Credit Crunch Explained

The credit crunch refers to a sudden shortage of funds for lending, leading to a resulting decline in loans available.

A Credit Crunch can occur for various reasons:

  • Sudden increase in interest rates (e.g. in 1992, UK government increased rates to 15)
  • Direct money controls by the government (rarely used by Western Government’s these days)
  • A Drying up of funds in the capital markets

The recent credit crunch was driven by a sharp rise in defaults on subprime mortgages. These mortgages were mainly in America but the resulting shortage of funds spread throughout the rest of the world.

Steps to 2007 / 08 Credit Crunch

  1. US mortgage lenders sell many inappropriate mortgages to customers with low income and poor credit. It is hoped with a booming housing market, the mortgages will remain affordable.
  2. Often there were lax contols in the sale of mortgage products. Mortgage brokers got paid for selling a mortgage, so there was an incentive to sell mortgages even if they were too expensive and high chance of default.
  3. To sell more profitable subprime mortgages, mortgage companies bundled the debt into consolidation packages and sold the debt on to other finance companies. In other words, mortgage companies borrowed to be able to lend mortgages. The lending was not financed out of saving accounts, for example.
  4. These mortgage debts were bought by financial intermediaries. The idea was to spread the risk, but, actually it just spread the problem.
  5. Usually subprime mortgages would have a high risk assessment rating. But, when the mortgage bundles got passed onto other lenders, rating agencies gave these risky subprime mortgages a low risk rating. Therefore, the financial system denied the extent of risk in their balance sheets.
  6. Many of these mortgages had an introductory period of 1-2 years of very low interest rates. At the end of this period, interest rates increased.
  7. In 2007, the US had to increase interest rates because of inflation. This made mortgage payments more expensive. Furthermore, many homeowners who had taken out mortgages 2 years earlier now faced ballooning mortgage payments as their introductory period ended. Homeowners also faced lower disposable income because of rising health care costs, rising petrol prices and rising food prices.
  8. This caused a rise in mortgage defaults, as many new homeowners could not afford mortgage payments. These defaults also signalled the end of the US housing boom. US house prices started to fall and this caused more mortgage problems. For example, people with 100% mortgages now faced negative equity. It also meant that the loans were no longer secured. If people did default, the bank couldn’t guarantee to recoup the initial loan.
  9. The number of defaults caused many medium sized US mortgage companies to go bankrupt. However, the losses weren’t confined to mortgage lenders, many banks also lost billions of pounds in the bad mortgage debt they had bought off US mortgage companies. Banks had to write off large losses and this made them reluctant to make any further lending, especially in the now dangerous subprime sector.
  10. The result was that all around the world, it became very difficult to raise funds and borrow money. The cost of interbank lending has increased significantly. Often it was very difficult to borrow any money at all. The markets dried up.
  11. This affected many firms who had been exposed to the subprime lending. It also affected a wide variety of firms who now have difficulty borrowing money. For example, biotech companies rely on ‘high risk’ investment and are now struggling to get enough funds.
  12. The slow down in borrowing has contributed to a slowing economy with the possibility of recession in the US a real problem.

Credit Crunch in the UK

  1. UK mortgage lenders did not lend so many bad mortgages. Although mortgage lending became more relaxed in the past few years, it still had more controls in place than the US.
  2. However, it caused very serious problems for Northern Rock. Northern rock had a high % of risky loans, but, also had the highest % of loans financed through reselling in the capital markets. When the subprime crisis hit, Northern Rock could no longer raise enough funds in the usual capital market. It was left with a shortfall and eventually had to make the humiliating step to asking the Bank of England for emergency funds. Because the Bank asked for emergency funds, this caused its customers to worry and start to withdraw savings (even though savings weren’t directly affected)
  3. As a result of the credit crunch, the UK has seen a change in the mortgage market. Mortgages have become more expensive. Risky mortgage products like 125% mortgages have been removed from the market. (mortgage squeeze)
  4. UK Banks continue to face problems. HBOS (Owner of Halifax) struggled to finance its balance sheet. Like Northern Rock, it financed an expansion of lending by borrowing. Now money markets have frozen up, they couldn’t raise enough money to maintain liquidity.
  5. Falling House prices. Now that mortgages are difficult to get, demand for houses has slumped. Therefore, house prices have fallen. Lower house prices mean many face negative equity. Therefore, mortgage defaults now cost banks even more (because they can’t get back the initial loan.
  6. Bradford & Bingley was nationalised because it couldn’t raise enough finance. The B&B had specialised in buy to let loans, which are particularly susceptible to falling house prices.

