Credit Crunch Likely to Hit Consumers the Hardest

The credit freeze, which is shifting into overdrive heading into the holiday season, is expected to hit consumers harder than corporate America.

As banks continue to refuse credit even to qualified borrowers, business will feel the pinch but consumers will feel it even more. Companies have alternate ways to raise money, such as selling stock and bonds. But consumers have few options besides bank loans and credit cards, which are harder and more expensive to get.

So they will borrow less and thus spend less, setting up a potentially ugly fourth quarter not only for corporate earnings but the entire economy.

"The consumers just don't have anything to spend right now," says Rick Pendergraft, market analyst at Investor's Daily Edge newsletter. "As long as that's the case, we're not going to see any improvement in the economy."

Because consumer spending accounts for roughly two-thirds of economic growth, a sharp slowdown could push the US into a recession.

"If consumers can't spend and make acquisitions of goods," Pendergraft adds, "that's not going to help corporate earnings at this point in time unless they're doing a lot of business overseas."

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The credit problems start at the top, where banks are balking even at lending to each other because of the riskiness of the entire sector and the corresponding surge in interest rates.

The interbank loan rate, known as Libor, posted its biggest one-day gain ever overnight, roaring 4.30 percentage points, or 430 basis points, to 6.87 percent, the highest in seven and a half years. (Track Libor and other key rates here)

That triggers a domino effect through the industry and makes it harder for consumers—who are at the end of the credit chain—to borrow money.

And even if Congress passes a revised financial rescue plan, as lawmakers pledged on Tuesday, the credit crunch is expected to continue for some time.

"The banking system now is simply too small given the size of the economy. There's not enough credit to go around now," Jim Bianco, president of Bianco Research, said on CNBC. "So we ration out the credit and we do it through these very high interest rates."

See Bianco's full analysis in video at left.

"We need to do one of two things--either expand the banking system to meet the demand that is out there, or we need to leverage, which is a very, very painful process. So long as the banking system remains too small, we're going to continue to have problems."

Companies will feel the pain in a number of ways that go beyond consumer behavior.

Retailers looking to borrow money to grow holiday inventories will have to dip into cash reserves or sell stock to raise money. Retail chief financial officers are expecting to cut inventories 37 percent, while 41 percent said they were experiencing credit tightening, according to a survey from BDO Seidman.

Pendergraft says the big winners in this environment will be discounters like Wal-Mart and Costco , both of which have strong cash positions and whose cut-rate products will be in demand as consumers look to save. Dillard's , meanwhile, will struggle as it tries to build inventories with a weak capital standing and a difficult credit environment, he said.

"I don't think retailers are going to be going out and building up inventories as we head into the holiday season," said Tom Higgins, chief economist at Payden & Rygel. "I think they'll run pretty thin inventories and then build as the cycle dictates."

Difficult, But Not Impossible

To be sure, credit is still out there, but the game has changed.

Consumers and companies with strong cash positions and credit ratings can still get credit, but at a higher rate and with tighter conditions.

Yet fears persist that unless Congress acts boldly the situation will worsen as the year progresses.

"Psychologically it's going to be very, very important both for the market and the companies directly affected by this--mainly banks and brokers," says Richard Sparks, senior analyst at Schaeffer's Investment Research. "For those sectors and those companies it's critical that something gets done. It seems as if they're very close and hopefully that will happen this week."

Not everyone, though, is convinced that a government bailout plan would have had a meaningful effect beyond propping up bank balance sheets, including institutions that eventually will fall anyway.

"I didn't think that bill they were voting on yesterday was going to do much good for anything," Bianco said. "Yes, it would have given a psychological boost--the problem is the banking system is too small. The banking system needs capital."

"It would have been a lot like all the other Paulson plans. None of them have worked so far," he continued. "This is just the sieve bailout, version 2008, which failed last year to get through."

In the meantime, retailers are bracing themselves for rough sledding ahead.

"The American consumer's in the retrenchment mode, building up savings as we go through this period where there's all this downside risk," Higgins said. "Consumer spending already looks very weak and we're expecting the fourth quarter to be no better. I think retailers are already thinking the same thing."

© 2009 CNBC.com