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What a Credit Crunch?

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  • Written By: Karyn Maier
  • Edited By: Bronwyn Harris
  • Last Modified Date: 09 September 2016
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A credit crunch is a term used in the banking industry to describe an economic state in which there is a decrease in loan availability. Usually occurring during a recession, a credit crunch indicates that banking institutions are unwilling to take on additional credit risk. Corporations as well as individual consumers may experience this credit squeeze. In addition, an ongoing credit crunch has a ripple effect and can eventually impact global economy.

There are a variety of reasons why changes in lending practices by banks may initiate a credit crunch. There may be less confidence in secured lending due to fluctuation in other markets, such as real estate. In fact, this kind of market price collapse is a key contributor to creating a credit crunch. Banking institutions may also become concerned about the solvency of other banks and their ability to repay long-term fixed debts. Even the government can play a role in affecting credit availability by imposing restrictions on lending institutions. An unusual degree of defaults on previously issued credit may also reduce a bank’s position to extend further credit. Any or all of these conditions can make obtaining credit lines and loans more difficult.

Whatever the cause of a credit crunch, it is almost always accompanied by higher interest rates, should a corporation or consumer succeed in obtaining credit. This increase is often visible in the subprime lending market segment first, with a windfall effect on the conventional lending market to follow.

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The mortgage crisis that began in 2007 in the U.S. subprime mortgage industry is an excellent example of a credit crunch in action. While the housing market peaked in 2005, prices soon fell and continued to spiral downward, making refinancing almost impossible. As a result, variable interest rates on current mortgages began to climb, even though they were initiated at very low rates. As more and more homeowners were unable to meet their financial obligations, a record number of loan defaults and foreclosures occurred.

Banks and lending institutions in the U.S. and around the world lost billions of dollars and a significant number of people lost their homes. In the U.S., more than 200 banks were severely affected, including some of the top lenders such as Countrywide and Washington Mutual. On a global scale, Swiss UBS reported losses that well surpassed that of other lenders in the world financial market.

Since a credit crunch and recession go hand-in-hand, it can take years for economic conditions to improve. As corporations are left unable to increase inventory or working capital, many businesses may become insolvent and forced to liquidate assets. For the home mortgage consumer, bankruptcy may be the only option to avoid foreclosure. As the availability of credit and loan products remain at a minimum and at a higher interest spread, there is usually a decrease in investment in business as well as overall consumer spending.

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Sunny27
Post 3

@GreenWeaver -I think that in order to survive the credit crunch you have to have money set aside. I remember in 2008, I was looking to buy a vacation property and purchase a foreclosure.

I was able to get preapproved from the bank for a mortgage, but they would not finance my property because the building in which the condo was located had a foreclosure rate of over 10% and it had less than 50% owner occupants.

So although I had excellent credit, I had to get a home equity line of credit on my primary residence that was paid off in order to be able to buy this property. So sometimes the credit crunch also hurts the buying prospects in certain developments.

This cash only purchase made it difficult for the average buyer to purchase a unit in the building. This is another unforeseen result of the credit crunch of 2008.

GreenWeaver
Post 2

@Cafe41 - I agree that the credit crisis was brought on my loose lending standards by the bank, but I also think that some people wanted to take advantage of the double digit returns in the real estate market and make a small fortune.

There were cases of people earning $40,000 a year that had mortgages on multiple properties. I think that the credit crunch can best be explained by everyone wanting to get rich quickly on the real estate market.

I remember that there were areas in Miami that would appreciate 10% in value in a few months. It was crazy. Now because of all of these problems we have a financial crisis because banks have a back

log of foreclosed homes that they need to sell to get off their books and many are resorting to auctions to get rid of the excess inventory.

This is really how the credit crunch can be explained because even credit unions were affected and many banks collapsed as a result.

cafe41
Post 1

I think the credit crunch crisis is a response to the collapse of the financial markets with record foreclosures. This financial crisis could have been avoided if banks continued traditional lending standards and did not take on the risky loans.

For example, there were banks that were conducting no doc loans. These were no documentation loans allowed borrowers to state what their incomes were with no questions asked.

The interest rates were a little higher on these types of loans, but the idea of a bank not verifying a borrowers income and ability to pay seems crazy to me. They were also providing these subprime loans that allowed people that would not normally qualify for a conventional loan

receive a variable rate loan that was often an interest only loan in the beginning of the term.

This allowed people to buy homes that they normally could not afford because the mortgage payment was half of what it would normally be. Many of these people thought that they would be able to resell their home once the interest rates got too high but, unfortunately the market plummeted and the subprime crisis became a big factor.

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