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It is often caused by a sustained period of lax and inappropriate lending which results in
losses for lending institutions and investors in debt when the loans turn sour and the full
extent of bad debts becomes known. These institutions may then reduce the availability
of credit, and increase the cost of accessing credit by raising interest rates. In some cases
lenders may be unable to lend further, even if they wish, as a result of earlier losses
restraining their ability to lend.
In the case of a credit crunch, it may be preferable to "mark to market" - and if necessary,
sell or go into liquidation if the capital of the business affected is insufficient to survive
the post-boom phase of the credit cycle. In the case of a liquidity crisis on the other hand,
it may be preferable to attempt to access additional lines of credit, as opportunities for
growth may exist once the liquidity crisis is overcome.
A prolonged credit crunch is the opposite of cheap, easy and plentiful lending practices
(sometimes referred to as "easy money" or "loose credit"). During the upward phase in
the credit cycle, asset prices may experience bouts of frenzied competitive, leveraged
bidding, inducing hyperinflation in a particular asset market. This can then cause a
speculative price "bubble" to develop. As this upswing in new debt creation also
increases the money supply and stimulates economic activity, this also tends to
temporarily raise economic growth and employment.
Often it is only in retrospect that participants in an economic bubble realize that the point
of collapse was obvious. In this respect, economic bubbles can have dynamic
characteristics not unlike Ponzi schemes or Pyramid schemes.
As prominent Cambridge economist John Maynard Keynes observed in 1931 during the
Great Depression: "A sound banker, alas, is not one who foresees danger and avoids it,
but one who, when he is ruined, is ruined in a conventional way along with his fellows,
so that no one can really blame him."
The 2007 sub prime mortgage financial crisis is considered by some to have caused a
credit crunch.
The panic in world financial markets has led to sharp falls in share prices and led to the
contraction of credit markets. BBC News looks at how key indicators around the world
have moved as recession fears grow.
Twelve months ago interest rates were 5.25%. By 30 January they had dropped to 3%.
They are now 2.25%, as of 18 March.
Wall Street bank Bear Stearns collapsed when other banks lost confidence in the value of
its investments in sub-prime mortgages. It was bought by JPMorgan Chase in March.
Collapsing Us Housing Prices
Underlying the financial market wobblies is a real decline in US house prices nationwide
for the first time since the 1930s.
The US sub-prime mortgage crisis has lead to plunging property prices, a slowdown in
the US economy, and billions in losses by banks. It stems from a fundamental change in
the way mortgages are funded.
Traditionally, banks have financed their mortgage lending through the deposits they
receive from their customers. This has limited the amount of mortgage lending they could
do.
In recent years, banks have moved to a new model where they sell on the mortgages to
the bond markets. This has made it much easier to fund additional borrowing,
But it has also led to abuses as banks no longer have the incentive to check carefully the
mortgages they issue.
It was a poor, working class city, hit hard by the decline of manufacturing and sharply
divided along racial lines.
Mortgage brokers focused their efforts by selling sub-prime mortgages in working class
black areas where many people had achieved home ownership.
They told them that they could get cash by refinancing their homes, but often neglected to
properly explain that the new sub-prime mortgages would "reset" after 2 years at double
the interest rate.
The result was a wave of repossessions that blighted neighborhoods across the city and
the inner suburbs.
By late 2007, one in ten homes in Cleveland had been repossessed and Deutsche Bank
Trust, acting on behalf of bondholders, was the largest property owner in the city.
House prices were high, and it was difficult to become an owner-occupier without
moving to the very edge of the metropolitan area.
But these mortgages had a much higher rate of repossession than conventional mortgages
because they were adjustable rate mortgages (ARMs).
The payments were fixed for two years, and then became
both higher and dependent on the level of Fed interest rates,
which also rose substantially.
There is a glut of four million unsold homes that is depressing prices, as builders have
also been forced to lower prices to get rid of unsold properties. And house prices, which
are currently declining at an annual rate of 4.5%, are expected to fall by at least 10% by
next year - and more in areas like California and Florida which had the biggest boom.
Credit Crunch
One reason the economic slowdown could get worse is that banks
and other lenders are cutting back on how much credit they will
make available.
They are rejecting more people who apply for credit cards,
insisting on bigger deposits for house purchase, and looking more
closely at applications for personal loans.
Bank Losses
The banking industry is facing huge losses as a result of the sub-prime crisis.
Although the banks say they do not own these SIVs, and
therefore are not liable for their losses, they may be forced to
cover any bad debts that they accrue.
If the banks are forced to reveal their losses based on current prices, they will be even
bigger.