Sinking Credit

The lending industry lowered standards too far. Now it's raising them abruptly, choking consumers when they need credit the most

At the head of Canada's Bay of Fundy, the salt water can fall a breathtaking 50 feet from high tide to low tide. But even the Bay of Fundy has nothing on the U.S. economy, where money has gone from superabundant to scarce in less than a year. The latest bad news: On Feb. 4, the U.S. Federal Reserve reported a sharp constriction of credit in its quarterly survey of banks' senior loan officers.

It appears that many banks are using the liquidity supplied by big Federal Reserve interest rate cuts to heal their balance sheets rather than to make new loans. "Restraint has become widespread, deep, and generic, affecting all types of borrowers and most types of loan categories," writes George Magnus, senior economic adviser at UBS (UBS) Investment Bank in London.

If Americans can't borrow, they can't spend as much. The increasingly dire numbers suggest that a consumer-led recession is likely if not already under way. Stoking such fears, the Institute for Supply Management reported on Feb. 5 a sharp decline in its index of nonmanufacturing activity in January. The report carved 370 points from the Dow Jones industrial average, the biggest one-day loss in nearly a year.

The first story in this week's Special Report zeroes in on the latest lending sector to feel a squeeze: credit cards. To guard profitability, issuers are imposing tighter lending standards, lower limits, and higher late fees. Some are cutting the credit lines of customers who appear to be on the edge.

But such actions could help precipitate the very recession that the card issuers fear most. Citing concerns of a recession, UBS on Feb. 4 slapped sell recommendations on the stocks of three of the biggest credit-card issuers: American Express (AXP), Capital One Financial (COF), and Discover Financial (DFS).

How did we get into this mess? One reason is that when the tide of money was still rolling in, lenders skipped the traditional vetting of borrowers and gave money to anyone with a decent FICO score—and plenty of people with mediocre ones. The second story in our package explores the company behind that score, Fair Isaac Corp. (FIC), and shows how a good idea in the wrong hands can lead to bad outcomes.

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