Credit Crunch - Ignoring the Signs - By: Helen March

Inappropriate lending and greed appear to be two causes of the credit crunch we face right now. Loans were granted to borrowers who should never have been allowed to add to their existing debt load. As these 'bad loans' began to turn sour, the banks and other lenders had a smaller supply of money to lend.

Suddenly borrowing became more difficult and expensive for everyone. Usually difficulty in borrowing would be due to a lack of confidence in a borrower's collateral.

With Lenders anticipating a decline in the value of the collateral provided by the borrower to secure the loan, guidelines for qualifying have become more stringent. Sometimes the issue may simply be a perception of risk regarding the solvency of other banks within the lending system.

With the law of supply and demand kicking in, as the supply or availability of money shrunk, the cost of borrowing rose. Most recently, some lenders stopped lending completely while others collapsed under the weight of the bad loans they had accumulated.

A Credit Crunch Gains Momentum

If the Central Bank raises interest rates or reserve requirements, the trickle down effect takes place and in an effort to comply, banks pass the costs down to the consumer and ... you guessed it, we end up in a credit crunch. The government can also create a credit crunch by imposing direct credit controls or by forbidding banks from lending for a period of time.

A prime example is the soft real estate market and resulting housing bubble in many areas of the country. "Easy money" or "loose credit" paved the way for a speculative frenzy in these real estate markets. It allowed consumers who, under more controlled lending practices would never have qualified, to buy a house.

With a greater demand for property than there was supply, frenzied competition and leveraged bidding resulted in hyperinflation in several real estate markets across the country.

When overinflated assets have been reduced in value, there is a financial crisis or credit crunch that results from that value or price collapse. Many believe the subprime mortgage crisis of 2007 - 2008 is the cause of the recent credit crunch.

The International Monetary Fund said, in a global financial stability report, that falling house prices and slowing economic growth are hitting credit. The US government has been attempting to shore up their economy with stimulus packages to limit the severity of the downturn, but this has become a contentious issue across the country as this spending will have to be funded by borrowing money as well.

Credit risks have spread from subprime mortgages to all other major credit categories, such as car loans and credit card loans.

Alan Greenspan former Fed chairman wrote in his book The Age of Turbulence: "Historically, societies that seek high levels of instant gratification and are willing to borrow against future incomes to achieve it have more often than not suffered inflation and stagnation.

The economies of such societies tend to run larger government deficits financed with fiat money from a printing press . . . Eventually, the ensuing inflation leads to a recession or worse, often because central banks are forced to clamp down . . . I regret that the US may not be wholly immune to it."

The subprime mortgage crisis and the practice of subprime lending in general, has led to a credit crunch, resulting in a restriction on the availability of credit in world financial markets as well as here at home.

Large numbers of borrowers have defaulted on their loans, filed for bankruptcy or are in mortgage foreclosure. Though this is no consolation, hundreds of subprime lenders have closed shop, filed for bankruptcy or been acquired by larger lending institutions.

About the Author

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