Saturday, 20 September 2008

The Credit Crunch

Credit crunch is a term used to describe a sudden reduction in the general availability of loans (or "credit"), or a sudden increase in the cost of obtaining loans from the banks.

There are a number of reasons why banks may suddenly increase the costs of borrowing or make borrowing more difficult. This may be due to an anticipated decline in value of the collateral used by the banks when issuing loans, or even an increased perception of risk regarding the solvency of other banks within the banking system. It may be due to a change in monetary conditions (for example, where the central bank suddenly and unexpectedly raises interest rates or reserve requirements) or even may be due to the central government imposing direct credit controls or instructing the banks not to engage in further lending activity.

The global credit crunch we’re now experiencing was caused when people with poor credit ratings (or “subprime credit risks”) were unable to meet higher debt repayments to US mortgage brokers due to rising interest rates. As more mortgages were foreclosed in America (so properties could be repossessed and then sold on for a profit), their previously buoyant housing market nosedived. These subprime losses started in early 2006 and continued to worsen throughout 2006 and into 2007.

The credit crunch will not end until the U.S. housing market has been stabilized— policymakers must understand that. Unfortunately, U.S. house prices are declining at an accelerating rate, while unsold housing inventories remain at record levels and a rising tide of foreclosures threatens to drive prices even lower. The available policy options are not pretty. But a policy of inaction is not a viable alternative.