Oct 1, 2008 5:56 pm US/Eastern
Credit Crunch Creeps Beyond Wall Street
(CBS4)
While Washington continues to negotiate some form of bailout plan, more and more financial experts are warning of a credit crunch or credit freeze. What does that mean?
A credit crunch is a quick reduction in the availability of credit or an increase in the cost of getting bank loans. In the current situation, tighter credit policies are tied to adjustable rate mortgages and over-valued property.
An adjustable-rate mortgage (ARM) features a low interest rate early in the life of the loan, with rates resetting later. Too many homeowners were lured into loans they couldn't afford once the early "teaser rate" period ended. Then these homeowners found themselves in financial trouble.
"I think in the past, the problem was banks would lends to anyone, and that's the reason we have the problem with the economy," said renter David Rost.
Some had purchased a home in hopes of "flipping" the property, selling it quickly to take advantage of a hot real estate market, but when interest rates went up and home values started going down, they found themselves owing more than the home was worth (in real estate terms, an "upside down mortgage"). All this caused the dramatic rise in foreclosures, which caused home prices to drop rapidly.
In the meantime, investment firms and banks had been dealing in packages of subprime and adjustable rate mortgages, so many financial institutions around the world found themselves holding loans that were defaulting.
Eventually, many of these institutions ran into trouble, including mortgage giants Fannie Mae and Freddie Mac, investment banks like Lehman Brothers and Bear Stearns, brokerage firm Merrill Lynch, and major commercial banks like IndyMac, Washington Mutual, and Wachovia.
These firms and others turned to the federal government for help in purchasing the bad mortgages and in making credit more available. As the scope of the mortgage mess became more evident, banks were reluctant to extend credit to the public or to each other, because no one knew just what all those bad mortgages and foreclosed properties would eventually be worth.
Brokers like Tom Strivecky, who's trying to sell units inside Wilton Station says banks are even tougher on people wanting to buy. He says banks now create a giant hoop of rings to jump through to get a mortgage.
"You may be faced with unforeseen expenses that will prevent you from paying your mortgage," said Strivecky.
The bailout bill was the administration's answer to the situation. It was spearheaded by Treasury Secretary Henry Paulson and Federal Reserve chief Ben Bernanke, who feared that a severe tightening of credit would create a deep recession.
Then on Monday, the stock market went into shock when the bailout bill failed. Credit markets, which had been extremely tight for the previous week, nearly froze. The result is that a problem that began with shaky mortgages made their way to Wall Street will now imperil businesses on Main Street. That's because it takes credit to hire workers, make payrolls, purchase inventory, and invest in new equipment and facilities.
And if that's not enough, consumers also find it tough to get new mortgages, car loans, and student loans. If all that happens, many businesses, both small and large, will fail, and the effects on the economy of the United States and the whole world could be devastating.
(© MMIX, CBS Broadcasting Inc. All Rights Reserved.)
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