The credit crunch: a domino effect.

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Introduction

In the shadow of the spotlight focused on the faltering nationwide housing market comes the all-encompassing catch phrase "credit crunch." However, the term is neither a prophet of doom nor is it unique only in light of housing, especially--as have assumed--subprime mortgage loans. Like dominoes, many factors impacted the economy to cause the current credit crunch, which, in turn, will impact other economic factors.

What Is a Credit Crunch?

To best understand the problem, it is necessary to define the term credit crunch. According to Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor, a credit crunch is a "period during which borrowed funds are difficult to obtain and, even if funds can be found, interest rates are very high." (1) Literally, a credit crunch is a time when borrowing money comes at a higher risk and a higher cost. However, Alex Wallenwein bluntly defines the root of the problem as a vicious cycle of debt feeding upon debt. (2) A credit crunch can be described (and has been described) as a "capital crunch," where a "shortage of equity capital has limited banks' ability to make loans, particularly in the most affected regions," and these banks have "imposed costs on some borrowers." (3) During a credit crunch, "lenders stop lending and start hoarding cash because they are afraid of rising bankruptcies and mortgage defaults. It leads them to charge higher interest rates or reject all but the safest loans." (4) Whichever definition is chosen, the fact remains that the nation is in the grips of a credit crunch, and the full effect and outcome remain to be seen.

Causes of the Credit Crunch

As implied earlier, most journalists are quick to point their fingers at subprime mortgages as the sole cause of the current credit crunch. However, while subprime mortgages are a major culprit in the current credit crunch, they are not the only contributor to the problem. In fact, the credit crunch may be seen as the end result of banks and credit companies offering easy credit and consumers spending beyond their means for way too long. Even with a poor credit rating, the American consumer has been bombarded with advertisements offering easy loans for large-item electronics and other luxuries. Often spurred more by envy than need, consumers have, in turn, refinanced or borrowed against home equity, forsaken savings, and used credit cards as cash. This self-destructive cycle, compounded by a slowing economy, overall falling stocks, increasing fuel prices, stagnant to negative job growth, the housing market slowdown, and, of course, the subprime mortgage debacle, has been part of the chain reaction that has led to the current credit crunch.

In 1993, Robert T. Clair and Paula Tucker noted six distinct causes of another credit crunch. In their findings, Clair and Tucker identified the following factors as contributors to the 1993 credit crunch: (5)

1. Declines in bank capital

2. FDIC and RTC resolution of failed depository institutions

3. Bank supervision overreaction

4. New credit standards set by bankers

5. Regulatory burden

6. Cost of increased legal exposure

One may compare these factors to Benjamin Bernanke's thoughts on the Federal Reserve's recourse during a credit crunch: "... a credit crunch does not seriously affect the Federal reserve's capacity to stabilize the economy but that it may make indicators of monetary policy more difficult to read." (6) However, in reality, the Federal Reserve does not have the power to stabilize the economy or, more importantly, the consumer; it can only react to economic indicators by raising or lowering interest rates, which are used by the banks for the banks. In essence, the Fed can only impact the economy indirectly and imprecisely at best.

Historically, the Fed has often reacted too late and to the extreme. Although it is too early to declare that the current economy is in recession--the National Bureau of Economic Research defines a recession as a "period of total decline in total output and employment, usually lasting at least two consecutive quarters, or six months" (7)--the Fed has reacted to current economic indicators by reducing interest rates five times since September 18, 2007, to the current rate of 2.25 percent. (8) (See Chart 1.) Yet, drastically lowering interest rates to entice the consumer to continue to borrow is as much a factor of the credit crunch as all the aforementioned factors.

Credit Crunch Impacts

Just as multiple factors have caused the credit crunch, the impact is far reaching. Financial institutions will incorporate more stringent loan policies and tighten the outflow of funds. However, the credit crunch will impact more than credit cards and home loans.

Starting with the housing market, home builders will be cautious, and home buyers will be even more wary. New construction will come to a standstill and will not resume until the excess supply of homes is sold, which may take several months.

The tightening of funds will spill over into daily consumer spending that is already negatively impacted by sustained higher energy prices. Although the upcoming refund checks to all 2007 taxpayers will provide some much-needed economic stimulus in the near future, their impact will be diminished by the continuing threat of inflation (the weakening U.S. dollar coupled with higher commodity prices).

All these impacts eventually make their way into the job market. With decreased demand for goods and services due to higher prices comes the need for companies to control costs, which will mean job cuts. Thus, the ultimate increase in unemployment sets the stage for a probable recession.

Colleges and universities may see a decline in enrollment as student loans become more selective and scarce. (9) Also, this limitation of educational funds will further exacerbate the job market as fewer trained students will leave higher education to enter the already competitive job market. However, with an increase in unemployment, displaced workers traditionally seek new skills and training and often enroll in college.

Perhaps the most damaging impact will be the one felt by minorities. As banks tighten policies and restrict loans from high-risk borrowers, more and more minorities will likely be turned away by lenders, especially with regard to home loans and mortgages. Angelo Mozilo, former Countrywide Financial Corporation chief executive officer, expected that in the near future there will exist "substantial disparities between whites and minorities." (10)

What to Expect Locally

The good news is that the Memphis housing market will not be a total bust as it will in some areas, according to Phillip Kolbe, an associate professor in the Department of Finance at the Fogelman College of Business & Economics at the University of Memphis. "Memphis did not have the boom in housing that other areas, especially on both coasts, had," Kolbe observes. "But the good news is that Memphis will not have the bust of those areas, just a slowdown." However, Kolbe also states that "until residential real estate comes back, the economy will be slowed."

In regard to subprime mortgages, Ronald W. Spahr, Ph.D., a local economist and professor and chair of the Department of Finance at the Fogelman College of Business & Economics at the University of Memphis, sees the credit crunch as having an adverse impact on low-income individuals and families in the Memphis area. "Since Memphis has a larger than normal percentage of subprime mortgages and a relatively larger portion of lower income households, the effect of the subprime mortgage crisis may be more severe in Memphis than in other regions," notes Spahr. "Not only will lower income people lose their homes from foreclosure, but they will find it more difficult to obtain mortgages in the future." Kolbe does agree with the subprime mortgage issue by saying that "the key problem was that lenders gave loans to people who should have been turned down." He adds that "lenders have now gone too far in tightening their underwriting standards and are turning down potential mortgagors who should be approved."

The Government Steps In

In mid-February 2008, the Bush administration announced a new plan to aid those facing foreclosure and the loss of their home. Under the new plan, called Project Lifeline, homeowners more than ninety days behind on their mortgages will be granted thirty days to try to obtain more affordable terms from their current lender. When Project Lifeline was announced, six major mortgage lenders had signed on, including Bank of America, Citigroup, Countrywide, JPMorgan Chase, Washington Mutual, and Wells Fargo. (11)

Project Lifeline is intended to build upon the Hope Now Alliance plan that was announced in late 2007. The Hope Now Alliance plan was designed to help borrowers with adjustable rate mortgages by freezing their interest rates for five years. But, the borrowers must be current with their monthly payments and not have been more than sixty days late on a mortgage payment within the last twelve months. In addition, this plan only covers borrowers who have an adjustable rate mortgage that would reset beginning in 2008. Unfortunately, borrowers who are unable to afford the loan will also be ineligible. Unlike the Hope Now Alliance plan, Project Lifeline has no requirement other than that the borrower is ninety days past due on his mortgage. (12)

How to Ride Out the Credit Crunch