Credit Crisis
This, the shaky American economy did not need. If an imploding housing bubble and energy price superspike weren't damaging enough, our ailing financial system decided to slide into full cardiac arrest. And while the White House, Congress, and Federal Reserve have all shifted to DEFCON 1 to try to deal with the exploding credit crisis, even the perfect mix of fiscal and monetary policies seems unlikely to now prevent the worst recession in a generation. As JPMorgan Chase summed things up in a note to its clients: "The fat lady sings." The whole financial fiasco has moved far beyond liquidity problems on Wall Street. "This is the big one--the biggest financial crisis since the Great Depression," says financial historian Niall Ferguson. "It is, in fact, unlikely that even $700 billion will suffice to contain this great credit crunch we're witnessing."
Rather than being contained, the credit crisis has gone viral. Some of America's biggest companies, such as Caterpillar, McDonald's, General Electric, are now having trouble accessing the credit markets. Business borrowing has "imploded," according to Brian Bethune, an economist at Global Insight. And the longer businesses remain uncertain about the future, the more reticent they will be to hire and invest. Rising layoffs are already apparent on Main Street. New jobless claims are now running close to 500,000 weekly, a classic recession signal. But wait, there's more. Consumer loans are getting tougher to get, housing remains depressed, small businesses are experiencing the start of a capital crunch and, of course, 401(k) plans are getting walloped.
The ugly truth is that banking crises almost always come at a high cost to economic growth. And government bailouts and rescue plans usually mark the end of the beginning rather than the beginning of the end. As a Federal Reserve analysis of financial meltdowns in Sweden, Japan, and other nations concludes, "Banking crises have negative long-term effects on the economy, such as slow growth, high interest rates, and lower living standards." Just look at Japan, where a financial crisis in the 1990s led to the infamous "lost decade" of economic stagnation.
Splat! The credit crisis has landed firmly on Main Street, and here is how it is affecting all of us:
The Homeowner
Think of credit as the Benedict Arnold of the housing implosion. After all, cheap and abundant credit--remember breezy lending standards and subprime loans?--was a turbopump for the housing bubble, allowing even folks with checkered credit histories to get in on the action and bid prices higher. But amid the market's painful collapse--which has already dragged home prices some 20 percent below their 2006 peaks--credit has switched teams. Now, a reduction in the supply of mortgage credit is putting additional downward pressure on the housing market and threatening to prolong the worst housing slump since the Great Depression. "The same credit explosion that was driving up home prices is going to work toward driving them down," says Harvard economist Kenneth Rogoff.
Want to buy a McMansion? Big loans to even well-qualified borrowers are getting more expensive. And although fixed mortgage rates are still relatively low, banks--facing higher delinquencies--have jacked up their lending standards for applicants of all stripes. Harder to find are 5 percent and 10 percent down mortgages; 20 percent may again become the norm. (Overall, Bankrate.com reports an average 30-year fixed mortgage rate of just more than 6.0 percent. A 30-year jumbo mortgage is hovering around 7.27 percent.) While tighter mortgage credit isn't the leading factor behind the national decline in home prices--the bloated inventory of unsold homes is an even bigger problem--it's certainly making matters worse. Susan Wachter, a professor of real estate at the University of Pennsylvania's Wharton School, says that by keeping would-be buyers on the sidelines, the tigtening works to reduce demand even as prices fall. "We could overshoot on the way down as the market overshot on the way up," Wachter says.
Rogoff says tighter credit will make the downturn in home prices, adjusted for inflation, roughly a third worse than it otherwise would have been. He expects home prices to stabilize toward the end of 2009 after falling some 30 percent from peak levels. Of course, some cities are already there. Prices in Las Vegas are down 29.9 percent just in the past year. New York University economics professor Nouriel Roubini's outlook is even darker: He expects a decline of at least 40 percent from the peak. "The credit crunch is really having a meaningful negative impact on the worsening situation in the housing market," says Roubini, whose downtrodden economic outlook has earned him the nickname "Dr. Doom." But for homeowners, what's really scary is the accuracy of his past projections. Roubini called the collapse of the housing bubble back in 2006, and predicted the subsequent unraveling of the credit markets and the financial system with alarming prescience. - Luke Mullins
The Consumer
No one should be shocked to find out that spendthrifts with a wallet full of maxed-out credit cards are having a tough time getting loans these days. But even responsible consumers--the ones who follow such formerly passé advice as paying their bills on time each month and buying only houses they can afford--are starting to notice higher interest rates and less access to credit.
When Amanda Tossberg, a public relations consultant in Nashville, went to buy a 2008 Mazda Speed3 in late June, she was shocked when the dealer offered her and her husband close to a 10 percent interest rate on a $13,000 loan. "I said, 'What's the point of spending all these years working to build good credit if you're not going to get rewarded for it?' " recalls Tossberg, who says her husband's credit score is in the 800s. She told the salesperson such a high interest rate was a deal-breaker, and after some back and forth, he offered her a rate of 4.9 percent over 60 months.
About two thirds of banks told the Federal Reserve that they tightened their lending standards for consumer loans between May and July. Many student loan providers had already done so earlier this year, and several companies, including student loan provider My Rich Uncle, recently stopped offering private loans altogether. Matthew Towson, a spokesman for Discover, says the credit card company has reduced its marketing in high-risk areas and may offer consumers in those regions lower credit limits.
Bank of America has similarly heightened its credit standards and is now more likely to refer some card applications, especially those from areas of the country experiencing more economic stress, such as California and Florida, for review by credit specialists. At the same time, the average interest rates on credit cards have remained virtually unchanged at around 12 percent, according to LowCards.com, suggesting current cardholders have not experienced any major shifts.
