Collateral Credit Damage

There was a very interesting article here on the Real Estate Dispatch last week. It was by Tom Koziol on the topic of consumer credit scoring models (article). I found it interesting because just one day earlier I was speaking to a friend of my who is an independent auto broker. She was telling me about several clients of hers who were having trouble obtaining auto loans despite stellar credit history and substantial income.

New Credit Reality

In their haste to shore up their credit portfolios, banks have been reducing

credit lines and credit limits. Banks fear that people will increase their debt load beyond their ability to repay. To guard against this banks have been slashing credit limits across the board regardless of their customer’s history. This preemptive strike has been impacting the credit of even the best borrowers.

It’s not unusual to see credit scores drop dramatically even though the borrower has never missed a payment, borrowed more money, or made any significant changes at all. What has happened is that the percentage of credit utilization has changed.

Imagine a scenario where Joe Customer has a FICO score of 720 and a $25,000 credit line from ABC Bank with an outstanding balance of $5,000. That’s a credit utilization ratio of 20%, a healthy number in the eyes of a lender. Now ABC Bank, concerned about the risk in their credit portfolio, decides to cut Joe’s limit down to $10,000. Joe isn’t concerned because he had no intention of borrowing more from them anyway. What Joe doesn’t realize is that his credit score has dropped because his credit utilization is now 50% and his ability to borrow on favorable terms has been impacted.

Credit Fueled Economy

The United States economy is so heavily dependent on credit. Homebuyers need mortgages, car buyers need auto loans, and purchasers of big-ticket consumer goods need access to credit. Very few people use cash to make these purchases, so no access to credit means that these goods aren’t sold. If the goods aren’t sold the manufactures are forced to cut back production. Production cutbacks lead to layoffs which, in turn, leads to an even further reduction in spending because laid off workers aren’t going to buy anything beyond absolute necessities.

An economy is nothing more that money in motion. When the money stops moving the economy stagnates. It is also a closed circle in normal times. A consumer makes a purchase, a manufacturer supplies the product that a worker is paid to produce, the worker uses his pay to become a consumer and the cycle starts again. Outside forces can act on the normal operation of that circular machine. One force would be the Government pumping money into the economy to stimulate it. However the tightening of credit acts to pull money out of that circle and slow it down.

Chicken and Egg

To say we are in an economic slump would be a classic understatement. Money needs to move to get the economic engine running again. It’s just like the classic question, which came first, the chicken or the egg? To create jobs the economy needs money flowing through it, to have money we need jobs. Credit allows people to use future dollars to pay for today’s purchases which, in turn, allows jobs to be created before the money is flowing sufficiently. Unfortunately when the credit is choked off we don’t have the ability to use those future dollars for today’s needs.

It makes perfect sense that the banks would want to reign in reckless borrowing by those who are irresponsible. However denying credit to your best and most responsible borrowers is pure insanity and, ultimately, economic suicide.

There is a basic lesson on financial crises that governments tend to wait too long, underestimate the risks, want to do too little. And it ultimately gets away from them, and they end up spending more money, causing much more damage to the economy.

- Timothy Geithner