America's Credit Catastrophe

This, the shaky American economy did not need. If an imploding housing bubble and energy price superspike weren't damaging enough, our ailing financial system decided to slide into full cardiac arrest. And while the White House, Congress, and Federal Reserve have all shifted to DEFCON 1 to try to deal with the exploding credit crisis, even the perfect mix of fiscal and monetary policies seems unlikely to now prevent the worst recession in a generation. As JPMorgan Chase summed things up in a note to its clients: "The fat lady sings." The whole financial fiasco has moved far beyond liquidity problems on Wall Street. "This is the big one—the biggest financial crisis since the Great Depression," says financial historian Niall Ferguson. "It is, in fact, unlikely that even $700 billion will suffice to contain this great credit crunch we're witnessing."

Rather than being contained, the credit crisis has gone viral. Some of America's biggest companies, such as Caterpillar, McDonald's, General Electric, are now having trouble accessing the credit markets. Business borrowing has "imploded," according to Brian Bethune, an economist at Global Insight. And the longer businesses remain uncertain about the future, the more reticent they will be to hire and invest. Rising layoffs are already apparent on Main Street. New jobless claims are now running close to 500,000 weekly, a classic recession signal. But wait, there's more. Consumer loans are getting tougher to get, housing remains depressed, small businesses are experiencing the start of a capital crunch and, of course, 401(k) plans are getting walloped.

The ugly truth is that banking crises almost always come at a high cost to economic growth. And government bailouts and rescue plans usually mark the end of the beginning rather than the beginning of the end. As a Federal Reserve analysis of financial meltdowns in Sweden, Japan, and other nations concludes, "Banking crises have negative long-term effects on the economy, such as slow growth, high interest rates, and lower living standards." Just look at Japan, where a financial crisis in the 1990s led to the infamous "lost decade" of economic stagnation.

Splat! The credit crisis has landed firmly on Main Street, and here is how it is affecting all of us:

The Homeowner

Think of credit as the Benedict Arnold of the housing implosion. After all, cheap and abundant credit—remem-ber breezy lending standards and subprime loans?—was a turbopump for the housing bubble, allowing even folks with checkered credit histories to get in on the action and bid prices higher. But amid the market's painful collapse—which has already dragged home prices some 20 percent below their 2006 peaks—credit has switched teams. Now, a reduction in the supply of mortgage credit is putting additional downward pressure on the housing market and threatening to prolong the worst housing slump since the Great Depression. "The same credit explosion that was driving up home prices is going to work toward driving them down," says Harvard economist Kenneth Rogoff.

Want to buy a McMansion? Big loans to even well-qualified borrowers are getting more expensive. And although fixed mortgage rates are still relatively low, banks—facing higher delinquencies—have jacked up their lending stand-ards for applicants of all stripes. Harder to find are 5 percent and 10 percent down mortgages; 20 percent may again become the norm. (Overall, Bankrate.com reports an average 30-year fixed mortgage rate of just more than 6.0 percent. A 30-year jumbo mortgage is hovering around 7.27 percent.) While tighter mortgage credit isn't the leading factor behind the national decline in home prices—the bloated inventory of unsold homes is an even bigger problem—it's certainly making matters worse. Susan Wachter, a professor of real estate at the University of Pennsylvania's Wharton School, says that by keeping would-be buyers on the sidelines, the tightening works to reduce demand even as prices fall. "We could overshoot on the way down as the market overshot on the way up," Wachter says.

Rogoff says tighter credit will make the downturn in home prices, adjusted for inflation, roughly a third worse than it otherwise would have been. He expects home prices to stabilize toward the end of 2009 after falling some 30 percent from peak levels. Of course, some cities are already there. Prices in Las Vegas are down 29.9 percent just in the past year. New York University economics professor Nouriel Roubini's outlook is even darker: He expects a decline of at least 40 percent from the peak. "The credit crunch is really having a meaningful negative impact on the worsening situation in the housing market," says Roubini, whose downtrodden economic outlook has earned him the nickname "Dr. Doom." But for homeowners, what's really scary is the accuracy of his past projections. Roubini called the collapse of the hous-ing bubble back in 2006, and predicted the subsequent unraveling of the credit markets and the financial system with alarming prescience. - Luke Mullins