Indeed, it's the people with sketchier credit backgrounds who are getting squeezed. Jesse Toprak, executive director of industry analysis for car site Edmunds.com, says some customers with poor credit are now paying upwards of 20 percent for car loans. Lenders have also started requiring larger down payments; the average for new vehicles climbed to $3,000 in September, up from $2,200 earlier this year.
Consumers close to foreclosure are also under extra duress, says Robert Strupp, director of research and policy for the Community Law Center, because banks have been reluctant to renegotiate mortgage terms while they wait to learn the details of the government's plan to purchase distressed debt. But considering that much of the financial crisis was caused by easy access to cheap credit, tighter lending standards ae only to be expected. - Kimberly Palmer
The Investor
After 18 years of do-it-yourself investing, retiree Alice Meyer is stumped. She faithfully stuck by a fairly aggressive portfolio of U.S. stock mutual funds through the 2000-'02 bear market, but today, she says the game has changed. "I'm not thinking as long term anymore," says Meyer, 65, of Faribault, Minn., who invests through an IRA. "I don't need the money immediately, but I don't know if it's going to be enough to last until I'm 85 or 90." Like many investors--especially retirees or those nearing retirement--Meyer is considering pulling her money out of the stock market and moving into more conservative investments. Some $43 billion flowed out of stock funds in September.
Younger investors have it easy: With decades to go before retirement, they can afford to ride out the turbulence. But older folks want assurance that their nest egg will be intact when it's needed. Just days before the Dow's 778-point drop on September 29, a fifth of people polled by Gallup said they'd seriously considered taking money out of the stock market, and 8 percent already had. "People who are most at risk are those that are five years out and five years in to retirement," says Mark Johannessen, managing director of financial advisory firm Harris SBSB in McLean, Va., and president of the Financial Planning Association. "If you just retired, you're sitting there asking, 'Do I need to go back to work?' and if you're a few years away, you're wondering if you have enough."
Before doing anything drastic, a plan is in order. Johannessen suggests investors identify how much they'll need each year in retirement, then stash away five to eight years' worth of cash needs in safe investments (such as short- and intermediate-term bonds). But if you do want to pull some money out of the market, he says you shouldn't do it all at once; a better idea is to spread it out over a few months: "You never want to be selling into a 7.7 percent down day." Though for stock buyers, such drops serve as screaming opportunities.
Even if investors are already in retirement--especially those who are looking at a potential 20- to 30-year timeline like Meyer--it's a good idea to leave a large chunk of money in the stock market. That's because bonds' after-inflation returns are pretty puny. (Since 1926, bonds have produced an average annual return of just 2 percent after figuring in an annualized 3 percent for inflation, according to Morningstar.)
Assuming a diversified portfolio, investors might not want to change anything, says Gary Hager, founder and chief executive of Integrated Wealth Management in Edison, N.J. "The sky is not falling. There's an incredible amount of emotional noise on the street right now. In 20 years, this is the most scared I've seen people," he says. Hager recommends investors devote a slice of their investments to alternative asset classes, such as commodities or metals, which add some insulation in volatile markets. "If the market does nothing but go down, your portfolio will still suffer, but it'll be nowhere near the suffering if you just have stocks, bonds, and cash." - Katy Marquardt
The Small-Business Owner
While a lack of liquidity in the commercial paper market is making a mess of funding for some Fortune 500 companies, it's a whole different ballgame when you scale down to the world of small business. According to a National Federation of Independent Business survey of a random sample of its half-million members, while only 2 percent of respondents in August saw their financial situations as their biggest problem, 10 percent did say they found loans harder to come by--the highest in more than five years. But NFIB chief economist William Dunkelberg notes that that number pales in comparison with previous economic downturns. In the early 1980s, some30 percent called access to credit their No. 1 headache.
Although credit is tightening, it's not completely clear how the increased turmoil in the credit markets since August has changed that equation when business owners were already saying banks were clamping down. But there's at least some reason for cautious optimism. Even though most banks have essentially stopped lending to each other, it does not mean they are not lending to businesses. Dunkelberg says that small, community banks--he is chairman of one in Cherry Hill, N.J.--are "not particularly affected" by the broader financial problems when it comes to making commercial loans. Notes small-business advocate and radio host Jim Blasingame, "If you're an established small business, you can get the money."
But even if there's no sectorwide credit crunch for small businesses yet, that doesn't mean many firms, especially the bigger ones, aren't being squeezed. George Gendron, director of the Innovation and Entrepreneurship Program at Clark University, says that right now, "there is no growth capital" for high-growth small companies with millions in sales--firms that tend not to deal with small banks. "I have never seen this population more concerned than they are today," Gendron says. Things might be getting worse, too. Rich D'Amaro, CEO of Tatum, LLC, an executive services firm, says that his clients--small and midsize businesses with $50 million to $500 million in annual revenue--are mostly finding growth capital "frozen," with the last 60 days especially bad.
Take the case of Steven Rothschild. He runs bulbs.com, a venture-capital-backed online light bulb distributor in Worcester, Mass., and has been seeking credit to finance a small acquisition. But a month ago, he was turned down by a large bank. The situation has forced Rothschild to consider hard choices: "Do you hoard cash, do you cut back on inventory--how insular do you become?"
Raising cash. Cutting back. Issues all of America is dealing with right now. - Matthew Bandyk
By Kirk Shinkle, Luke Mullins, Kimberly Palmer, Katy Marquardt and Matthew Bandyk