Credit crunch

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What is it?

'Credit crunch' is the broad term given to the fact that banks have suddenly greatly reduced the amount of credit that's available to borrowers. As a result of the crunch, it's now become a lot harder to get a mortgage, take out a personal loan, or borrow hundreds of millions of dollars to buy up a rival company.

Why has the credit crunch happened? Put simply, banks were too lax with their lending during the boom times. A key example was subprime lending. According to The Economist, the value of sub-prime mortgages issued in the US rose from $190bn in 2001 to $600bn in 2006.

Banks' lax lending standards have been blamed on the process of securitization, namely, bundling mortgages up and selling them on. Because the mortgages were sold on, the argument goes that the people who originally persuaded borrowers with poor credit histories to take out mortgages had no incentive to make sure the mortgages would be paid back.

In many cases, mortgages were sold to special purpose entities, which issued related products like mortgage backed securities and CDOs.

Alongside the process of securitisation, it has also become de rigeur to blame the financial crisis on an excess of liquidity as money flowed from Asia into Western economies. Former US Treasury Secretary Hank Paulson is one exponent of this view. Before he left office, he told the Financial Times that as investors all tried to put their mass of money into high yielding investments, returns on those investments fell. As a result, it was wrongly assumed that what they were investing in wasn't very risky. This was a mistake.

What's it got to do with the financial crisis?

The upshot of the credit crunch is that banks have so far been forced to writedown more than $1 trillion in assets that are now worth a lot less than they'd previously thought. Pessimists like Nouriel Roubini, professor of economics at New York University, predict writedowns could reach as much as $2-$3 trillion before the crisis ends.

As their assets have taken a dive, banks have been understandably keen to maintain their capital adequacy and are therefore making fewer loans and taking a lot fewer risks than in the past. According to The Economist, US bank loans contracted at an annualised rate of 8% over the 13 weeks to June 2008, for example.

Banks are also less willing to lend to each other, which means LIBOR, the interbank lending rate, has shot up and central banks are powerless to bring interest rates down.

The sudden reduction in the availability of credit is making itself particularly felt in the housing market. Mortgages are a lot less available than they used to be. And other forms of credit - such as loans to set up new companies, to fund expansion, or simply to extend existing debt - are increasingly hard to come by.

For much of 2009, access to credit has increased, largely due to the stimulus. Mortgage-backed securities saw their value rise as much as 40%, as did junk bonds. Many economists believe these increases are largely temporary, however, until the underlying structure of the system of credit sees repair.

Negative feedback loop

This risks creating a 'negative feedback loop' - as credit is sucked out of the system, the economy goes into recession. And as the econony goes into recession, more existing debts default. And as existing debts default, banks are forced to make additional writedowns and hoard capital, making credit even less available. And so on...

For this reason, government-led bailouts have been an increasingly popular, though highly expensive, option, with the price tag in the US alone estimated at around $24 trillion. The bailouts have created a financial dependence among the banks, however, and they will find it difficult to raise enough capital to replace the government's largesse.

Last updated on 7 September 2009.

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