Definition of Credit Crisis

By John Walton

  • Overview

    The ongoing credit crisis has affected people around the world, even people usually isolated from the world of high finance. However, despite being a major economic catastrophe that has dominated the news for literally years, many still lack a clear understanding of the origins and consequences of a credit crisis.
  • Identification

    A credit crisis (sometimes alternately called a credit crunch or credit squeeze) is when there is a sharp reduction in the availability of loans. For most people, this is represented by an increase in the standards necessary to take a secured loan from the bank and rising interest rates or outright lack of availability for unsecured loans, such as credit cards and personal loans.
    Bear Stearns Building, headquarters of a failed bank.
  • Interest Rates and Credit in Crisis

    Typically central banks regulate the availability of credit by raising or lowering interest rates and reserve requirements. When you watch the news and hear of the "Federal Prime Rate," this is the Federal Funds Rate plus 3 percent. The Federal Fund Rate is the rate that is mandated for short-term loans between banks to cover their minimum reserve requirements (or the amount of money they are required to have on hand). If the Federal Reserve were to tighten credit, it would raise interest rates and perhaps also reserve requirements, increasing the amount of money a bank needed to have on hand and also the cost of borrowing to meet that target, and thereby reducing the amount it can loan out. To loosen credit, it would do the reverse. In a credit crisis, however, the connection between interest rates and the availability of credit is weakened or broken by other factors, curtailing the ability of a central bank to intervene.

  • Causes

    As previously noted, a credit crises is usually the result of external factors, or though sometimes a government looking to tighten credit a little may precipitate one through an overzealous hike in interest rates and reserve requirements. However, the main culprits are usually either a steep decline in the value of assets used by banks to secure collateral, an increased perception on the part of the financial system as a whole that particular banks or banks in general are at risk of insolvency, or both. These factors are often the result of a sustained period of reckless and inappropriate lending, lending institutions (and their investors) when the loans turn sour. As the extent of the bad loans become known, a crisis of confidence in one or more bank arises. Banks in general will then reduce the availability of credit. They will stop loaning each other money to meet reserve requirements or for other purposes, because no one really knows how bad a bank's balance sheet will be six months from now. They will also restrict loans to the public and to commercial enterprises in order to retain capital and shore up their balance sheets, and also because of an irrational "snapback" response, from reckless lending to overly conservative lending.
  • Financial Crisis of 2007 to 2009

    The roots of the 2007 to 2009 financial xrisis were in the preceding 2006 subprime mortgage Crisis. The years before the outbreak of the subprime crisis were marked by a speculative boom in the housing industry, driving up real estate values in many areas to unsustainable levels. Reckless lending to prospective home buyers grew to a widespread practice, injecting more capital into the real estate bubble and driving home values ever higher. In the meantime, a booming business in mortgage-backed securities had grown up. These securities were based on the payments from a package of mortgages bundled together, and traded around the world as foreigners invested in the U.S. housing market. The slowdown in the housing boom, coupled with slowly climbing interest rates caused the real estate bubble to falter and then collapse. The result were the most inflated properties dropped significantly in value, while variable interest rate Subprime mortgages saw their interest payments spike upwards. People started defaulting on their mortgages, causing the value of the mortgage-backed securities (many now in the hands of institutions that are not even in the home mortgage business) to become extremely suspect and decline rapidly in value. As things became worse, banks became increasingly suspicious of each other, as no one could be sure what they value of these mortgage-backed securities were, or just how many of these "toxic" securities were held by their colleagues. Here we see the two main, external causes of a financial crisis: reckless lending practices and a crisis of confidence in financial institutions. The result was that, despite low interest rates, a general reluctance on the part of financial institutions to lend to anyone.
  • Prevention

    The key to preventing a credit crisis is to restrain reckless lending practices before they get out of hand, and to have a regulation system that is effective enough to reassure both the general public and the financial sector that any major crisis will be contained and of limited effect. Note that the former is a regulatory affair, while the latter is largely based on perception. These two conditions are usually interconnected--a SEC and Federal Reserve that were determined to cool down an overheated investment bubble are also likely to inspire confidence in a crisis. The problem is that it takes a great deal of courage and respect for the public interest to step in and restrain a speculative bubble, which is after all driven by people trying to make money. It is also problematic to know when to restrain that bubble.
  • Solution

    Fixing a credit crisis is a tricky business. It starts with the government encouraging the loosening of credit, but as we have seen the effect of a credit crisis is to cause external conditions that lessen or shatter the government's ability to influence this. This was clear between 2007 and 2009, when the Federal Reserve steadily lowered interest rates, but this had no effect on the availability of private, financial or commercial credit. The next steps are to take direct measures that restore confidence in the financial system: guarantees against institutional collapse, cleansing the toxic debt from the books of the banks, new regulations and new regulators that inspire confidence are among the tools available.
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