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Five Things You Need to Know: What is a Credit Crunch?

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What you need to know (and what it means)!

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Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. What is a "Credit Crunch"?

The simple answer is that a "credit crunch" is a general decline in the the supply of, and demand for, credit.

Under ordinary circumstances, the market (and sometimes the Federal Reserve) can induce a decline in the supply of credit by raising interest rates. This makes money more expensive for borrowers, and as a result slows the growth and demand for available credit.

But a "credit crunch" occurs when banks become more risk averse - less willing to lend - even though interest rates may remain the same, and in extreme cases, even though interest rates may go lower.

This risk aversion on the part of lenders makes it more difficult for even the most credit-worthy borrowers to obtain money at reasonable terms. In effect, interest rates - the cost of money - can become infinitely high for many borrowers. As a result, it becomes difficult to fund projects and investments, which can slow economic growth, which can make lenders even more unwilling to lend.


2. Why does credit growth matter in the first place?

Because in our fiat-based monetary system, economic growth is dependent upon credit expansion.

What does that mean? And why is it a problem?

First, by "fiat-based monetary system" we are not criticizing the economic system in the United States. This is just the name economists give to an economic system where money is created through fractional reserve banking techniques.

Fractional what? Say again?

Fractional reserve banking is the practice of issuing more money than a bank holds in cash reserves. So, in a fiat-based monetary system, if risk appetites are supportive - that is, if borrowers are willing to take on debt - then credit expansion can feed into normal risk-seeking behavior, and if excessive can foster unsustainable booms; dot.coms, housing.

As long as credit expansion and demand for credit continues at an accelerating pace, the appearance of prosperity continues as asset prices increase.

The "accelerating pace" aspect is critical. It is the key to maintaining the boom.

Just look at where financial markets are year-to-date:

S&P 500: UP 2.5%
DJIA: UP 5.9%
Nasdaq: UP 7.6%

Markets are actually up year-to-date.

Then why are so many market commentators insistent that the Fed try and stimulate additional appetite for credit by lowering rates? Whether it is by intuition, or unconscious recognition, these market commentators feel the psychological pain created by growing risk aversion and waning appetite and demand for credit.


3. What is credit expansion, anyway?

Credit expansion occurs when new money is created by the banking system and offered at artificially low interest rates, or to borrowers with low credit quality.

We know this creates "malinvestments," but how?

By offering willing borrowers money at artificially low rates, this encourages increased time preferences among economic actors, which is to say that investment horizons are lengthened and risk tolerances are widened. It also creates the "illusion" of rising asset values. In the simplest terms, the demand for money outstrips the supply. This money is then overinvested and misallocated by investors in, say, dot.com ventures, or houses.

In hindsight, it always seems these investors were dumb. After all, who could now believe that an "undertaking of great advantage; but nobody to know what it is" could be a reasonable investment? Probably, no one. However at the time, during the South Sea Bubble of 1720, quite a few investors figured just such a company made really good economic sense. Seriously.


4. How, then, do we transition from credit expansion to a "Credit Crunch"?

Because credit expansion distorts capital investments and spending by creating the "illusion" of prosperity, when the time comes to pay back what is borrowed investors and lenders discover that they have misallocated their capital. This leads to losses because the only way to turn a misallocation of capital into a gain is to sell it at a higher price to someone who still believes it will go up in the future.

This loss of capital creates risk aversion; lenders suddenly find they are not being repaid, say, by subprime borrowers who are defaulting on their mortgages. These lenders in turn - remember this is a fractional banking system -find that because they used the repayment of these loans as collateral for loans they took out to "malinvest," suddenly discover they are unable to repay some of their debts. The lender's lender is in the same boat, as is the lender's lender's lender. So, what do these lenders do? They "de-lever." In other words, they sell whatever they can - whatever is still liquid (say, U.S. stocks, for example) in order to raise capital to repay loans. This pressures asset prices.

We then have a situation where the fear of not having money (U.S. dollars) to pay down debt spreads. This deepens further risk aversion. Time preferences shrink. Lenders then in many cases cannot, or are no longer willing to, extend credit beyond the very short term, for they fear not being repaid.


5. What does a "Credit Crunch" look like?

So what happens next? If we are in a "Credit Crunch," how do we get out of it?

The Fed can make even more credit available; a monetary response. This may temporarily relieve tight credit conditions among financial institutions.

Also, the government can step in and create any number of mechanisms to essentially bailout borrowers; a fiscal response. Is that appropriate?

On the one hand we're a compassionate society that sees people being foreclosed upon in record numbers, and our first instinct is to "do something." But we have to ask what the ramifications of that are? The unintended consequence of helping people avoid foreclosure is removing the market's penalty for unsuccessful speculation, and that changes the function of markets as we know it.

Most likely we will see a combination of the two - a combined monetary and fiscal response. That will most likely delay a deflationary credit collapse, but it won't address two key issues; consumer time preference and risk aversion.

If consumer risk aversion becomes entrenched then we will see a long-term shift in market leadership away from financials and consumer discretionary-dependent sectors, and toward consumer staples and sectors with less exposure to consumer purchasing decisions.

And what about time preferences? Markets are too large for any central bank or group of central banks to control for long. And ironically, the more they act to try and prop up or even slow the decline in asset prices, the larger the market becomes. Think about it. If people begin to suspect that asset prices won't really be allowed to go down, what is the rational response to that? It's to increase the size of the bet.

So by targeting asset prices and attempting to "manage the economy" the Fed ironically creates the conditions for a market that is too large for it to control. As a result, crashes, unwindings of speculative bubbles, become more devastating, and affect far more people in the real economy.

No positions in stocks mentioned.

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