YOU DECIDE: Why is it hard to get a loan?

Media Contact: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

By Dr. Mike Walden
North Carolina Cooperative Extension

Credit is the life-blood of an economy. Even the best run business or most prosperous household sometimes needs access to credit. Sellers of big-ticket items like homes, vehicles and furniture often need credit for their buyers.

One of the big — and controversial — economic issues today is the apparent lack of credit. Credit availability contracted during 2008 and 2009. This should not be surprising. Those were the worst years of the recession, and credit always gets tighter during economic downturns. The fact that the recent recession was the worst in 75 years means credit conditions were the tightest in memory.

But after the typical recession, lending activity usually rebounds. For example, after the 2001 recession, credit growth doubled within three years.

But not so this time. Although credit conditions were better in 2010 than in the previous two years, credit growth was still only one-third the rate as after the 2001 recession.

The worry is that with credit expansion so slow, the economy simply won’t be able to generate much steam. At the current rate, unemployment in two years in the nation will still be above 7 percent, and in North Carolina will be more than 8 percent.

So why does credit remain so tight? As you might expect, a number of reasons have been offered.

First and foremost is the argument that credit growth is slow because few households and businesses want or have the capability to acquire loans. Households have been busy paying down on the record debt levels they posted a decade ago. They are also limiting their spending and building up their savings. They don’t want more loans; instead, they want to pay-off the loans they already have.

And since households have turned frugal, businesses have cut back their spending plans, which means their need for loans has also been curtailed.

While conceding the above argument has merits, others present additional explanations. One of the main alternatives has to do with the “credit pendulum” perhaps moving too far the other way.

Here’s the idea. The credit pendulum refers to the cycle normally seen in credit availability. During good economic times, when incomes are rising, profits are high and optimism is strong, making loan payments is easier. Lenders are, therefore, motivated to lower standards and extend credit to more households and businesses.

When recessions hit and fear escalates and pessimism reigns, lending attitudes move in the opposite direction. Lenders become more cautious, and credit standards are increased. As a result, fewer households and businesses can qualify for loans. The lending pendulum has thus moved toward strictness.

But some say the pendulum — especially now — has moved too far to compensate for the perceived laxness that prevailed when the economy was booming. For example, with home prices falling and no firm sense of where they’ll stop, appraisers may be setting values very low. A low appraisal increases the difficulty of a potential buyer qualifying for a mortgage loan.

The Dodd-Frank financial re-regulation bill passed by Congress has also come under fire for setting financial standards for lenders — in the opinion of some — too high. Plus, with three-fourths of the implementing regulations of Dodd-Frank yet to be written, lenders still aren’t certain what specific rules they will have to follow. In the face of uncertainty, the general rule is, be cautious.

Last, there’s the impact of the Federal Reserve (the Fed), which has power over both the quantity and price of credit. The Fed has certainly done its part in increasing the availability of credit, having more than doubled the supply since late 2008. Yet the majority of this new credit sits in the vaults of banks as “excess reserves.”

Why? Going back to the first point, some say it’s due to a lack of demand by credit-worthy borrowers. But others say it’s a direct result of Fed policy. The Fed is actually paying a 0.25 percent annual interest rate to banks on their excess reserves. While a low rate, it is risk free, and some think banks are quite happy to earn this guaranteed return in these uncertain times.

The Fed says it is paying this rate on excess reserves to maintain a floor on interest rates and as a hedge against deflation. But some analysts see it differently. They think that if the Fed eliminated the payment or even charged banks for holding excess reserves, then new loans would start flying out of the bank vaults.

So we have a chicken and egg question. Is lending tight because there are few good loans to be made? Or is lending lacking due to too-tight regulations and an overly-generous Federal Reserve? You decide!

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The College of Agriculture and Life Sciences communications unit provides his You Decide column every two weeks. Previous columns are available at http://www.cals.ncsu.edu/agcomm/news-center/tag/you-decide

Related audio files are at http://www.cals.ncsu.edu/agcomm/news-center/category/economic-perspective/