Hedge fund woes could hit Main Street

Upheaval in credit markets could hit consumer, business borrowing - and slow the economy; risk premiums already rising.

By Chris Isidore, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) -- When Bear Stearns's hedge funds melted down this week because of too big a bet on subprime mortgages, it may have seemed like a Wall Street problem.

But numerous economists said the latest turmoil in the nation's credit markets could spill over to Main Street as well, raising borrowing costs for consumers and businesses alike - and possibly putting the brakes on the surprisingly resilient U.S. economy.

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Subprime mortgages, made to home buyers with less than top credit ratings, have been skidding since early this year as delinquencies and foreclosure rates soared. Now problems with those mortgage loans have sparked a big headache for Bear Stearns (Charts, Fortune 500) and the Wall Street firms that lent it money to invest in subprime mortgages, such as Merrill Lynch (Charts, Fortune 500), JPMorgan Chase (Charts, Fortune 500) and Citigroup (Charts, Fortune 500).

But the problems threatening the credit markets could mean far more than just billions in possible losses for those firms. It could push rates higher for corporate debt, which has been relatively cheap even for companies with poor credit ratings.

Even if those companies don't fall behind in their debt payments the way many subprime borrowers have on their mortgages, the investors making money available for those riskier loans are now demanding a much higher premium than they had until just recently.

That could choke off the supply of relatively cheap money that has kept the U.S. economy humming in recent years, putting a dent in everything from business investment to consumer spending.

"That's clearly high on my list of things to worry about," said David Wyss, chief economist at credit-rating agency Standard & Poor's. "I think it's healthy that pricing for risk changes. I think it's too loose now. But the transition could be painful. It depends on how fast it happens."

Wyss doesn't believe that the rise in borrowing costs for most companies will plunge the U.S. economy into recession - and many economists agree with him. They said there's enough underlying strength in the economy to keep it growing. But it will mean slow growth in the second half of this year rather than more normal "trend" growth of 3 percent a year or greater, said John Silvia, chief economist at Wachovia.

"I would think that that as you reprice risk, it will have a negative impact on economic growth going forward," said Silvia. "It will extend the workout in the housing market. And at the margin, they [higher rates] will crimp consumers and their spending."

Others see an even more drastic correction. Peter Schiff, president of Euro Pacific Capital, a brokerage firm specializing in overseas investments, said he had already been expecting a recession in late 2007. Now he believes the recession will come sooner, and hit harder, because of the problems with the Bear Stearns hedge funds.

"This is just another graveyard they can whistle by," he said, referring to Wall Street firms. "Eventually they're going to be overwhelmed. Interest rates are going to rise across the spectrum, and spreads are going to widen considerably."

That widening of the spreads - the difference between what it costs top borrowers and those deemed more risky - has already started. The spread between corporate debt that is not investment grade, popularly known as junk bonds, and a basket of U.S. government bonds was 2.89 percentage points on Thursday, according to Wyss, up from a record low of 2.65 percentage points on May 25.

Wyss said the spread had gotten too narrow and that a correction was likely even without the Bear Stearns problems. A more typical spread is close to four percentage points, and it was as high as 3.85 percentage points as recently as last September.

But he said an event in the credit market such as this week's meltdown typically sends spreads soaring. He noted the rise of roughly one percentage point in just two months in 2005 from a then record low in March following General Motors (Charts, Fortune 500) and Ford Motor (Charts, Fortune 500) debt being cut to junk bond status for the first time. Top of page