As more homeowners run into trouble making loan payments, it is not just borrowers and lenders who are at risk, but the US economy as well.
The danger is that banks will feel impelled to tighten credit standards too much, possibly extending beyond mortgages to other forms of consumer and business lending. This could slow both business investment and consumer spending at a time when the economy is already in a stretch of below-normal growth.
Worry about a possible "credit crunch" was one reason that stock prices took a dive Tuesday. The Dow Jones Industrial Average fell by 2 percent, to 12075.96, after the Mortgage Bankers Association reported that the percentage of loans entering foreclosure hit 0.54 percent in the final quarter of 2006, a record high and a jump from 0.46 percent three months before.
At the very least, this appears to portend more difficulty in the housing market. Banks have already been tightening standards on home loans – especially in the troubled category of subprime loans, which are aimed at the least creditworthy borrowers. Whether it prompts banks to tighten credit more broadly remains to be seen.
"If they tighten up on commercial and [business] loans, then that would really spell a problem" for the economy, says Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University in Atlanta.
"Housing activity will be weak for this year," he says, and he expects that consumer spending will also take a hit from a chill in credit.
This elevates the risk that the economy could enter a recession. But Mr. Dhawan believes the Federal Reserve will cut interest rates in late spring, particularly if Fed policymakers see signs that the economy is being squeezed by a lack of credit. That should be enough to avert a period of outright decline in economic activity.