Credit Crunch: The Sequel

As any smart investor will tell you, what looks like bad news is often good news in disguise. And that certainly seemed to be the case in March when investment bank Bear Stearns became the highest-profile victim of the credit crisis. Liquidity problems at the 85-year-old firm led the Federal Reserve to orchestrate an emergency loan and broker a merger with JPMorgan to prevent a financial catastrophe. But rather than seeing the unprecedented intervention as a sign that the banking system was dangerously fragile, Wall Street cheered and markets rallied. It was clear to the pros that Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson would do whatever it took to prevent a financial meltdown. In April, with Uncle Sam on the case, JPMorgan Chase CEO Jamie Dimon said the credit crisis was now "maybe 75 percent to 80 percent" done. And Goldman Sachs CEO Lloyd Blankfein told investors that "we're closer to the end than the beginning."

But rather than the beginning of the end, it now looks more like merely the end of the beginning. After that promising springtime thaw, credit markets have frozen up again. Mortgage rates are moving higher, and consumer loans are becoming tougher to get. And the bond market—spooked by potential defaults—is jacking up borrowing costs for businesses, making companies less likely to invest in new projects or add employees. More and more, economists are talking about an emerging "negative feedback loop," whereby a slowing economy generates higher credit losses at banks, which leads to more restrictive lending, weakening the economy even further, and round and round. "It's already happening," says New York University Prof. Nouriel Roubini. For an economy already struggling to grow, the result could be the nastiest recession in a generation.

Spreading concern. The economy's crankshafts can't turn without credit. Just ask former employees of Bear Stearns, which imploded in a matter of days after clients fled and funding dried up. Since then, credit has become even more elusive. Bond investors pushed the difference, or spread, between the yields of ultrasafe 10-year treasury notes and those of high-yield—or junk—bonds to more than 8 percentage points in late August. That's up sharply from an average spread over the past five years of 4.5 percentage points; it's even wider than spreads reached right after the Bear Stearns collapse. With companies that issue investment-grade debt facing similar headaches, firms of all sorts will be paying more for financing through the end of the year at least, says Diane Vazza of Standard & Poor's. At the same time, spreads between 10-year treasuries and 30-year fixed mortgage rates have returned to mid-March levels—the widest they've been since 1986. That means that, even with the Fed slashing its benchmark interest rate 3.25 percentage points since last summer, mortgage rates remain largely unchanged.

The big problem today is the same one that first seized up markets back in August 2007. The collapse of the housing bubble unleashed a flood of home foreclosures and defaults on subprime loans, which made investors unwilling to buy complex securities backed by mortgages. From there, problems spread far and wide, saddling banks with painful losses, cutting local governments' tax revenues, and forcing consumers to pay more for home loans. Mortgage giants Fannie Mae and Freddie Mac are the most recent victims of the turmoil, and concerns about their financial well-being have been a leading force behind the recent credit tightening, says Kim Rupert of Action Economics.

And despite the interest rate cuts and the Fed's liquidity measures, the credit contagion looks to many as if it has further to run. "There is increasing concern about what's the next shoe to drop," says Stephen Stanley, chief economist at RBS Greenwich Capital.

Failing banks. Indeed, the nation's credit problems seem to have moved off Broadway and out to the rest of the nation via regional and small banks. Federal regulators expect a growing number of small banks—especially those heavily concentrated in real estate lending—to go under in the coming months. The entire industry has reported higher loan delinquencies on everything from business to credit-card loans. The Federal Deposit Insurance Corp., which guarantees accounts at the nation's 8,500 banks, increased the number of "problem" banks to 117 in the second quarter, up from 90 in the first quarter. And the agency has even suggested that it may need the Treasury Department to lend it money to cover the costs of failures. Ten banks have failed so far this year, compared with three last year and none in 2006 or 2005.

Just how many banks will fail? Stanley Tate, the former chairman of the National Advisory Board of the Resolution Trust Corp., which liquidated the assets of failed savings and loans beginning in the 1980s, calls the banking industry's current problems "substantially more significant" than those he faced during the S&L crisis. The turmoil could take out as many as 2,000 banks, either through mergers or outright failures, he says. But few expect the tally to get nearly that high. Dick Bove, a bank analyst at Landenburg Thalmann, argues that the industry, while troubled, still has sound levels of capital, reserves, deposits, and cash flow. He expects 100 to 150 small banks to go under.