How to Survive the Credit Crunch

How to Survive the Credit Crunch
Illustrationby Jonny Hannah

Driving along Interstate 94 on the outskirts of Minnesota's Twin Cities, you can't miss the nation's largest mall. A massive citadel of consumerism, the Mall of America boasts some 520 stores in a space big enough to hold 32 Boeing 747s. Spend a few hours there and big numbers stop fazing you—numbers like the record $2.5 trillion in U.S. household debt, which rises to $13.6 trillion with mortgages tossed in. Bigger is better, you say, with a wink, charging that 52-inch flat-screen TV. I Yet the credit crunch could mark a major turning point for the U.S. consumer economy. Half a century of spend-with-abandon attitude may be winding down. The shift won't come about because consumers embrace a new frugality. What's happening is that the average consumer now looks like a towering risk to the folks who extended all the debt—credit-card companies, mortgage lenders, and, most recently, student loan outfits. And those lenders are pulling back, making it harder to borrow.

That doesn't mean the Mall of America is going to empty out like New York City in the new Will Smith movie I Am Legend. But the fallout from tougher lending standards should be making you think about adjusting your financial strategy, from plotting your portfolio to figuring how you'll finance home purchases and college educations. Says Ross Levin, a certified financial planner and president of Accredited Investors in Edina, Minn.: "The implications are gigantic when it comes to personal finance."

HOME EQUITY, NOT HOME ATM

Anyone shopping for a home will feel the immediate impact of the new attitude among lenders. With no-doc and low-doc mortgages a thing of the past, lenders are demanding more traditional 10% to 30% down payments. A 30% down payment? It sounds extreme. But maybe not, considering that mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) are hiking fees sharply for borrowers with less-than-stellar credit scores who put down less than 30% for a home.

A year or so ago, a credit score of 620 or above defined a good borrower. Now Freddie and Fannie are imposing a sliding scale fee, with a new 2% charge for anyone putting down less than 30% with a credit score of 620 and a 0.75% charge on scores between 660 and 679. The new prime borrower sports a credit score of 680 and above. Private mortgage insurers are also boosting premiums on homeowners.

Homeowners may also need to adjust retirement plans to reflect this reality: The rapid escalation of single-family home prices during the boom years of 1995 to 2005—when prices rose by an inflation-adjusted 44%—won't repeat. Home price appreciation should return to its long-term trend of just outperforming inflation, as homeowners and developers wait for young families, immigrants, and other new home buyers to accumulate enough capital to make a reasonable offer. Instead of home equity being tapped regularly as a sort of personal ATM, value will build over time.

A chilly credit climate will dramatically affect how much risk investors are willing to take. While using lots of leverage was greeted with a yawn not long ago, it's more often met now with alarm. The market's downdrafts have companies with conservative balance sheets looking sexier, and investors are making a flight to quality. Traditionally defensive blue-chip stocks, including soft drink and utility companies, have already made a sharp move in price.

To goose stock market returns without turning to leverage, more investors will clamor for lush dividend payments—but may not get them for a while. For much of U.S. stock market history, average dividend yields topped 4%, and more than two-thirds of the market's total return came from dividends. But over the past decade or so the dividend yield has averaged less than 2%. Eventually, the need of battered companies to attract more shareholders may turn the tide, but right now the credit crunch has more companies husbanding their precious cash and cutting dividends.

Among bonds, quality will also be king.

Before the subprime debacle, investors weren't demanding a big premium for taking on far more risk with junk bonds than they were with Treasuries. That's changing. Rating firm Moody's (MCO) predicts the default rate on junk bonds will jump from its current record low of less than 1% to 4.2% if there isn't a recession in 2008—and 10% if the economy slumps into negative territory. If past is prologue, returns would be squeezed by the twin pincers of rising defaults and falling sales. In 1990, with the onset of a recession, junk-bond returns fell 4.4%.

That said, investors won't be content pouring money into two-year Treasury notes yielding 2.76%, and 5-year Treasuries at 3.15%. No, investors will try to bolster returns by focusing on higher-quality corporates. For instance, two-year mortgage-related securities from blue chip Fannie Mae yield 3.29%; five-year notes yield 3.89%. There's no get-rich-quick scheme in buying securities yielding slightly more than Treasuries. But there's a lot less risk in the portfolio.

With gains harder to come by, households may decide the best way to earn a good return on cash is cutting debt. By paying down credit-card debt, you lock in a return equal to the interest rate on that debt. For instance, if an investor carries $20,000 in credit card debt with a rate of about 14.4% (the current average rate for a credit card), paying off that debt is the equivalent of earning a 14.4% rate of return in the market.

The credit crunch is also roiling the world of student loans. For more than 30 years, students and their parents have funded a tuition bubble with borrowed money. But more of them will now pay with savings and grants rather than loans, much like in the '50s and '60s. That's because the $78 billion student loan market is retrenching in light of rising defaults and worries about student debt levels. Sallie Mae recently noted in a regulatory filing that it will become more selective in its loan originations.

Helping fuel the skittishness is research exploding the myth that student default rates are the modest 4% to 5% cited by the Education Dept. Reaching back into the early '90s and following student experience over the years, the white student default rate is about 7% and the African-American rate nearly 40%, according to researcher Erin Dillon of Education Sector, an independent think tank in Washington. One in five students with loans of $15,000 or more defaulted during the 10 years after graduation.

Some borrowers will be squeezed out, but a number of colleges are eliminating loans for middle- and low-income students in favor of grants or sharp tuition cuts. Harvard got the most attention when it cut tuition to families earning up to $180,000 a year; they'll pay a maximum $18,000 a year, compared with the more than $30,000 tab today. Close to 40 more colleges have eliminated or mostly cut out loans, especially those to low-income families.

In the end, the credit crunch may force consumers to do what financial planners have urged for years: Cut debt, make sure returns compensate for risks—and be patient.

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