Credit Crunch Won't Pick on Anyone Its Own Size

This post first appeared on Minyanville.

Each day that the engine of economic growth -- credit -- is prevented from flowing freely, the crisis worsens - and its effects on the broader economy keep piling up.

Even as Congress rushes to pass the latest iteration of the bailout plan -- or emergency rescue plan, or stimulus plan, or whatever it happens to be called to make it sound politically expedient and palatable to confused and frightened Americans -- the economy is grinding to a halt.

After years of fudging the numbers to make growth look stronger than it actually is, policymakers may have to finally accept the fact that recession is inevitable. Weekly jobless claims rose to a 7-year high, new car sales are tumbling, and the stock market is gyrating wildly on an almost hourly basis.

The recession they promised wouldn't come is just around the corner.

There's a long-held belief that economic slowdowns allow small businesses to thrive, since larger competitors are scaling back and hunkering down to wait out the storm. Meanwhile, entrepreneurs -- who are typically less risk-averse than big companies -- can seize on the opportunity to expand, open new stores and comb through the ranks of unemployed to hire skilled workers on the cheap.

Banks are apt to rein in lending during a downturn as defaults on existing loans rise and cash becomes pricier. Credit standards tighten, loan amounts fall and lenders scrutinize applicants more thoroughly before extending loans. Still, small businesses are usually able to find enough money to continue their existing business strategies, at the very least - albeit with the higher risk associated with tough economic times.

The credit crunch, however, is throwing that assumption out the window.

Both the Wall Street Journal and New York Times ran stories this morning about how small businesses and entrepreneurs are "feeling the chill" as banks squeeze cash flow to a mere trickle. Mounting defaults on loan portfolios, fear about future losses and frozen short-term money markets are forcing banks to deny credit in droves.

As the banking system continues to jam years of consolidation into a few weeks, the survivors -- Wells Fargo (WFC), Bank of America (BAC), JPMorgan (JPM), Citigroup (C) TD Ameritrade (AMTD) and countless small, regional banks -- must choose between customers and shareholders.

Extending credit to customers and thereby maintaining sometimes longstanding relationships runs the risk of wasting precious balance-sheet space on what could be a losing bet. Washington Mutual and Wachovia (WB) both experienced firsthand what happens when banks load up on what turn out to be bad loans.

On the other hand, banks make money -- well, they used to, anyway -- by the simple business strategy of borrowing cheap (deposits), lending out at higher rates (mortgages, credit cards, construction loans, etc.) and picking up the spread in the middle. If they don't engage in this, their core business, future earnings prospects could be dire.

Banks must carefully balance continuing profit-generating business while protecting against future losses. And with the risk management track record many have racked up in the past year, it shouldn't come as a surprise if most choose prudence over profits in the years to come.

Meanwhile, back on Main Street, business owners who just weeks ago couldn't spell "credit default swap" are starting to learn why the tangled web of untested, unregulated financial derivatives that tied the world's financial system together matter to even the smallest of businesses.

It''s official: This is no longer just Wall Street's problem.