home-equity lines of credit, says Richard DeKaser, chief economist at National City Corp. in Cleveland. "The standard home-equity line used to be the prime interest rate [the interest rate charged to the best customers] minus half of a percentage point," he explains. "Now, we are starting to see prime minus one-quarter of a percentage point or just plain prime."

Individuals who have purchased their homes in the past year or two may even have negative equity in their homes since housing prices have fallen in many areas. "They would be unable to get the same line of credit," Mr. DeKaser says.

The reduction in home-equity lines could be particularly difficult for the economy because homeowners have tapped into them to modernize their homes, buy boats, or go on vacations. According to the Federal Reserve, as of Feb. 8 banks had $493.7 billion in outstanding lines of home-equity credit to individuals.

Lenders are also becoming much more selective in making loans to individuals who are buying homes for investment purposes. "One of the biggest elements of speculative borrowing was the Alt-A mortgage [a mortgage made to individuals who may not have a formal W-2 form, for example], meaning the borrower at least theoretically met the lender's requirements but didn't have all the documents," says DeKaser. "Buyers now will need more cash on their own. It's one of the reasons contributing to the decline in home sales in the last year."

Corporate borrowers are likewise finding it harder to borrow and run up their debt. "We have not seen a real downturn in nonfinancial companies, but if that happens, the companies will have some problems in servicing their debt," says Mr. Kaufman. "It's one of the risks as we look into the second half of the year."

As investors become more cautious in their lending strategies, a greater load is falling on the banks, says DeKaser. This is showing up as a surge in commercial loans. "There is probably some crowding out going on, and lenders are becoming more choosy about where to extend credit," he says.

However, DeKaser warns against too much pessimism. "Just as we thought easy money would last forever, tight money won't last forever," he says. "I would caution against reading the moment as more permanent than it is."

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