How Long will the Credit Crunch Last?

The credit crunch could last a long time. This is because:

  1. House prices are still falling in the US, reducing the value of mortgage loans
  2. Many homeowners still face rising interest rates, when their introductory periods come to an end
  3. It can be difficult to regain confidence in the financial markets
  4. A recession in the US and global downturn could cause a further rise in bad loans

Other Crisis

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45 Responses to Credit Crunch Explained

  1. John March 13, 2008 at 9:46 am #

    Credit crunch is always a big cause of concern for all of us who are planning to take mortgage loan.

    John

  2. Credit Crunch Blog May 29, 2008 at 6:14 pm #

    Apparatnly, the credit crunch is only just starting, and is actually going from strength to strength. It’ll be interesting to see where it goes!

  3. jay July 17, 2008 at 8:16 pm #

    Nice post, I also think that attempted Government intervention both in the US and UK will actually prolong the effects of the credit crunch. They have tried too shore up the economy where collapse (at least to a degree) is inevitable. This has been both costly and not a little futile.

  4. mike August 26, 2008 at 11:53 pm #

    Great site keep up the good work

  5. stubsy September 21, 2008 at 2:10 pm #

    Thats a really good explanation of the credit crunch.

  6. Ally Hauptmann-Gurski September 28, 2008 at 5:55 am #

    One of the problems is mostly overlooked, i.e. the rating agencies who put good ratings on bad bonds.
    The overhaul of the financial system must include making them liable for giving good ratings to dud investments. The credit rating agencies determine state budgets, thus steering elected politicians, but we have no idea how they reach conclusions. Now that they have been proven to be false, we would need better rating agencies or reduce their influence on banks and politics.

  7. Discover Unearthed October 3, 2008 at 10:20 am #

    This is a very helpful contextual piece – I find that with all the focus on the here and now the circumstances that led to this situation are often neglected or only explored at a very shallow level. However, it is all a little depressing and if you need some light relief – check out credit crunch comfort food at http://discoverunearthed.wordpress.com

  8. Andrew Liput October 5, 2008 at 8:11 am #

    A partial solution to the financial problems around the world is for the governments to look into recovering bonuses, and assests that have been taken out of the financial institutions. Over the period of poor financial control, this must amount to billions of pound. When this has been done goverments can then consider using taxpayers money to fund the shortfall.

  9. smoke October 6, 2008 at 8:48 am #

    Sounds like US brokers have made money from this and sold a lemon to the rest of the world…. Thought they had educated people running the world markets…Banks deserve to be kept in check after they charge through the nose to look after my own money..

  10. Christian October 6, 2008 at 9:03 pm #

    Don’t kid yourselves there is still a bucket load of bad debt that’s being hidden in the balance sheets of many financial organisations. Which will eat into the billions the governments are using to bail out the people responsible for the mess. The next big downturn will be within the collateralised derivatives markets a third of the organisations can’t even value their assets!

  11. David Turner October 10, 2008 at 1:29 pm #

    This ‘credit crisis’ is constantly related to sub-prime morgages.
    When are the banks going to let us know what their losses for credit cards are, as well as bankrupt businesses?
    The british government (new labour) takes pride in taking the credit for the longest economic boom in history. In actual fact, the boom started with John Majors government and by prolonging the economic cycle, labour can with justification claim the crash is entirely their making.
    Before we had an independant bank of england, the interest rates were set by the government.
    It seems obvious that by ignoring the amount of dept the country was amassing the debt mountain would inevitably get so large that a banking crisis would follow.
    The announcements made so far by the labour government demonstrate they have little understanding of economics.
    Gordon Brown ran the economy and took us into this mess.
    Alistair Darling said not long ago that Britain was best placed to avoid a recession. We had low unemployment etc.
    ‘AD’ norther rock had good assets and was a profitable business.
    Labour have let the country down.
    The reason for all the dithering is because they know their mistakes were made a long time ago and there is nothing they can do to correct the situation.
    Has anyone explained why it was necessary for the government to save the banks. So what if they all end up owned by the bank of china.

