The Credit Crunch Cuts Deeper and Wider

Despite lofty commodity prices and signs of inflation, tight credit continues to torment investors and economists. Can U.S. exports save the day?

On Wall Street, the yearlong credit crunch continues to hog headlines. For example, the future is still in question for investment banks like Lehman Brothers (LEH) and mortgage financiers (, 8/22/08) Fannie Mae (FNM) and Freddie Mac (FRE).

Some retail banks have cracked under the pressure: On Aug. 22, Kansas bank Columbian Bank and Trust Co. became the ninth U.S. financial institution to fail during the current credit market difficulties.

Still, the loudest complaints on Main Street relate to rising commodity costs and inflation, especially expensive fuel and food. Gasoline prices have become a key issue in the Presidential campaign. U.S. consumers are spending less as retailers and restaurants struggle.

Stuck on Credit

So have inflation worries finally replaced credit conditions atop the list of investors' biggest concerns? Is the credit crunch finally waning? Not a chance.

An August survey of economists conducted by the National Association for Business Economics did show an uptick in worries about energy prices and inflation, to 16% and 15%, respectively. However, 46% of economists said the credit crunch and the state of the financial system was their top worry.

"The more persistent threat is going to be the credit crunch," says First American Funds chief economist Keith Hembre. As the economy weakens and the unemployment rate rises, inflation pressures should ease, he says.

But the credit crisis is like a bad song stuck on repeat: Each time it plays, the tune grows more annoying.

The Wrong Momentum

More than a year of credit troubles has passed, with financial firms reporting hundreds of billions of dollars in losses from credit investments gone sour. Yet the crisis persists. It may be getting worse.

"The longer this draws out, the more difficult it's going to be to get the economy rolling again," says Gary Wolfer, chief economist with Univest Wealth Management & Trust.

Though pricey gasoline hurts in the short term, many economists say they worry more about tightening credit. If businesses and households can't borrow money, economic activity inevitably slows.

"Banks are reluctant to lend," says Michele Gambera, chief economist at Ibbotson Associates. Stuck at high levels are the interest rates banks charge other banks, as well as those they provide mortgage-seeking home buyers. In many cases, private equity firms can't borrow to launch leveraged buyouts.

Best Not to Need Credit

"Everyone is tightening credit," says Robert Ellis, a banking expert at financial consultancy Celent.

Credit-worthy home buyers or corporations can still get loans—even if many need to jump through more hoops. "I'm sure Warren Buffett can get a good home loan at any time," quips Gambera.

But if you're struggling financially and really need credit, there's a good chance you won't find it. Subprime home buyers with poor records have been frozen out of the mortgage market, and strained financial firms are having trouble finding lenders or investors.

Mistrust Among Banks

U.S. consumers can still get credit cards, but banks are less interested in allowing customers to transfer balances at low interest rates, Ellis says. In any event, credit cards with 20% interest rates are a poor substitute for lower-rate home equity loans. As housing prices have fallen, banks have drastically cut back home equity lending.

And then there are lingering threats of more losses at banks, or further bank failures.

"Banks must really convince each other of being sound," says Gambera. More writedowns and mortgage losses might persuade the industry that the bulk of losses have finally been wrung out of the system. Even now, most banks believe most other banks are financially secure, Gambera says, but they're reluctant to lend to each other because they're uncertain exactly "who is not O.K."—that is, which banks might fail and be unable to repay their debts.

Can Exports Save the Day?

When it comes to the credit crunch, nearly every problem eventually leads back to the poor condition of the U.S. housing market. Hembre believes the credit environment will remain knotty until home prices stabilize. "The biggest component of the credit markets is mortgages," he says, so the credit crunch won't end until the housing market works out the vast oversupply of homes.

But the housing sector's ills could take years to work themselves out, absent a massive effort by the U.S. government to revive the housing and credit markets.

Some economists hope that a jump in U.S. exports can keep the economy chugging along in the face of the credit crunch. Strong exports helped contribute to the 1.9% rise in U.S. gross domestic product in the second quarter. Calling this "a remarkable improvement," Gambera says a sustained rise in exports would be "the best hope we have for the economy turning around."

The Virtues of Thrift

A slowdown in the world economy, however, raises questions about whether the U.S. export boom can continue, Hembre notes.

When it comes to the credit crunch, there is a growing suspicion that Americans are witnessing not a temporary crisis, but a permanent shift in the way the U.S. economy operates.

"I really don't think things are going to [go] back to normal," Wolfer says, because the U.S. economy is shifting from a reliance on debt and consumer spending to an emphasis on saving and exports. "This is going to be a painful process," he says.

The nation Wolfer envisions would be stronger and more secure, with less debt and greater savings. For now, that's little comfort to investors dealing with the dismal conditions of the present.

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