Debt Crisis: Worse than Some Commentators Tell Us

I ran into a neighbor today. He is an attorney who, for many years, has run a successful practice specializing in working for creditors to recover defaulted debt payments. We began talking about the economy and I, half jokingly, said “at least your business should be up in this credit crisis.” He quickly corrected me. “My business is really getting squeezed now because of this credit crisis.” The credit squeeze affects him at both ends of the market. First, in the demand for his services. His credit-extending clients have drastically reduced their lending because of current and anticipated defaults. One of his clients, a automobile leasing firm, faced so many defaults that they have stopped writing new leases entirely. At the other end of his business, he is also suffering because he is unable to collect as much as he once could. The people who are defaulting are often under water on their automobile or house values compared to loan values. These debtors simply turn the asset back over to the creditor. If the borrower has no equity, nor enough income, the debt goes unpaid. So he suffers just like everyone else in the economy. Well, that’s not totally correct. He did tell me that the attorneys who are doing very well right now are those who handle evictions, which follow closely on the footsteps of forecloses.

His story brought to mind something I read the other day. A well-informed commentator was explaining that the credit crisis should not cause a great deal of worry for most of us because the sub-prime loans were only 1 to 2% of all the mortgages outstanding. I think there is an important fallacy in this argument when you consider who takes the loss and where they take it. The banks are taking most of these losses. And the losses are coming out of the banks’ capital. Banks use this capital as the basis of their lending. Roughly speaking, the banks can lend six dollars for every dollar of capital. So, if a bank loses 2% on its mortgage lending, the loss carries through to the capital base of the bank. The bank will be unable to make the equivalent of 12% of its mortgage loans in the future. A 6 to 12% reduction in mortgage lending sounds a lot more treacherous than 1 or 2%. You compound this, of course, with the other credit losses that will follow as the people who have defaulted on their mortgages also default on their other important debts.