The Greatest Threat to the Current Economic & Housing Market Recovery

As I mentioned at the end of my blog article titled “Why What Happened on Wall Street This Week Was Important and What’s The Concern About Inflation”, dated Saturday 3/22/08, the situation to watch with regard to housing market recovery would be tightening credit which threatens to halt any recovery. Well, that is exactly where we are at right now!

Here’s exactly what I said in that article: “We now have a situation in which lenders do not want to lend. The danger here is that the Fed is wanting to stimulate the economy while the banks are digging in their heels. This is the situation to watch at this point. It will be interesting to see how this works its way out.”

We are now navigating this difficult and potentially perilous course in the river of economic recovery. Here’s what’s going on:

Over the last three months, according to the Federal Reserve, consumers and businesses have found it more difficult to borrow money. In other words, we are experiencing a credit crunch.

According to a survey done by the Fed (Senior Loan Officer survey) in April, more than half the banks surveyed said they have tightened up on commercial an residential loans, real estate loans, and home-equity lines of credit. Back in January only about one-third of those banks surveyed had tightened credit.

The credit crunch has effected more than the sub-prime segment of the market. In fact, it affects almost every borrower. What this translates into is less borrowing, less (and slower) economic growth, and less consumer spending – not the stuff that supports an economic recovery.

Why have the banks tightened credit? Because they need to minimize their risks and turn a profit on their loans in order to stay solvent. As a result, banks demand increasing interest-rate spreads on loans (the difference between a lender’s cost of funds and the rate they charge to their customers for those funds), more documentation, more collateral, etc.

25% of the banks surveyed are less willing to make consumer loans. Requirements being place on home-equity loans and even credit cards are becoming much tougher. Few banks are willing to make student loans for the next academic year.

Nearly 80% of the banks surveyed have increased standards for commercial real estate loans. Concerning commercial and industrial loans, 55% of banks have tightened their standards as well.

The tightening of credit, to one degree or another, is necessary at a time like this. Not long ago, people who had dubious credit did not have much of any problem obtaining loans. People were beginning to feel that obtaining money by credit was a right, not a privilege regardless of their credit-worthiness. These questionable loans, in many cases, have now become loans in default thus causing lending institutions to suffer with some of them even going into default. So, now we are back to reality and realize that credit truly does depend upon a person’s credit-worthiness.

However, at a time when the Federal Reserve is loosening credit and seeking to make money cheap to borrow, the banks are doing just the opposite. This does not bode well for an economic recovery. As a matter of fact, while it commonplace for lenders to tighten up credit during an economic downturn, lenders are tightening up even more than they have in past downturns.

When credit standards are changed (either loosened or tightened) there is usually a lag of about 9 months between when this happens and the impact it has on the economy. As credit tightens, it will blunt, or perhaps even stall, the effects of an economic recovery and expansion in the months and next few years ahead.

As I mentioned in a blog article posted earlier today 5/10/08, titled “Investors Begin Buying Up Mortgages – A Very Good Sign For Economic Recovery”, investors are starting to buy up billions of dollars in mortgages that have been stuck on the books of banks. While this has not yet freed up money for new mortgages, it is a critical precursor for banks to begin lending again at levels that will both secure good risks for them but also loosen credit sufficiently and have the intended effect of supporting and hastening, not halting, a economic and housing market recovery.

The action of the banks by tightening credit at this time is perhaps the most critical matter and potential stumbling block concerning the recovery of the economy and housing market. It is certainly worth watching and seeing what the Fed, Administration, and GSEs (government sponsored enterprises such as Fannie Mae and Freddie Mac) will do.

Another major concern for the housing market is that of record losses sustained by mega-lenders such as Countrywide Financial Corp. and GMAC. However, that is the subject of another article at another time.

-Written by Ross Gill