Credit crunch

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A credit crunch (also known as a credit squeeze, credit tightening or credit crisis) is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates. In such situations, the relationship between credit availability and interest rates, changes. Credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability (i.e. credit rationing occurs). Many times, a credit crunch is accompanied by a flight to quality by lenders and investors, as they seek less risky investments (often at the expense of small to medium size enterprises).

Contents

Causes

U.S. household debt relative to disposable income and GDP. U.S. Household Debt Relative to Disposable Income and GDP.png
U.S. household debt relative to disposable income and GDP.

A credit crunch is often caused by a sustained period of careless and inappropriate lending which results in losses for lending institutions and investors in debt when the loans turn sour and the full extent of bad debts becomes known. [1] [2]

There are a number of reasons why banks might suddenly stop or slow lending activity. For example, inadequate information about the financial condition of borrowers can lead to a boom in lending when financial institutions overestimate creditworthiness, while the sudden revelation of information suggesting that borrowers are or were less creditworthy can lead to a sudden contraction of credit. Other causes can include an anticipated decline in the value of the collateral used by the banks to secure the loans; an exogenous change in monetary conditions (for example, where the central bank suddenly and unexpectedly raises reserve requirements or imposes new regulatory constraints on lending); the central government imposing direct credit controls on the banking system; or even an increased perception of risk regarding the solvency of other banks within the banking system. [3] [4] [5]

Easy credit conditions

Easy credit conditions (sometimes referred to as "easy money" or "loose credit") are characterized by low interest rates for borrowers and relaxed lending practices by bankers, making it easy to get inexpensive loans. A credit crunch is the opposite, in which interest rates rise and lending practices tighten. Easy credit conditions mean that funds are readily available to borrowers, which results in asset prices rising if the loaned funds are used to buy assets in a particular market, such as real estate or stocks.

Bubble formation

U.S. house price trend (1987-2008) as measured by the Case-Shiller index. Between 2000 and 2006 housing prices nearly doubled, rising from 100 to nearly 200 on the index. Case-shiller-index-values.jpg
U.S. house price trend (1987–2008) as measured by the Case-Shiller index. Between 2000 and 2006 housing prices nearly doubled, rising from 100 to nearly 200 on the index.

In a credit bubble, lending standards become less stringent. Easy credit drives up prices within a class of assets, usually real estate or equities. These increased asset values then become the collateral for further borrowing. [6] During the upward phase in the credit cycle, asset prices may experience bouts of frenzied competitive, leveraged bidding, inducing inflation in a particular asset market. This can then cause a speculative price "bubble" to develop. As this upswing in new debt creation also increases the money supply and stimulates economic activity, this also tends to temporarily raise economic growth and employment. [7] [8]

Economist Hyman Minsky described the types of borrowing and lending that contribute to a bubble. The "hedge borrower" can make debt payments (covering interest and principal) from current cash flows from investments. This borrower is not taking significant risk. However, the next type, the "speculative borrower", the cash flow from investments can service the debt, i.e., cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal. The "Ponzi borrower" (named for Charles Ponzi, see also Ponzi scheme) borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat. [9]

Often it is only in retrospect that participants in an economic bubble realize that the point of collapse was obvious. In this respect, economic bubbles can have dynamic characteristics not unlike Ponzi schemes or Pyramid schemes. [10]

Psychological

Several psychological factors contribute to bubbles and related busts.

These and other cognitive biases that impair judgment can contribute to credit bubbles and crunches. [6]

Valuation of securities

The crunch is generally caused by a reduction in the market prices of previously "overinflated" assets and refers to the financial crisis that results from the price collapse. [12] This can result in widespread foreclosure or bankruptcy for those who came in late to the market, as the prices of previously inflated assets generally drop precipitously. In contrast, a liquidity crisis is triggered when an otherwise sound business finds itself temporarily incapable of accessing the bridge finance it needs to expand its business or smooth its cash flow payments. In this case, accessing additional credit lines and "trading through" the crisis can allow the business to navigate its way through the problem and ensure its continued solvency and viability. It is often difficult to know, in the midst of a crisis, whether distressed businesses are experiencing a crisis of solvency or a temporary liquidity crisis.

