Borrowers: Out In the Cold

David Stoyka, a senior account executive at Marx Layne & Co., a public-relations firm in Farmington Hills, Mich., was surprised to receive a letter in January from Countrywide Financial Corp. The mortgage lender had frozen access to his $25,000 home-equity line of credit, on which Stoyka and his wife owe about $16,000. "I had never missed a payment, and have excellent credit," he says. But with housing values declining, wary lenders are turning off the spigots, even to residents of tony Grosse Pointe Farms.

Six hundred miles to the east, a drama is transfixing New York's real-estate community. Harry Macklowe, one of the city's largest landlords, was unable to refinance $7 billion in short-term debt taken out to buy a portfolio of New York office buildings in 2007. He's been feverishly negotiating with lenders to stave off default. Macklowe has put the iconic General Motors Building on the block in an effort to raise cash.

From homeowners in Michigan to Wall Street financiers, Americans at every income level are caught in a full-blown credit crunch. While problems in housing-related credit are now familiar even to casual readers of the financial pages, the rot of bad debt is spreading. "In addition to mortgages, there are also indications that people are straining in credit cards, auto loans and student loans and default rates are starting to rise," says Nouriel Roubini, professor of economics at New York University.

That's bad news for a country that already seems on the brink of recession. If America's $14 trillion economy is a high-powered engine, credit is the motor oil that helps it run smoothly. When the lubricant is in short supply, the economy—like an engine—is more prone to knocks and stalling. "A year ago it was 'no borrower left behind'," says Adam Levin, president of, the San Francisco-based consumer-education firm. "Now it's 'no borrower is getting on the train'."

To a degree, today's credit crunch is the inevitable and entirely predictable flipside of the credit binge of the past several years. Banks that have taken 10-figure write-downs and credit losses on subprime mortgages and other soured debt are raising capital from foreign sources, and generally hoarding cash. Finance, like physics, is subject to Newtonian laws. And as Newton's third rule of motion notes, every action inspires an equal and opposite reaction. "The wild euphoria of a year ago devolved into abject pessimism and almost panic in some quarters of the credit market. It has gone from free flowing and cheap to bottled up and increasingly more expensive," says Mark Zandi, chief economist at Moodys/

As in past credit dry spells, high-risk corporations and homeowners with poor credit face the prospect of paying more for debt. But in this, the first debt drought of the 21st century, the impact is evident in unexpected places. Due to the well-documented subprime losses—and to the generally weak housing market—caution has spread to the entire home-lending industry. In the Federal Reserve's January survey, 55 percent of U.S. banks said they had tightened lending standards on prime mortgages in the past three months, while 60 percent had done so for home-equity lines of credit. Lenders are focusing the types of loans they can sell to Fannie Mae, or Freddie Mac, the government-sponsored entities that purchase mortgages meeting strict criteria. According to Inside Mortgage Finance, in the fourth quarter of 2007, 68 percent of all new mortgage debt was so-called agency debt. The upshot? "Anyone who doesn't have a big down payment or equity in their home or good credit may be out of luck when it comes to getting a mortgage," says Guy Cecala, publisher of Inside Mortgage Finance.

In Grosse Pointe Farms, where property values have fallen markedly, David Stoyka isn't banking on getting access to his home-equity line of credit any time soon. "I'm very concerned that housing values will never come back to where they were." Similarly, Mike and Ann Todd have also felt the crunch, despite good credit scores. Because of tighter credit and the declining value of their home in Shelby Township, Mich., the couple had a tough time getting their mortgage modified in December—they now owe more on the home than it is worth.

With their homes no longer functioning as ATMs, many Americans are looking to credit cards to finance purchases. But as defaults on credit-card debt have risen—in December, 7.6 percent of credit-card balances were either 60 days late or in default, according to Risk Metrics Groupcredit-card issuers have morphed into Scrooges. "Given recent market trends, we have changed the underwriting criteria for applicants with certain mortgages and suppressed credit-line increases on accounts with high-risk mortgages," says David Nelms, CEO of Discover Financial Services. About one third of credit-card applications are approved today, down from 40 percent last year, according to Robert Hammer, chief executive of credit-card consultant R.K. Hammer. Borrowers also can expect higher late fees, rising interest rates, and caps on borrowing limits.

