Credit squeeze's potential ripple effects

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.

"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."