Credit Contagion

In the face of the worst credit and financial crunch since the Great Depression, many of our politicians, commentators, and even nonfinancial CEOs seem to be in a state of virtual denial of the risks we face. Mere talk about change and hope will not cut it. The past has caught up with us, and there won't be much of a future until we work those problems out.

We are having a bad hangover from easy money. Very easy. Thanks to low interest rates and an expanding money supply, people and companies borrowed more than they could reasonably pay back. The average debt-to-income ratio for the middle class in America has climbed to 141 percent, twice what it was in 1983. In the United States as a whole, the ratio of all debt to GDP rose to 342 percent at the end of September 2007, more than double what it was in 1975. It grew rapidly after 2000, in what could be described only as a bubble.

Asset prices increased and economic growth accelerated with a double bubble in credit and housing. Banks were willing to lend more and more to purchasers who bid more and more for a house, causing home prices to rise and giving the banks and other buyers even more confidence that prices would increase, justifying even more lending. So, too, with other asset prices. Banks set up off-balance sheet subsidiaries that piled up debt; leveraged-buyout groups borrowed many billions to take companies private; hedge funds borrowed to invest in assets—and the beat went on.

Spreading problems. But the way up is also the way down. As the price of assets began to decline, the result was a contraction of debt as banks lost billions, first on subprime mortgages that rested on declining residential real estate. Then the contagion spread to other categories of debt: credit cards, car loans, student loans, leveraged-buyout loans, commercial mortgage-backed securities, and other financial instruments—all of which once looked solid and now began to experience capital losses. Banks had to call in lines of credit because they needed to rebuild their capital and fulfill their capital ratio requirements, which meant reducing loans, forcing more borrowers to sell assets, which begat lower prices, which begat further declines in the collateral of the bank loans, which begat banks cutting their loans and credit lines again. This became the inverse of the original debt buildup that once fueled asset prices.

One symptom of the bubble was that investors and lenders had come to depend on cheaper short-term borrowing to finance higher-yield long-term holdings. When lenders got nervous, short-term borrowing became either unavailable or too expensive. This is unprecedented, for in the past 26 years the yields on longer-term paper—the 10-year treasury notes—have been higher than the yields on the short-term paper—the 3-month treasury bills—for all but 22 out of 313 months, according to the Wall Street Journal's Jon Hilsenrath. This borrow-short, invest-long strategy has worked over 90 percent of the time. When it doesn't, the consequences are proving to be catastrophic because of the degree to which this kind of leveraged structuring took place. Where lenders once seemed to overlook this risk, there is now a crisis of confidence, causing bubbles to burst all across the credit markets.

With all this money available, credit cards, auto loans, and other consumer debt were extended to almost everyone who could walk, resulting these days in a dramatic increase in loan delinquencies and defaults. And this is coming even before the unemployment rate has increased cyclically and before a formal recession has struck. American Express has responded by raising its provisions for loan losses by 70 percent to $1.5 billion. Goldman Sachs predicts credit card losses will reach $100 billion out of the roughly $1 trillion in the revolving balances of all U.S. credit cards. Lending standards are being tightened on nearly all types of consumer credit, and this may lead to the first full-scale contraction of consumer credit in over 15 years. The concern is that consumers may be pushed to the breaking point, reflecting not only the shutdown of the their buying spigot but a fundamental shift in their optimism and confidence in the economy.

Public views of the economy are the most negative in 15 years. Six in 10 believe the United States is already in a recession, according to a recent Washington Post/ABC poll. As a result consumers, especially those nearing retirement, will increase their savings the old-fashioned way, not out of asset appreciation but out of income, raising the possibility that the consumption share of GDP will likely drop from the current level of 72 percent back to the 25-year trend level of 67 percent. This may mean a recession that will be longer and deeper than anything we've had since the end of WWII.