How a credit crunch may hurt the world economy

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.

Is world banking system in trouble?

Not unless things worsen dramatically, experts say.

"What you have is a sectoral problem, not a systemic problem," says Edward Kane, a finance professor at Boston College.

Some financial firms – those most exposed to the subprime home-loan sector – face much bigger losses than others. Among the hardest hit is America's Citigroup. But Citi and others are still making new loans, and have a cushion against losses. Some may need to expand that cushion by cutting dividends or seeking capital from outside investors.

In this scenario, the global economy can escape major damage.

"That's an optimistic view," Ms. Packard says. "We see it that way."

But she says a pessimistic scenario is also possible, if global economic growth decelerates more than expected. That could push down prices of many assets – real estate, stocks, and more. Bank losses would multiply, and lending would be curbed more sharply. The downward pressure on asset prices could come partly from investors such as hedge funds if they are forced to "deleverage," to sell assets to cover losses on other investments made with borrowed money.

"It's like a lake where parts of the ice are very thin" for the economy to keep skating on, Packard says.

Even the optimistic case creates some headwinds of tighter credit.

"Credit costs will likely peak in 2009 or 2010," concludes a recent analysis by the investment firm UBS. But "we do not believe in a bank Armageddon scenario – [with] widespread bank insolvency."

Why are all these credit problems happening?

In part, credit tends to ebb and flow with the cycles of the economy. Loans often turn sour when their collateral – think US home prices – gets shaky.

Packard says a structural problem arose during an era of low interest rates: Too much money – including rising cash troves in developing nations – was chasing too few solid new investments.

And to the degree that money became artificially cheap, the resulting excesses can't last, economists say. "Eventually you're going to the pay the price," says Joseph Mason of Drexel University in Philadelphia.

Analysts lay part of the blame on policymakers. The trend of deregulation, some say, created a climate where bankers innovated with too little oversight.

Other say the financial industry may have become complacent in part because history tells them that central banks will be there with a safety net if things get tough.

Finally, finance experts say that private-sector players – including the firms that evaluate security risks – often have pay incentives that skew too much toward risk-taking, not enough toward caution.

What's the solution?

It may take months, but many experts say that credit problems will diminish as banks disclose their loan losses and gradually absorb them.

In the meantime, they say the key is for central banks to play a reassuring role. The Federal Reserve has cut short-term interest rates, and many central banks globally have provided new channels of credit for commercial banks to meet their short-term borrowing needs.

At the same time, even those who support these moves are concerned that the assistance not be over-generous.

A danger is "moral hazard" – the risk that policymakers simply encourage damaging future behavior if they essentially bail out banks that got themselves into a jam.

It's natural for big financial firms to play up the sense that there's a wide credit crisis, Mr. Kane says. Banks "would rather shift as much of the loss onto the safety net as they can."

The whole economy will pay, for example, if an easing of monetary policy fans extra inflation.

Jean-Claude Trichet, president of the European Central Bank, recently talked about the need to monitor "heightened" uncertainty, and to help ensure the smooth functioning of money markets. But he also said these efforts should not conflict with holding inflation in check.

A lively debate surrounds the question of achieving the right balance. Some say that monetary easing will help ordinary workers, not just banks.

"What central banks need to do is to reduce interest rates more aggressively," Lachman argues, "to prevent the present credit crisis from leading to a steep recession which would only deepen the present crisis."