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.

Meanwhile, with investors less eager to buy up mortgage loans, lenders have tightened on borrowers. This is typical of any credit squeeze after a boom, but the recent boom was so big that the squeeze could put an unusual amount of downward pressure on home prices over the next year or more.

For most homeowners, their house is their most important financial asset. "This time, they will feel it more" than in past eras of financial-sector tightness, says Rajeev Dhawan, who heads Georgia State University's economic forecasting center in Atlanta.

Just as financial ease fed the housing boom, the end of the housing rush has blown back at financial markets, causing home prices to fall. But unlike in the past, the housing boom faded without the onset of a recession or a significant rise in mortgage rates; the surge in home buying and easy lending simply reached a point where too few buyers remained to sustain the momentum.

Now, as mortgage rates have edged upward, consumers face another financial head wind. More home buyers have been drawn to adjustable-rate loans, rather than loans with fixed rates, in recent years. As those loans reset, the pinch of higher mortgage payments is likely to push foreclosure rates higher, economists say.

The problem: many of the recent adjustable loans came with low "teaser" rates, but payments will reset much higher.

Meanwhile, lenders have grown pickier about whom they lend to, because it's no longer easy to resell the loans as mortgage-based derivatives. Countrywide Financial Corp., a large mortgage provider, summed up its own situation in a statement last Thursday: "[The] situation is rapidly evolving and the potential impact on the company is unknown." Those words might be echoed by many hedge funds and Wall Street brokerage houses.

Wall Street could remain a volatile place in coming weeks as investors try to sort out the scope of the problem.

The irony is that derivatives have been viewed by many as a tool for reducing risk, in part by spreading it around. But they did not eliminate risk. And, in a way, the risk was just repackaged.

"Things designed to reduce risk, at certain special times, have a way of not always going perfectly," says Peter Kretzmer, an economist at Bank of America in New York.

Despite the credit-market challenges, most economists expect that the fallout on Main Street won't be bad enough to send the economy into recession.

"I doubt it's going to ripple very much," says Mr. Hymans.

Mr. Kretzmer adds that, "Only really large changes in the valuation of securities and wealth matter" in terms of consumer spending. Most consumption, he says, hinges on two factors, "Do I have a job, and what is my income growth like?"

Unemployment remains low in the US. Most economies worldwide have been growing solidly. Perhaps most significant is that central banks have shown in recent days that they stand ready to calm credit markets if they appear to be freezing up. The Federal Reserve funneled $38 billion into the system Friday. In addition, some economists believe the Fed will cut short-term interest rates soon.

"They're clearly vigilant," but not panicked, says James Sarni, a managing principal at Payden & Rygel, a fixed-income mutual-fund company in Los Angeles. "I think they're doing the right thing."