Credit Crunch May Impact '08

Don't believe all the hype about the "credit crunch." Not yet, anyway. It's supposedly suffocating the economy. Big banks and investment houses have suffered multibillion-dollar losses on "subprime" mortgages and related securities; CEOs have departed. But outside of housing —where lending has collapsed—the effects on consumers and businesses have so far been modest. What we should be wondering is whether all this is the first act of a three-act drama, or whether the worst is past. If it's act one, the crunch isn't just about economics. It could decide the next president.

People vote their pocketbooks, as the old saying goes. Up to a point, this is unfortunate, because politicians of both parties usually get too much praise or blame for the state of the economy, when their influence on its behavior is often negligible. Voters ought to cast their ballots on issues where what politicians do, or don't do, matters. But politics isn't always rational or fair, and a slowing economy is already a burden that—along with Iraq— Republicans will carry into the election. A harsher credit crunch could be fatal.

Consider the latest economic forecast from Global Insight, a well-known advisory firm. Though not yet predicting a recession, it sketches an economy that won't feel good for much of the 2008 election cycle. To wit:

• Housing's slide continues. New home starts fall to 1 million, down from 2.1 million in 2005. By early 2009, home prices decline a cumulative 11 percent from their peak. On a median-priced home of $220,000, the loss is $24,000.

• Car and light-truck sales dip to 15.7 million, the lowest since 1998; they were 16.9 million as recently as 2005.

• Unemployment averages 5 percent, up from 4.6 percent this year.

• Pretax corporate profits decline 2.1 percent, the first decrease since 2001.

Let it be said: this economy—if it materializes—isn't a calamity, but neither is it much to brag about. And Global Insight thinks there's a 35 percent chance that the predicted slowdown will turn into a recession. Two threats loom. One is oil. The forecast assumes that prices will fall from about $90 a barrel now to $76 in 2008. Every $10 above that is reckoned to raise gasoline prices 19 cents a gallon and cut employment by 100,000. The second threat is an aggravated credit crunch.

What we call "crunch" is merely a new label for the old credit cycle. In a strong economy, borrowers and lenders feel optimistic. People think they can handle more debt. Lenders relax credit standards. Sooner or later, the process reverses. Heavy debt payments oppress borrowers. Lenders react to rising delinquencies by tightening lending. Housing's recent boom and bust adheres perfectly to this script.

But elsewhere, the credit crunch's effects are muted. Other consumer debt (credit cards, auto loans, personal loans) is growing at about a 5 percent annual rate, says Susan Sterne of Economic Analysis Associates. Although corporate bond issuance has declined, the main consequence seems to have been a drop of mergers, acquisitions and private-equity buyouts. These have relied heavily on bonds for financing. Business investment in new machinery, software and buildings seems barely affected so far.

Lending hasn't collapsed in part because the subprime losses, though large in billions, are still small compared with the financial system's total capital. Brian Bethune of Global Insight figures that American investors have so far lost $50 billion. By contrast, stockholders' equity in U.S. banks alone exceeds $1 trillion. Still, the crunch is the first major crisis for a new financial system that has taken shape slowly since 1980. Loans that were once made and held by banks are now increasingly "securitized." That is, they're bundled into bondlike financial instruments and resold to other investors (pension funds, mutual funds, insurance companies, hedge funds, other banks). Two major problems have emerged.

First, because banks and other loan "originators" didn't keep all the loans they made—and earned fees for making the loans—they got careless and greedy. They relaxed credit standards; weak borrowers got mortgages or were persuaded unwisely to refinance existing mortgages for higher amounts. That triggered the surge in mortgage defaults, up about 75 percent since 2005, says Moody's

Second, some of the securities into which the mortgages were packaged were so complex that the people selling and buying them didn't understand, with hindsight anyway, what they were doing. As a result, it's hard to determine the securities' value. Given that uncertainty, write-downs of the securities' worth have often exceeded what the mortgage defaults alone would justify.

The specter of the subprime debacle is that it's just a start. Huge amounts of auto loans, credit-card debt, commercial mortgages and equipment leases have also been securitized. If similar problems emerged, it would shake confidence in the securitization model and, by magnifying investors' losses, threaten to turn the credit crunch from a slogan into a reality. This broader crisis, though a long shot, can't be excluded.

All of which brings us back to politics. Global Insight has one of many computer models that calibrate voting behavior with the economy's performance. The model has picked the winner of the popular vote in 13 of the last 15 presidential elections (it missed 1968 and 1976). Right now, the Republican and Democratic candidates are, putting Iraq aside, dead even. A deeper credit crunch would swing the advantage to the Democrat. The irony is that, while all the candidates are fighting frantically for their parties' nomination, the nation's financial markets may be quietly determining the ultimate victor.