  12. Phil October 14, 2008 at 8:00 pm #

    I’m not sure how to explain the whole economic system shuddering to a halt… or how shifting money from the ‘government’ (ie taxpayers) to banks can help.
    See my question –
    http://pleasewalkonthegrass.blogspot.com/2008/10/you-never-know-i-studied-economics-once.html

  13. Avtarjeet Dhanjal October 15, 2008 at 10:50 pm #

    Some people see it coming and some don’t

    James Robinson wonder in the Media page of the Observer 12.10.2008 (p 11) ‘Why didn’t the City journalists see the financial crisis coming?’; except a lone voice of Gilian Tett of the FT. One would expect that papers like FT, who has the resources, envy of many others, would have someone who is not involved in the day to day manufacturing of the NEWS, but who sits back and just takes long term view of the markets and the system as a whole, where it is coming from and where it is heading to?

    I wonder why none of the journalists working for papers like FT, even the other broadsheet papers, couldn’t stand back and see the bigger picture; the media needs to think its role again.

    I was an occasional writer for a small publication AN (Artists’ Newsletter) in 1980s and 90s, as an artist, I could see such a need to cast an overview of the humanity as a artist and creative person. I quote from one of the pieces I wrote in 1980s,

    ‘If we imagine, the whole of the humanity is a large caravan travelling with time. In this caravan most people are busy pushing pulling, carrying their possessions, sweating in a race of material achievements.
    It is the Artist, who disengages him/herself from this entourage; frees from this rat-race, runs ahead of the caravan, finds a vantage point to grasp/intuit an overview, where the caravan is coming from and where it is heading to? Then the Artist expresses this vision by singing a song, playing a piece of music, writing a poem, making a painting or a sculpture to share it with the world.’
    I commented again in 1989, when Francis Fukuyama, made his big declaration of ‘End of History’, it was published in The Guardian Nov. 14, 1989,

    “In the cycle of history, every system grows and vanishes. Russia and its allies tried to hold on to the wheel of time, hoping they might stop it. That was a mistake they are paying for. Capitalism is not absolute system. Its only advantage is that with liberal mix, it leaves a lot of breathing points, so the system survives longer.”

    Now what we see now these breathing points what liberal Capitalism has grown so big that it exhausted all the energy, leaving a skeleton that came down like a carcass of a dead cow.

    Its not only the meltdown of the core (Wall Street) of the Western financial system, but it is exhaustion of an idea/system that West wanted to project as an example of the monetary system for the rest of the world to follow.

    As an outsider I could see it coming in 1995, when I wrote a proposal for a World Symposium to imagine a future in the 21st century.

    The second major event since the 2nd world war has been the disintegration of the Soviet Union, which has its global implications. This one event did make you feel, as if you wake up one morning and hear the news that the Earth has lost its South Pole and was left with only one ‘the North’. Imagine how much chaos it would create; the planet may lose its orientation and its annual cycle. Today, as a result of this one event in history, it is not only that any alternative view of the world have died a death, but we are left with a ‘one party/one opinion’ world.
    (This was the opening para in a paper I presented in a seminar, ‘Shaping Histories – Imagining Futures’ At UNESCO Conference on Culture & Development, March 31, 1998, Stockholm.) (Clink on this link to read the full paper)
    Now the real concern of George Bush, Gordon Brown other Western leaders, in not that few Banks have collapsed or they had to put trillions of dollars of public money to shore the system; the very idea/horse that they were riding to demolish all other kinds of ideas/systems in the world that very horse has collapsed. As a result they also lost the moral whip they used to most of the world.

    Now watch it the day, the OPEC countries switch over from Dollar as trading currency to Euro, the Dollar will be worth very little may bring another major crisis in the US economy, no one has imagined. There are already countries Venezuela and Iran tried to put the currency change issue on the table in the last OPEC meeting early this year; Saudi Arabia, who has invested most of its reserve in the US, and strong supporter of the US, brushed aside the idea of currency change. But this postponement would not go on for ever.

    Dollar, that was the choice currency at one time in the tourist trade in India, now the tour guides prefer to be paid in Indian Rupees that in Dollars. That is how the world values this currency now.

    Can you imagine the scenario if only one country, say Saudi Arabia, who has invested over $750 Billion in the US economy, decides to switch its reserve to Euro-zone, America would not have resources to pay in any precious metal or the other currencies? Saudis certainly threatened to so when families of US victims of 9/11 tried to sue for damages personally 4 members of the Saudi Royal family in 2002.

