“One day they ask for a score of 620; the next it’s 680.”

By Dean Calbreath
UNION-TRIBUNE STAFF WRITER
Excerpted

As politicians struggle to patch up the nation’s ailing financial system, credit – the grease that keeps the global economic machine running – has been drying up to a dangerous extent.

Over the past two weeks, many banks have ceased lending money to one another – or to corporate clients that need loans to cover their cash flow.

It was paralysis in the credit market that prompted the Treasury Department and the Federal Reserve to propose a $700 billion plan to take over mortgage-backed assets.

How did this credit crunch happen? How dire is it? And how could a squeeze in lending between banks on Wall Street evolve into a recession – or worse – in the broader economy?

The heart of the crisis lies in the interbank lending network, which allows banks to borrow from each other to guard against fluctuations in cash flow.

“On any given day, banks are borrowing money,” said John Eggemeyer, president of Castle Creek Capital, a private equity firm in Rancho Santa Fe. “Your inflows and outflows of cash never match up; the money you loan is sometimes in excess of the money that’s coming in. So you need to balance that off by borrowing money yourself.”

Similarly, corporations rely on “commercial paper” to help make up for similar fluctuations. They essentially print IOUs and sell them in the interbank market, where the loans between banks also take place.

That system has fallen into a shambles because of the U.S. mortgage crisis.

Hundreds of billions of dollars in the interbank system are instruments tied to mortgage-backed securities, which have plummeted in value. Because of the faulty way in which Wall Street packaged those securities, it is impossible to know how much they are worth.

“That can lead to a real domino effect that starts feeding on itself,” said David Ely, a finance specialist at San Diego State University.

If banks can’t borrow from one another, it becomes harder for them to lend money. Companies that can’t raise money through loans or commercial paper might have to scale back operations by cutting workers or freezing wages.

In areas such as San Diego County, which has been hit hard by the bursting of the bubble in home prices, credit is already getting tighter. The days of the no-down-payment, interest-only adjustable-rate mortgages or “zero interest, zero credit history” auto loans are largely gone.

Lenders are increasingly asking would-be collegians to get cosigners for their student loans. And credit card issuers have sharply cut back on telemarketing calls, direct mailings and TV commercials offering cheap and easy credit.

Arguably, the tighter credit reflects a return to rationality in a marketplace that went off the tracks during the early half of this decade. Many healthy banks and credit unions are still making loans to worthy customers.

“If you have good credit, a good job and you’re willing to make a 20 percent down payment, you can still get a loan,” said David McDonald, president of the local chapter of the California Association of Mortgage Brokers.

But McDonald stresses that lenders are much more conservative than they used to be. “The credit scores the lenders ask for keep increasing,” he said. “One day they ask for a score of 620; the next it’s 680.”

Dean Calbreath: (619) 293-1891; dean.calbreath@uniontrib.com

Source: San Diego Union-Tribune