Higher fees aren't the only indirect impact of the credit crunch. Credit comes from the Latin credo—meaning "I believe." The now global credit markets, which ultimately dictate the interest rates a homeowner in Cincinnati pays for a $200,000 mortgage or a big corporation in Denver pays for a $2 billion bank loan, are suffering from a crisis of faith. While the credit crunch is driven in large measure by the rising real problems in mortgages and consumer lending, it has a large psychological dimension. "There's been a shift in the collective view of risk," said Zandi.

Today loans aren't simply extended from lenders to borrowers. They are packaged into securities; sliced and diced into pieces, and sold as investments to hedge funds, pension funds, mutual funds and financial institutions. But with many of these funds having been burned on disastrous subprime bets, many of the buyers who helped maintain an orderly market for debt have disappeared, while the survivors are twitchy and suspicious. They have lost faith—in the ability of borrowers to pay back debts, in the ratings assigned to debt and in the companies that insure many forms of debt.

This crisis of confidence is creating occasionally bizarre dislocations in credit markets. Municipal bonds, bonds issued by governments whose interest payments are tax free, are among the safest investments in the world. But in recent weeks, a subsection of the market—the auction-rate market, in which rates reset every week—seized up. Interest rates on the bonds of the Port Authority of New York and New Jersey, which collects tolls on the George Washington Bridge, spiked to a bizarre 20 percent. The lack of ready buyers for securities also explains why people with excellent credit who seek jumbo loans—mortgages larger than the amount Freddie Mae and Fannie Mae will buy—have to pay higher rates than they did a year ago.

Student borrowers who are not eligible for federally guaranteed loans are likewise facing higher interest rates and fewer choices. Lenders in what is known as the private market, like First Marblehead and Sallie Mae, have realized they extended too much credit to students who might not be able to pay it back. Sallie Mae is scaling back commitments to lend to students at for-profit schools like Corinthian Colleges. In a conference call with analysts, First Marblehead said it will increase "fees and rates that borrowers will pay."

The credit crunch is now spreading to the corporate world, which had held up well even as consumers suffered. According to Standard & Poor's, in 2007 there were only 16 defaults on corporate bonds in the United States; in January, there were five. As a result, risky corporations are paying substantially more for debt today than a year ago. The spread—the difference between the interest rate on a 10-year Treasury bond and the typical rate a junk-bond issuer might pay—has expanded from 3 percentage points to 7 percentage points in the past year, according to Diane Vazza, head of global fixed-income research at Standard & Poor's.

The nation's most solvent individuals—private-equity barons—have not been immune from the ill effects of the credit crunch. In recent years, banks like Citigroup and Morgan Stanley willingly committed hundreds of billions of dollars to fund takeover deals for private-equity firms like the Blackstone Group and Cerberus—with the presumption that they could sell the loans to other investors. But as buyers have evaporated, the banks are now wary of extending further credit. Steven Schwartzman, the billionaire CEO of Blackstone, suffers no personal liquidity problems. But his firm, and others like it—have had to call off a series of proposed acquisitions because they can't get financing.

How bad will it get? The volume of bad debt—consumer, auto, student loan and corporate—is still rising. In theory, the Federal Reserve's campaign of lowering interest rates aggressively, which began in September, should help. The Federal Funds rate now stands at 3 percent, compared with 5.25 percent in September. But while that can help banks gain access to capital, lower rates alone won't help people who can't pay back mortgages, or companies that are unable to pay back loans, even at lower interest rates.

Policymakers are maintaining a stiff upper lip. But the data show the engine is running at a lower speed. Testifying before the Senate in February, Federal Reserve chairman Ben Bernanke dispensed with the usually opaque Fedspeak: "More expensive and less-available credit seems likely to continue to be a source of restraint on economic growth." Thanks, Mr. Chairman. That helps a lot.