The Credit Crunch Continues

The Credit Crunch Continues
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By Meredith Whitney, WSJ | 15 October 2009

Anyone counting on a meaningful economic recovery will be greatly disappointed. How do I know? I follow credit, and credit is contracting. Access to credit is being denied at an accelerating pace. Large, well-capitalized companies have no problem finding credit. Small businesses, on the other hand, have never had a harder time getting a loan.

Since the onset of the credit crisis over two years ago, available credit to small businesses and consumers has contracted by trillions of dollars, and that phenomenon is reflected in dismal consumer spending trends. Equally worrisome are the trends in small-business credit, which has contracted at one of the fastest paces of any lending category. Small business loans are hard to find, and credit-card lines (a critical funding source for small businesses) have been cut by 25% since last year.

Unfortunately for small businesses, credit-line cuts are only about half way through. Home equity loans, also historically a key funding source for start-up small businesses, are not a source of liquidity anymore because more than 32% of U.S. homes are worth less than their mortgages. Why do small businesses matter so much?

In the U.S., small businesses employ 50% of the country's workforce and contribute 38% of GDP. Without access to credit, small businesses can't grow, can't hire, and too often end up going out of business. What's more, small businesses are often the primary source of this country's innovation. Apple, Dell, McDonald's, Starbucks were all started as small businesses.

What's especially disturbing is how taxpayer dollars have supported "too big to fail" businesses yet left small businesses unassisted and at a significant disadvantage. Small businesses do not have the same access to government guarantees on their debt. After all, most of these small businesses don't issue public debt.

As is true in most recessions, banks' commercial lending portfolios shrink as creditworthy customers pay down their debts and the less-worthy borrowers are simply denied loans. Banks, in other words, want to lend only to those that don't want to borrow. Challenging as that may be, in the last cycle small businesses at least had access to their credit cards. [[And their homes, whose values were skyrocketing!: normxxx]]

Small businesses primarily fund themselves through credit cards and loans from local lenders. In the past two years, credit-card lines have been cut by over $1.25 trillion. During the same time, 10% of all credit-card accounts have been cancelled. According to the most recent Federal Reserve data, small business lending is down 3%, or $113 billion, from fourth-quarter 2008 peak levels— the first contraction since 1993.

Credit cards are the most common source of liquidity to small businesses, used by 82% as a vital portion of their overall funding. Thus, it is of merit when 79% of small businesses surveyed tell the Small Business Association that credit-card lending standards have tightened drastically and their access to credit lines has decreased materially. Incentives should be provided to smaller banks to step up small-business loans on a greater scale.

Smaller banks could not only bridge gaps created by the shut down in the securitization market but also gaps being created by a massive contraction in credit-card lines. Arguably credit would perform better with these types of loans as they would reintroduce and reinforce the most important rule in banking: "Know Your Customer". I believe that we are only in the early stages of the second half of this credit cycle.

I expect another $1.5 trillion of credit-card lines to be removed from the system by the end of 2010. This includes not only the large lenders reducing exposure but also the shuttering of several major subprime credit-card lenders. Beginning in the fourth quarter of 2007, lenders began reducing available credit by zip code.

During the past four quarters, lenders have cut "inactive" accounts (whether or not the customer viewed the account as a liquidity vehicle). The next phase will likely be credit-line cuts as lenders race to pre-emptively protect themselves from regulatory changes associated with the Credit Card Accountability, Responsibility and Disclosure Act, passed in May of this year, and the 2008 Unfair and Deceptive Acts and Practices Act. Regulators should be mindful that regulatory change during the midst of a credit crisis often ends with unintended consequences.

Those same consumers that regulators are trying to help are actually being hurt by a vast reduction in available credit. Main Street represents the foundation of this country. Reviving it should take priority over any regulatory reform or systemic overhaul.

— Ms. Whitney is CEO of Meredith Whitney Advisory Group, LLC.