In the case of a credit crunch, it may be preferable to "mark to market" - and if necessary, sell or go into liquidation if the capital of the business affected is insufficient to survive the post-boom phase of the credit cycle. In the case of a liquidity crisis on the other hand, it may be preferable to attempt to access additional lines of credit, as opportunities for growth may exist once the liquidity crisis is overcome.

Effects

Securitization markets were impaired during the crisis. This shows how readily available credit dried-up during the 2007-2008 crisis. Securitization Market Activity.png
Securitization markets were impaired during the crisis. This shows how readily available credit dried-up during the 2007-2008 crisis.

Financial institutions facing losses may then reduce the availability of credit, and increase the cost of accessing credit by raising interest rates. In some cases lenders may be unable to lend further, even if they wish, as a result of earlier losses. If participants themselves are highly leveraged (i.e., carrying a high debt burden) the damage done when the bubble bursts is more severe, causing recession or depression. Financial institutions may fail, economic growth may slow, unemployment may rise, and social unrest may increase. For example, the ratio of household debt to after-tax income rose from 60% in 1984 to 130% by 2007, contributing to (and worsening) the Subprime mortgage crisis of 2007–2008. [6]

Historical perspective

In recent decades credit crunches have not been rare or black swan events. Although few economists have successfully predicted credit crunch events before they have occurred, Professor Richard Rumelt has written the following in relation to their surprising frequency and regularity in advanced economies around the world: "In fact, during the past fifty years there have been 28 severe house-price boom-bust cycles and 28 credit crunches in 21 advanced Organisation for Economic Co-operation and Development (OECD) economies." [6] [13]

See also

Related Research Articles

An economic bubble is a period when current asset prices greatly exceed their intrinsic valuation, being the valuation that the underlying long-term fundamentals justify. Bubbles can be caused by overly optimistic projections about the scale and sustainability of growth, and/or by the belief that intrinsic valuation is no longer relevant when making an investment. They have appeared in most asset classes, including equities, commodities, real estate, and even esoteric assets. Bubbles usually form as a result of either excess liquidity in markets, and/or changed investor psychology. Large multi-asset bubbles, are attributed to central banking liquidity.

<span class="mw-page-title-main">2000s United States housing bubble</span> Economic bubble

The 2000s United States housing bubble was a real-estate bubble affecting over half of the U.S. states. It was the impetus for the subprime mortgage crisis. Housing prices peaked in early 2006, started to decline in 2006 and 2007, and reached new lows in 2011. On December 30, 2008, the Case–Shiller home price index reported the largest price drop in its history. The credit crisis resulting from the bursting of the housing bubble is an important cause of the Great Recession in the United States.

<span class="mw-page-title-main">Financial crisis</span> Situation in which financial assets suddenly lose a large part of their nominal value

A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy.

<span class="mw-page-title-main">Hyman Minsky</span> American economist

Hyman Philip Minsky was an American economist, a professor of economics at Washington University in St. Louis, and a distinguished scholar at the Levy Economics Institute of Bard College. His research attempted to provide an understanding and explanation of the characteristics of financial crises, which he attributed to swings in a potentially fragile financial system. Minsky is sometimes described as a post-Keynesian economist because, in the Keynesian tradition, he supported some government intervention in financial markets, opposed some of the financial deregulation of the 1980s, stressed the importance of the Federal Reserve as a lender of last resort and argued against the over-accumulation of private debt in the financial markets.

A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, frequently "lending" by investing in securitizations, but also by investing in corporate bonds and funding by issuing commercial paper and medium term notes, which were usually rated AAA until the onset of the financial crisis. They did not expose themselves to either interest rate or currency risk and typically held asset to maturity. SIVs differ from asset-backed securities and collateralized debt obligations in that they are permanently capitalized and have an active management team.

In finance, subprime lending is the provision of loans to people in the United States who may have difficulty maintaining the repayment schedule. Historically, subprime borrowers were defined as having FICO scores below 600, although this threshold has varied over time.

