A credit crunch is when there is a decrease in the availability of loans due to changes in bank lending practices, causing higher interest rates and impacting the global economy. The 2007 US subprime mortgage crisis is an example. It can take years for economic conditions to improve, leading to insolvency and bankruptcy for companies and consumers.
A credit crunch is a term used in the banking industry to describe an economic state in which there is a decrease in the availability of loans. Usually occurring during a recession, a credit crunch indicates that banking institutions are unwilling to take on additional credit risk. Businesses and individual consumers can face this credit crunch. Furthermore, an ongoing credit crunch has a ripple effect and can eventually impact the global economy.
There are several reasons why changes in bank lending practices can trigger a credit crunch. There may be less confidence in secured loans due to fluctuation in other markets such as real estate. Indeed, this type of market price collapse is a major contributor to the creation of a credit crunch. Banking institutions may also be concerned about the solvency of other banks and their ability to pay long-term fixed debts. Even the government can play an important role in the availability of credit by imposing restrictions on lending institutions. An unusual degree of default on previously issued credit may also reduce a bank’s position to extend additional credit. Any or all of these conditions can make it difficult to get lines of credit and loans.
Whatever the cause of a credit crunch, it is almost always accompanied by higher interest rates if a business or consumer is able to obtain credit. This increase is usually visible in the subprime loan market segment first, with an unexpected effect on the conventional loan market next.
The mortgage crisis that began in 2007 in the US 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 fall, making refinancing nearly impossible. As a result, variable interest rates on current mortgages have started to rise, despite starting at very low rates. As more and more homeowners failed to meet their financial obligations, a record number of defaults and foreclosures occurred.
Banks and lending institutions in the US and around the world have lost billions of dollars and significant numbers of people have lost their homes. In the US, more than 200 banks were severely affected, including some major lenders such as Countrywide and Washington Mutual. On a global scale, Swiss UBS posted losses that well outpaced those of other lenders in the world’s financial markets.
As a credit crunch and recession go hand in hand, it can take years for economic conditions to improve. As companies are unable to increase inventory or working capital, many companies can 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 remains minimal and with a higher interest spread, there is generally a decrease in business investment and overall consumer spending.
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