    This is the result of very arrogance of the US governments over decades since the 2nd World War, more so since the fall of the Soviet Union, it has become a bully/policeman of the world in a, what I called above the One Polar, world.

    World, including me, is curiously waiting to see where it stands, when the planet seems to have lost it’s the only pole it was left with when Soviet power disintegrated in 1989. I am an incurable optimist, still believes that world will be more balanced without one dominating pole it was left with. Francis Fukuyama swallowed back its claim ‘End of History’; I believe this beginning very very interesting history is in the making in the 21st century.

    Avtarjeet Dhanjal

  14. Stan January 5, 2009 at 1:35 pm #

    Nice breakdown of how the credit crunch began and has evolved!

    It’s amazing how the state of affairs in the US had such a big impact on us. The CRA law over in the states is without a doubt one of the main roots of the problem, the simple fact that people who were not financially viable were given mortgages in the first place. This has in turn caused the downward spiral of the events that have caused the crisis over here in the UK.

    If nothing else a lesson has been learnt (hopefully!) and lenders both here and in the states should take measures to ensure that

  15. jackie February 12, 2009 at 10:14 am #

    yes, don’t forget the Clinton administration which penalised banks who did not show a healthy proportion of sub prime lending on their books every month. The amercian bad debt was forcibly created under his administration. By the time Bush was in place. most of the first time sub-prime mortgages were already established.

  16. James February 28, 2009 at 1:47 am #

    Despite the economic downturn there is useful tips and info available on how to optimize your spending and still maintain a good standard of living.

  17. Garry Pickles March 14, 2009 at 12:51 am #

    Credit crunch help is available online in so many different areas these days. I have no doubt all the hard work put in by the likes of martin lewis the money saving expert will pay off for thousands of people in helping there financial situation.

  18. Chris April 18, 2009 at 1:50 am #

    I’ve just been enlightened by reading How I Caused the Credit Crunch. If you want to understand it all in a very accessible manner, it’s a great read and very informative too. Makes sense of everything written down here.

  19. bob April 23, 2009 at 10:55 pm #

    how far will the downturn go tho, thats what we have to think about

  20. Don Sabatini April 27, 2009 at 1:51 pm #

    Nicely explained

  21. Paul July 8, 2009 at 9:42 pm #

    This is a good summary about how the Credit Crunch came about. I look forward to hearing more about these so called green shoots.

  22. chris January 1, 2010 at 7:08 pm #

    I have been ready, in anticipation, for some time now, for the credit crunch which is upon us.
    I believe that the real cause of this,was the second world war,as we have been operating in a state of bankruptcy since then.
    Please do your own research on this and you will find it to be fact.
    War is the most expensive thing that mankind indulges in and the only people that win, are the private bankers that lend the offending governments the money for war, plus interest.
    Rothschild is to have allegedly made $200,000,000 as a result of world war two.
    Heaven only knows what this figure is by today’s standards.
    I see the only solution, is to generate a passive income, so that you no longer trade time for cash.
    As a result your time is free to generate another passive income , and so on.
    Many don’t know how to do this, but one method is to do this on line.
    This can be a minefield as there are many individuals that will sell you a product which is really “information overload” and leaves you confused as to how to make an on line income.
    In essence you need:
    a product, put it on a website
    and drive customers to it.
    The video presentation on my site will show you exactly how to do all three stages.

  23. Andrea Compton July 29, 2010 at 6:05 am #

    This is a very good example how credit crunch came avoid debt.

    Hamilton Associates have been helping our clients for over 28 years though our fully trained team of financial advisers with debt helps for both individuals and Businesses. All our advisers have had many years of experience dealing with debt problems and are totally understanding with your circumstances and are committed to help you in eliminating the stress that debt can cause.

  24. Robert August 7, 2010 at 6:08 pm #

    recent government plans may actually have a negitive effect on Great Britain ie causing the dreaded double dip recession

  25. Ed T March 29, 2012 at 11:47 am #

    Thats an excellent article. Definitely worth a read for students of economics. Good work. Ive also read a couple of articles on BBC and one on

    http://half-bridge.blogspot.com/2012/03/history-and-causes-of-credit-crunch.html

    i found it really interesting.

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