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.
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.