What A Credit Crunch Looks Like

When the Fed decreases interest rates to increase loan demand, but the banks make it tougher to borrow because of deteriorating loan conditions, we have a credit crunch. The real problem is that the Fed will continue to decrease rates, but it will not achieve the desired effect. The Fed is running out of ammunition. The banks still have a ways to go in terms of deteriorating loan conditions. No one is sure how bad the economy in the US will get in 2008 and 2009, which will exacerbate both interest rates and loan opportunities. Ever wonder what a slippery slope looks like? Now you know. Text in bold is my emphasis. From Bloomberg:

The Federal Reserve said it became tougher for U.S. companies and consumers to get loans in the past three months, particularly to buy real estate.

Most lenders anticipate more delinquencies and losses this year, assuming ``economic activity progresses in line with consensus forecasts,'' according to the central bank's quarterly survey of senior loan officers released today in Washington.

The survey, conducted last month through Jan. 17, was available to Fed policy makers last week and may help explain the central bank's fastest easing of monetary policy since 1990. Chairman Ben S. Bernanke and his colleagues lowered their benchmark rate by 1.25 percentage points last month, aiming to revive lending and spending, averting a recession.

``It's definitely a broader-based tightening than we've seen before,'' said Edward McKelvey, senior U.S. economist at Goldman Sachs Group Inc. in New York. ``The economy is weakening and weakening in a pretty substantial way.''

About 80 percent of banks raised standards on commercial- property loans, a record, while a majority tightened terms on prime home mortgages.

Bernanke warned in a Jan. 10 speech that there was ``considerable evidence that banks have become more restrictive in their lending to firms and households.''

``Financial markets remain under considerable stress, and credit has tightened further for some businesses and households,'' the Federal Open Market Committee said in its Jan. 30 statement.

The survey covered 56 domestic banks and 23 foreign institutions. The 56 banks together have $5.95 trillion in assets, representing about 54 percent of the country's $11.1 trillion total for all domestically chartered, federally insured commercial banks.

About one-third of U.S. banks said they increased their standards on commercial and industrial loans, while two-fifths said they widened spreads of interest rates over their cost of funds. Both responses represented an increase from the October.

In commercial real estate, the proportion of banks tightening terms was the highest since the Fed began seeking information on the subject in 1990. About 45 percent, on net, of both U.S. and foreign institutions said demand for such loans weakened in the past three months.

Many banks became stricter because of a ``less favorable economic outlook,'' and a ``large fraction'' of U.S. banks reported a ``reduced tolerance for risk,'' the Fed said. Examples of credit standards in commercial real estate include the maximum loan size and maturity and loan-to-value ratios, the Fed said.

For home loans, about 55 percent of U.S. banks toughened terms for prime mortgages, up from 40 percent in October, while 85 percent of respondents made it tougher to get nontraditional loans, up from 60 percent, the survey said. A majority of U.S. respondents said demand worsened for prime, nontraditional and subprime mortgages. (Remember my comments about how the demand for housing was being choked off?)

The Fed also asked banks about their outlook for delinquencies and charge-offs in 2008. For seven of eight questions, no banks expected loan quality to improve for business and consumer loans; most expected the quality to worsen.

Banks are making it tougher to get financing after $146 billion in asset writedowns and credit losses since the beginning of 2007 damaged their balance sheets.

Surging defaults on subprime mortgages caused losses to ripple through the finance industry, and banks and securities firms are now searching for as much as $84 billion of capital to shore up their finances.

Fed Governor Randall Kroszner today urged lenders to ``quickly'' enact modifications of home loans at risk of default, before 2 million mortgages reset higher over the next two years.

The Treasury last year brought mortgage lenders together through an alliance called Hope Now to fast-track loan modifications and keep Americans in their homes.

Today's Fed survey showed that 35 percent of respondents expected ``streamlined loan modifications of the sort proposed by the Hope Now alliance to be at least a somewhat significant loss- mitigating strategy for banks.''

Some 85 percent of banks said loan-by-loan modifications based on individual circumstances would be ``significant'' in their approach to stemming losses.

``As rates reset, it is important that we take steps to protect homeowners, communities, the mortgage market, and the economy from the adverse consequences of unnecessary defaults and foreclosures,'' Kroszner said in a speech at a conference in Las Vegas today.

Housing figures have yet to signal a recovery. A report last week showed that purchases of new homes in the U.S. unexpectedly fell to a 12-year low in December, capping the worst sales year since records began in 1963. The median price dropped 10 percent from December 2006, the most in 37 years, the Commerce Department said.

The tougher standards may have yet to spread to smaller companies. William Dunkelberg, chief economist at the National Federation of Independent Business, which conducts its own survey of members, said he hasn't seen ``any difference in credit availability for small businesses'' since mid-2007.

Credit-card lenders have tightened loan standards for consumers in California, Florida and other states most affected by the housing slump. Citigroup Inc., the third-largest lender to Visa Inc. and MasterCard Inc. cardholders in the U.S., reduced lines of credit for borrowers it considers more likely to default and had to double fourth-quarter reserves for card losses.