How far will the credit crunch spread?

The financial markets are right to be worried about the potential for a credit crunch.

In a credit crunch, lenders stop lending and credit becomes tough to obtain. A credit crunch can bring down everything from weak, deeply indebted companies to overextended lenders to over-leveraged borrowers to an economy as a whole.
So the question is: Are we in the midst of a credit crunch?
In the market for mortgage-backed bonds, leveraged-buyout loans and high-yield, or junk, bonds, yes, the crunch is upon us. The absolute paucity of buyers for those classes of assets -- what I described as a buyers strike in my July 31 column, "Stocks feel the pain of a buyers strike" -- has led lenders to cut way back on putting their capital at risk in leveraged loans or junk bonds. In these markets, not only have prices collapsed, but deals are being scrapped because of a lack of new credit.

But in the general economy where consumers live and spend, the credit crunch hasn't yet materialized. Banks are still lending, credit card issuers are still issuing, and mortgage lenders are still refinancing. Until a credit crunch hits the consumer, the damage will remain confined to the most leveraged sectors of the financial markets, and there the damage could be severe. But the economy as a whole will keep perking along at a growth rate of 2.5% to 3% -- and perhaps better -- for the rest of 2007.
A crisis that feeds on fear and uncertainty
We've certainly got some of the raw ingredients for a credit crunch right now. To create a credit crunch you need fear. Because they're taking a beating on existing loans, lenders fear that they will book big losses on future loans -- which makes them reluctant to lend.
But fear isn't enough. To create a credit crunch you also need uncertainty. A lender can compensate for fear by raising interest rates, tightening credit standards or writing more protective covenants into the terms of a loan. But if the size of the losses is uncertain enough, lenders can't compensate for the additional risk because lenders don't know how large that risk might be. Lenders become afraid to make any loan because they fear that any additional return that they ask for will turn out to be inadequate to cover the actual risk, whatever it may turn out to be.


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