A crash course in credit

When lenders are afraid to lend, the economy stalls and uncertainty grows

Don Castle can't get a loan to finish the work on his house. He took a ''Get out of Debt'' class at Salem State and is looking for a part-time job. (Yoon S. Byun/Globe staff)

To understand the urgency of the biggest government bailout in US history, look no further than Don Castle, Roberta O'Connor, and Don Chiofaro.

Castle is a Lynn probation officer awash in mortgage and credit card debt who cannot get a new loan to pay for home improvements. O'Connor is a new-furniture store owner in Salem who had a credit line cut and doesn't know how she will pay for more inventory.

Chiofaro, a Boston developer, is worried about moving forward with a new waterfront development because of a virtual shutdown in lending for large real estate projects.

The enormous challenges these borrowers face in getting credit illustrates how the dried up lending markets is putting a chokehold on the US economy. The consequences are far-reaching: Consumers, who fuel 70 percent of the nation's economic activity, are drastically cutting back, and companies are hoarding cash and putting off expansion that creates jobs.

The result is an economic paralysis that is fueling fears of a prolonged recession. To avert a deeper disaster on Wall Street, the Bush administration and lawmakers are weighing a $700 billion plan to buy toxic debt imperiling the balance sheets of financial firms, freeing them up to begin lending again.

"Right now the only ones who can get credit don't need it," said Gus Faucher, director of macroeconomics at Moody's Economy.com. "It's only getting more severe."

The Consumer
Since buying his Lynn bungalow with no money down three years ago, Castle has used his first home like an ATM.

He's refinanced twice to help pay for more than $35,000 in home improvements, including installing 24 new windows, renovating the kitchen, building a deck, and replacing the roof.

Castle had big plans to turn his second-floor attic into a huge living space by adding new wiring and insulation. But the well of cash has run dry. Several local banks and online lenders recently rejected his applications for a $20,000 home equity loan.

So instead of spending his days designing a master suite, Castle, 41, took a "Get out of Debt" class at Salem State and is now looking for a part-time job.

"Banks were giving out money like candy and now you can't get anything," he said.

Homeowners across the country used their houses as Castle did, which allowed them to spend in ways they otherwise couldn't afford. When real estate values soared, money flowed and merchants like Home Depot and Linens 'N Things rode the wave of consumption created by the easy cash people were able to wring from their homes. But now that housing values have plunged, defaults on mortgages and loans have mounted, and the chaos on Wall Street has spread, the good times have ended for homeowners like Castle.

Already, reduced consumer spending has taken its toll: Linens 'N Things filed for bankruptcy protection and Home Depot is slashing jobs, closing shops, and delaying new store openings.

In recent months, banks have tightened lending standards for homes and cars, requiring higher credit scores and bigger down payments. Consumers are also running out of options with credit cards, as big companies like American Express and Bank of America, facing unprecedented late payments and huge balances, cut credit lines and close accounts. Citibank is pushing hard to reduce balances by offering to match a percentage of payments for some cardholders.

These days, Castle, who cut up his Bank of America credit card after maxing it out last year, is using all the money he has to make his $2,100 mortgage payment and putting hundreds more a month toward paying off his debt: $7,000 in credit cards, $7,000 in private bank loans, and $30,000 in postponed student loans now coming due.

Castle admits it was a risk to take on so much debt and he has a responsibility to pay it back.

But he believes banks should have been more prudent with lending and not let consumers get in over their heads.

As Castle watched television coverage of the bailout debate at the gym on Friday, he said, "There needs to be some strict oversight and accountability of these companies and we need to make sure consumers are protected."

In the meantime, Castle has tried to scale back on some of his favorite pastimes, the lunches out and dinners with friends. But what's more painful is the constant reminder of his unfinished dream, the empty second floor.

"People aren't getting pay raises, interest rates are going up," Castle said. "Everyone is hurting."

The Small Business Owner
Roberta O'Connor knew it was a tough time to start a business when in May she opened the doors to Cabin Fever, a vintage Brazilian furniture store in downtown Salem.

Shortly before the shop's debut, Washington Mutual, which was seized by federal regulators on Thursday, cut a home equity line she planned to use for inventory and daily business operations, despite her high credit score.

So the 35-year-old mother of two tapped into her savings and ran up $40,000 in credit card charges to cover the gap.

But nothing could have prepared her for the recent financial meltdown on Wall Street and Main Street, when sales at her business dropped 40 percent over the past two weeks alone.

"Everyone's in panic mode and people aren't spending," said O'Connor, a former marketer.