The United States subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the 2007–2008 global financial crisis. The crisis led to a severe economic recession, with millions of people losing their jobs and many businesses going bankrupt. The U.S. government intervened with a series of measures to stabilize the financial system, including the Troubled Asset Relief Program (TARP) and the American Recovery and Reinvestment Act (ARRA).

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United States housing prices experienced a major market correction after the housing bubble that peaked in early 2006. Prices of real estate then adjusted downwards in late 2006, causing a loss of market liquidity and subprime defaults.

<span class="mw-page-title-main">Minsky moment</span> Sudden collapse of asset values which generates a credit or business cycle

A Minsky moment is a sudden, major collapse of asset values which marks the end of the growth phase of a cycle in credit markets or business activity.

In financial economics, a liquidity crisis is an acute shortage of liquidity. Liquidity may refer to market liquidity, funding liquidity, or accounting liquidity. Additionally, some economists define a market to be liquid if it can absorb "liquidity trades" without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, reduction in the number of market participants, or simply difficulty in trading assets.

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The Subprime mortgage crisis solutions debate discusses various actions and proposals by economists, government officials, journalists, and business leaders to address the subprime mortgage crisis and broader 2007–2008 financial crisis.

<span class="mw-page-title-main">Causes of the Great Recession</span>

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Leverage is defined as the ratio of the asset value to the cash needed to purchase it. The leverage cycle can be defined as the procyclical expansion and contraction of leverage over the course of the business cycle. The existence of procyclical leverage amplifies the effect on asset prices over the business cycle.

<span class="mw-page-title-main">Mortgage industry of the United States</span>

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<span class="mw-page-title-main">2007–2008 financial crisis</span> Worldwide economic crisis

The 2007–2008 financial crisis, or Global Financial Crisis (GFC), was the most severe worldwide economic crisis since the Great Depression of 1929. Predatory lending targeting low-income homebuyers, excessive risk-taking by global financial institutions, and the bursting of the United States housing bubble culminated in a "perfect storm".

References

  1. ↑ Has Financial Development Made the World Riskier? Archived 2011-10-16 at the Wayback Machine , Raghuram G. Rajan
  2. ↑ Leverage Cycles Archived 2021-06-15 at the Wayback Machine Mark Thoma, Economist's View
  3. ↑ Is There A Credit Crunch in East Asia? Archived 2004-05-03 at the Wayback Machine Wei Ding, Ilker Domac & Giovanni Ferri (World Bank)
  4. ↑ "China lifts reserve requirement for banks". Archived from the original on 2011-08-08. Retrieved 2009-01-12.
  5. ↑ Regulatory Debauchery Archived 2021-02-27 at the Wayback Machine , Satyajit Das
  6. 1 2 3 4 5 Rumelt, Richard P. (2011). Good Strategy / Bad Strategy. Crown Business. ISBN   978-0-307-88623-1.
  7. ↑ Rowbotham, Michael (1998). The Grip of Death: A Study of Modern Money, Debt Slavery and Destructive Economics. Jon Carpenter Publishing. ISBN   978-1-897766-40-8.
  8. ↑ Cooper, George (2008). The Origin of Financial Crises. Harriman House. ISBN   978-1-905641-85-7.
  9. ↑ "McCulley-PIMCO-The Shadow Banking System and Hyman Minsky's Economic Journey" (PDF). Archived (PDF) from the original on 2016-03-03. Retrieved 2022-04-15.
  10. ↑ Ponzi Nation Archived 2011-04-12 at the Wayback Machine , Edward Chancellor, Institutional Investor, 7 February 2007
  11. ↑ "Securitisation: life after death". Archived from the original on 2020-05-01. Retrieved 2007-11-14.
  12. ↑ "How the French invented subprime". Archived from the original on 2012-07-01. Retrieved 2008-03-07.
  13. ↑ "Real Estate Booms and Banking Busts: An International Perspective". University of Pennsylvania. July 1999. Archived from the original on 31 October 2014. Retrieved 1 June 2014.

Bibliography

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