Ominous Credit Squeeze

Political pundits and market analysts are continuously trying to discern the signs of the times, trying to pick out from among the seemingly innumerable particulars of life those few which, taken together, indicate the direction that politics, society, the markets, or the economy is taking, a direction which otherwise is wholly unexpected. We call this "connecting the dots." The dots are there. The trick is discerning which dots are the significant ones, and thus to be connected in forming a picture of the future. One of the things I try to do on my blog is throw dots out there that I think are significant.

Try these for dots.

I draw your attention to a report in today's New York Times, "Markets Fall as Lender Woes Keep Mounting" by Vikas Bajaj (August 4, 2007).

On the one hand, the economy is strong. Consumer confidence is high. Bajaj reports that, "yesterday’s jobs report was not weak enough to suggest that the Federal Reserve would cut its benchmark short-term interest rate when it meets next week." In addition, "investors now expect the Fed to cut its rate to 5 percent, from 5.25 percent by November...." On top of that, "businesses have been reporting strong earnings. Profits are up 9.6 percent in total for the 80 percent of the companies in the S.& P. index that have released results for the second quarter."

Sounds great! ...But...

Something is screwy in the housing market. Prices are ridiculous and there is trouble under foot.

When I was boy in 1972, my dad, a civil servant, bought a four bedroom home in a nice Toronto suburb for $45,000, a lot of m0ney at the time. His annual salary was roughly the same figure. Maybe it was less, but not a whole lot less. Today, on Long Island, for me to buy the same house I would have to pay seven times my income. (In addition, because of various forms of social decay which express themselves in the public school system through not only the students but also the teachers, we have the added expense of our children's private education.) What's happened?

Of course, since then women have flooded into the workforce. More dollars chasing the same goods = inflation. I know, it's more complicated than that. But it's partly that. In addition, credit has become quite freely available. No money down. 103% mortgages. People are in debt with second and third mortgages, car loans and of course high interest credit cards. More dollars chasing the same goods = inflation. People can pay more for homes, so sellers make sure that they do. The same is true of college tuition, by the way. Parents can borrow against their $400,000 homes, so colleges raise tuition and require it. (For the full story, see The Two-Income Trap: Why Middle-Class Mothers and Fathers Are Going Broke by Harvard Law School bankruptcy professor Elizabeth Warren and her financial consultant daughter Amelia Warren Tyagi.)

With that in mind, back to the Bajaj article. Too many people can't live too far beyond their means indefinitely. A crash will come and pain will be widespread.

"Mortgage companies have significantly tightened credit lately to borrowers with weak credit histories and are even cracking down on those with solid records who are taking on riskier loans."

Steve Walsh, a Scottsdale mortgage broker, sees "a liquidity crunch. It’s a credit freeze." Again, Bajaj:

"Lenders say they are increasingly unable to persuade investors to buy packages of home loans made to borrowers with little or no down payment or those who cannot fully document their incomes. As a result, many companies are no longer offering such loans to potential buyers (emphasis added)."

Loans to people "who cannot fully document their incomes?" Will someone explain that? Richard F. Syron, chief executive of Freddie Mac, speaks of "excesses in the market in recent years." With reference to the evaporating, but shortsightedly overextended credit pool, he says, “There are...loans that probably should never have been made and providing more liquidity will make that situation worse in the long term.”

Douglas M. Peta, chief market strategist at J. & W. Seligman & Company, a New York investment firm, says, “It seems to me things got every bit as silly in the credit markets in the last few years as they did in tech stocks in the late 1990s.” The housing market is flat, and I have been hearing about a lot of foreclosures recently.

If we see tighter credit and a wave of foreclosures while the economy continues to grow, that means hope that one-income middle class families like mine might squeak into the housing market. Everyone else should read The Two-Income Trap and radically reconsider the meaning of the word "credit limit" before they become foreclosure statistics themselves. But will the falling housing market take the economy with it?

Lesson for citizen-consumers: live within your means.

Lesson for statesmen: the public good still includes fostering a virtuous citizenry. You cannot leave this to the market. Far from supporting citizen virtue naturally with an invisible hand, the market is more likely to be what you have to combat.