With her inventory starting to run low, O'Connor is considering applying for a small business loan to finance a $50,000 buying trip to Brazil. Watching the collapse of major financial institutions over the past two weeks has only made O'Connor more nervous about getting access to capital.

Even though small businesses typically need only small amounts of cash, these firms and start-ups are likely to get hurt the most in a credit crunch. Many small businesses lack the assets necessary for a traditional bank loan, making them a riskier option for financing. Already, bank loans for small businesses are at a 15-year low. In July, 65 percent of banks reported tightening lending standards for approving applications for small business loans, up from 7 percent in January 2007, according to the Federal Reserve.

But it is small businesses like Cabin Fever that are key to fueling the economy because they create the most new jobs. So when small businesses can't get money from banks, they can't grow or add new jobs.

"There's just a lot of upheaval. Money is going to be hard to come by, but we're in a wait-and-see mode right now," O'Connor said. "What else can we do?"

In the meantime, O'Connor is trying to make it through the holiday season by appealing to wary consumers with lower-priced items. At a cocktail reception Thursday, where she hoped to drum up business, $12 flower note cards and $23 soy candles sat on top of a $6,000 art deco caviuna wood console with bar. Near the $1,800 jacaranda wood and linen chairs, $13 coasters rested on a $2,800 console table from the 1960s.

Before opening her boutique this spring, O'Connor said she was confident there was a niche in the market and enough wealth on the North Shore to support her business, despite the tough economic conditions.

But these days, what keeps O'Connor up at night is the possibility that conditions will not significantly improve in 2009. There isn't much fat left to cut in her business: She doesn't take a salary and the rent is already paid through May.

Without a major turnaround next year, O'Connor is not sure how long Cabin Fever will survive.

"Nobody is going to come out of this unscathed," she said. "It scares me."

The Developer
For once, Chiofaro is not rushing to break ground on a bold new development in downtown Boston.

That's because he knows the timing for a large project could not be worse. Construction costs are sky high. Commercial banks and other lenders are in turmoil. And accessing a loan is more difficult than it's been in two decades.

"It's impossible to break ground right now," said Chiofaro, who is waiting out the financial tumult before proceeding with a planned development at the site of the Harbor Garage along the city's waterfront.

Chiofaro bought the garage for $153 million in December of 2007 and is planning a "significant mixed-use project" on the property. He would not give details until he files a proposal with the city.

Chiofaro, president of the Chiofaro Co., has been in the development business for nearly three decades. He has built suburban office parks in Westford and Westborough, and developed the International Place towers in downtown Boston, a project that took him through the financial turmoil in the late 1980s and early 1990s.

He said the latest downturn has set off such panic in financial markets that they can only be repaired through government intervention. "There isn't any confidence in the system, so it's an absolute necessity," he said of the bailout. "This is not going to fix itself."

The credit crunch has dramatically slowed the pace of development in Boston and across the nation. During the past several months, the market for commercial mortgage-backed securities, the cheapest and most frequently used form of debt, has dried up almost completely.

In a single year, the amount of securitized loans issued in the United States dropped to just $12.5 billion so far this year from a high of $230 billion in 2007, leaving developers without their primary source of debt capital, according to the Commercial Mortgage Securities Association.

Real estate professionals say lenders are carefully scrutinizing any request for a new loan. They are looking for experienced developers, large equity investments, and assurances that office and retail have tenants lined up before construction starts. In short, they don't want any whiff of financial vulnerability.

"The difficulty is that development deals by their nature are risky, and [lenders] don't want any risk right now," said George Fantini, chairman of the commercial banking firm Fantini & Gorga.

The city of Boston has more than $12 billion in projects planned for neighborhoods across the city, but many of the largest proposals are expected to be delayed by the credit crunch. Several projects are already struggling, including the massive Columbus Center residential and retail project over the Massachusetts Turnpike and another mixed-use project at the former Filene's in Downtown Crossing.

The slowdown in development creates broader economic problems because it is a major source of construction jobs. It also lures new tenants and retailers to downtown buildings, fueling consumer spending and business expansion.

Commercial bankers say the silver lining in real estate is that interest rates remain low and that banks have not shut down lending completely the way they did in the early 1990s, when overbuilding left the marketplace flooded with unwanted product.

Still, no one seems to know when today's credit crunch will begin to ease and how financing will change when it's over.

"Nobody knows what the rules are going to be," Chiofaro said. "We're flying in a fog."

Casey Ross can be reached at cross@globe.com, Jenn Abelson can be reached at abelson@globe.com.