Tighter loan standards add to economic slowdown fears

Banks reported softer demand for mortgage and commercial loans in the three months ended in July, the Federal Reserve said Monday, adding to evidence that the pace of economic growth has slowed.

The Fed's quarterly survey found 56% of 16 lenders making subprime loans had tightened standards from April to July 26. Subprime loans are higher-cost products aimed at consumers with poor credit. Subprime loan demand was down more than 40% — more than twice the dip of the second quarter.

Still, concerns about the housing recession and soaring defaults in the subprime market affected a minority of prime borrowers, according to the survey. About 14% of lenders clamped down on mortgages to customers with good credit. That's slightly below the 15% figure in the second quarter of the year, but "not an insignificant proportion," Moody's Economy.com said in an advisory.

"Also worrisome is the fact that demand for (commercial and industrial loans) has weakened noticeably and that banks are tightening standards on these loans due to a more uncertain economic outlook and a lower appetite for risk," Economy.com said.

About a quarter of the 52 domestic banks that took part in the Fed's survey noted tighter standards for commercial real estate loans, about the same level as in April. The commercial real estate market has been soaring, while home building has been in recession.

The survey may not show the true extent of problems in the mortgage markets, however. It was completed before last week's stock and bond market meltdown when the Federal Reserve pumped liquidity into the banking system to keep its key short-term interest rate at 5.25% and reassure lenders that the Fed would not let credit markets freeze up.

The subprime lending debacle has forced dozens of lenders out of business and sparked wide concern about the soundness of bonds backed by the mortgages. It has contributed to market volatility and worry about the soundness of other investments.

Reflecting the ongoing problems in the housing sector, U.S. home builder Hovnanian Enterprises said Monday that deliveries fell 31% in its third quarter from a year ago and its contract cancellation rate was 35%, up from 33% a year earlier.

The problems have sparked a broad debate about whether the Fed will eventually have to cut interest rates to keep the economy from slowing too much.

"I don't think a cut would do anything," says John Silvia of Wachovia. "The economy doesn't need it at this point. You have a lot of individuals with individual problems that need to be worked out."