Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Five Things You Need to Know: What Does "Credit Crunch" Mean?


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


Minyanville'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 remain the same.
  • 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 feeds into this risk-seeking behavior and creates 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 finanical markets are year-to-date:
    S&P 500: UP 3.2%
    DJIA: UP 6.6%
    Nasdaq: UP 6.1%
  • Markets are actually up year-to-date.
  • This is why so many market commentators have been 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, 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.

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?

This is what a "Credit Crunch" looks like:

  • H&R Block CEO: Mortgage Market May Be Worst Since '30s - New York Times
  • H&R Block subprime sale may collapse - Financial Times
  • Freddie Mac Profit Down 45 Percent - the result of larger provisions for bad loans - New York Times
  • A Fight Over $24 Billion in Financing - KKR, Banks Maintain Positions on First Data - Wall Street Journal
  • Commercial Paper Extends Slump on Asset-Backed Woes - Bloomberg

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.
  • PIMCO's Bill Gross has recommended that government step in and create an RMC – Reconstruction Mortgage Corporation - essentially a bailout of borrowers; a fiscal response.
  • 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.
  • Ultimately, if consumers begin to show risk aversion and undertake balance sheet repair, 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.
  • Whether the performance of those less-consumer-dependent sectors show absolute performance, as opposed to relative outperformance, remains to be seen.
  • If the Consumer Staples sector declines by 15%, but Consumer Discretionary declines by 20%, then Consumer Staples will have outperformed on a relative basis, though both declined on an absolute basis - small consolation, but there it is.
  • Ultimately, this just leads us right back to where we began... with our fiat-based monetary system, where economic growth is dependent upon credit expansion.
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

Featured Videos