Looks Like an Old-Fashioned Consumer Credit Crunch
Looks Like an Old-Fashioned Consumer Credit Crunch
Expect shock waves as credit standards and normal risk premiums return to the credit markets
by Dennis Jacobe
GALLUP NEWS SERVICE
PRINCETON, NJ – Once upon a time, a housing- and autos-led recession was a basic feature of the U.S. economic cycle. In those days, there were interest rate ceilings – a legacy of the Great Depression of the 1930s -- on the interest rates financial institutions could pay for deposits. As a result, as the Fed raised interest rates above those deposit-rate ceilings, money flowed out of local financial institutions, creating a "consumer credit crunch" that severely limited the availability of housing and auto loans. In turn, the economy slowed, often going into recession until inflation and interest rates came back down to levels that encouraged money to flow back into the nation's depository institutions.
Of course, all of those artificial regulatory limits on money flows are long gone and with them the experience of a consumer credit crunch. Today's financial markets allow the free flow of money worldwide, making liquidity readily available to consumers, businesses, and investors by way of numerous forms of securitization -- the packaging of loans for sale to investors. In fact, one of the factors extending the economic expansion of recent years and the boom on Wall Street that sent the Dow Jones average to a record 14,000 on July 19 may have been a worldwide glut of liquidity.
Over the past couple of weeks, however, financial market conditions have changed dramatically. As substantiated by the UBS/Gallup Index of Investor Optimism for July, the nation's residential real estate markets continue to get worse, not better. At the same time, the subprime mortgage debacle has many investors concerned about a consumer credit crunch and has sent the Dow Jones average plunging more than 800 points since its July peak. In this regard, the average investor may have been somewhat prescient in UBS and Gallup's most recent poll, because the Index of Investor Optimism declined in July for the second month in a row. In addition, the issues of a significant tightening of global liquidity, a U.S. consumer credit crunch, and the possibility that the current economic slowdown might turn into a full-fledged recession are likely to be major discussion topics as the Federal Open Market Committee (FOMC) meets this week.
Residential Real Estate Continues to Deteriorate
The old quip that the light at the end of the tunnel is really a train coming through may well apply in most residential real estate markets as the summer comes to a close. During the first half of July, 71% of investors said they perceived that residential real estate conditions nationwide were getting worse. This maintains a pattern of pessimism concerning the national outlook for the housing market that has persisted in Gallup's surveys for many months. Further, 78% of investors said the potential for a housing or real estate crash in some local markets was hurting the investment climate a lot (41%) or a little (37%) during July.
It is likely that this national perception has been affected somewhat by the well-publicized problems of various housing markets that once were super hot, not to mention the subprime mortgage mess. As a result, the finding that 60% of investors believe conditions in their local real estate markets are getting worse is of even greater concern. Presumably, most of the nation's investors are much more knowledgeable about their local housing market conditions than they are about those nationwide.
Potential "Consumer Credit Crunch"
A consumer credit crunch takes place as lenders refuse to make money available to many if not most borrowers. During the first half of July, 76% of investors said the consumer credit crunch was hurting the investment climate a lot (40%) or a little (36%). This is not as high as some other investor concerns, such as the worry over energy prices, with 92% of investors saying those high prices are hurting the investment climate a lot (70%) or a little (22%). Still, its comparative newness as a significant investor concern, the general public's lack of recent experience with a real consumer credit crunch, and the fact that the UBS-Gallup poll was taken during the first half of July -- before the equity markets began their recent plunge -- all suggest that the danger of a consumer credit crunch was surprisingly high on investors' worry lists early last month.
Potential for Recession
Over the past couple of years, fears of a potential recession have tended to center on the willingness of the U.S. consumer to continue spending. In this regard, some have seen the bursting of the housing bubble as a reason for the consumer to pull back on spending as the "wealth effect" benefits of past homeowner equity gains dissipated. Similarly, soaring gas prices have been seen as another drag on consumer spending, particularly for low- and moderate-income consumers.
Still, many observers have argued that consumers will continue spending as long as they have jobs and can continue to borrow money. This is where the real danger of an old-fashioned consumer credit crunch comes to bear. A consumer credit crunch, as noted, takes place as lenders refuse to make money available to many if not most borrowers. In fact, even borrowers with top-notch credit scores can see their cost of borrowing surge higher as liquidity is reduced.
What causes a credit crunch? In today's financial markets, many lenders make loans but do not hold them in their portfolios. Instead, they sell them to investors in the form of securitized investments. What appears to be happening in recent weeks is that the huge losses associated with some subprime mortgage investments are not only creating significant new risk premiums but also causing potential investors to shun all mortgage investments not guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae. For example, on Friday various mortgage lenders announced that they could no longer sell various types of jumbo mortgage loans and special feature mortgage loans to the investment markets. As a result, some lenders decided to stop making various types of mortgage loans and sharply increase the pricing of the loans they would make.
Will this kind of consumer credit crunch be contained to selected areas in the mortgage market or will it spread to home equity loans/lines and maybe even to small business loans? The reality is no one really knows -- no one has any experience with this kind of potential liquidity problem. It depends on how much exposure holders of various kinds of securitized debt have and what happens to the value of that debt, particularly some of Wall Street's more exotic creations. What is known is that fears about the potential fallout in the mortgage securities market, not to mention a global tightening of liquidity, are already creating a consumer credit crunch. In this regard as well, the investors in our July poll may have been truly prescient.
Will There Be a Fed Bailout?
When the FOMC meets at the Federal Reserve Board on Tuesday, the discussions may include a number of topics not discussed in those hallowed halls for many years. Inflation, interest rates, economic slowdown, and even potential recession are fairly common topics for monetary authorities. However, "liquidity" is a totally different kind of issue. A lack of liquidity can lead not only to financial failures but also to the failure of the capital markets to function properly. Of all the responsibilities of the Fed, maintaining orderly financial markets heads the list.
At the conclusion of the FOMC meeting next week, monetary authorities may well come out with some reassuring words about the stability of the financial markets and their willingness to stand ready to provide liquidity to the system if necessary. On the other hand, they may say nothing about the liquidity issue, fearing that any statement will only make things worse, not better. Either way, the hope will be that the fears of the past couple of weeks will blow over and the credit crunch can be contained to the mortgage securities market. However, if following the FOMC meeting, the Fed states that it will provide liquidity to various investment banking firms and/or hedge funds, then a much more serious scenario may be underway.
Regardless, the return of a real consumer credit crunch would leave no doubt that the recovery of the housing markets will take a lot longer than previously anticipated and that consumers will have to pull back on their spending significantly. If that happens, then the probability of a recession late this year and into early 2008 would increase significantly.
Survey Methods
Investor results are based on telephone interviews with 800 investors, aged 18 and older, conducted July 1-12, 2007. For results based on the total sample of investors, one can say with 95% confidence that the maximum margin of sampling error is ±4 percentage points. In addition to sampling error, question wording and practical difficulties in conducting surveys can introduce error or bias into the findings of public opinion polls.
August 6, 2007 at 05:02 PM in Consumer trends, Financial Services | Permalink
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