Credit Crunch

A credit crunch refers to a sharp reduction in the availability of credit. It could refer to a sharp increase in interest rates but often it involves a significant shrinkage in supplies of lendable funds. It likely shuts out some subset of borrowers from access to credit. The term came into use in the 1960s when the home mortgage industry began experiencing periodic credit crunches. By 2000, financial innovations and markets for wider ranges of financial assets minimized the possibility that one or two economic sectors would bear the full brunt of a credit crunch. Nevertheless, the credit crunch of 2007–2008 began in the home mortgage industry, and residential construction was the hardest hit economic sector

The home mortgage industry experienced credit crunches in 1966 and again in 1969, 1973, and 1974. These episodes of credit crunches occurred over a span of years roughly coinciding with the Vietnam War, a time when defense related expenditures of the Cold War put the maximum strain on the financial resources of the United States. In addition to heavy government borrowing, a piece of banking law called “Regulation Q” banned payment of interest on checking accounts and limited the payment of interest rates on savings accounts to the 5 percent range. At the time of these first credit crunches, a type of financial institutions called savings and loans dominated the home mortgage industry.

These institutions raised funds by offering savings deposits to depositors, and these funds were lent to home buyers in the form of home mortgages. As inflation and government borrowing exerted upward pressure on interest rates, savers began removing funds from savings and loan deposits. Instead, they invested in 90- day treasury bonds, which paid a substantially higher interest rate. The flow of funds out of savings and loan institutions and into the bond market was called “disintermediation.” An increase in short-term interest rates prompted disintermediation, forcing savings and loan institutions to curtail lending, and residential home builders to cut back on construction.

The development of secondary mortgage markets eased the squeeze of these early credit crunches. It severed the link that forced mortgage lending and residential construction to move in step with the flow of deposits in and out of thrift type institutions. The secondary mortgage market allowed the institutions that had expertise in evaluating borrowers and establishing customer relationships to continue to originate mortgages. Instead of financing mortgages out of savings deposits, thrifts sold mortgages to third parties as an investment.

In 2007 and 2008, another type of credit crunch, the subprime meltdown, shut out borrowers from access to credit. A wave of defaults on mortgages negotiated with subprime borrowers shook the secondary market for mortgages, forcing originators of mortgages to greatly raise the bar of creditworthiness. Subprime borrowers are borrowers who paid higher interest rates to compensate for weak credit ratings.

A contraction in home mortgages led to a contraction in the housing industry, raising the specter of recession. Lenders, stunned by high mortgage defaults and expecting a recession, began tightening credit standards for a wide range of loans, including automobile loans and other types of consumer credit. As the Federal Reserve slashed interest rates to ward off recession, lenders made it harder for individuals to qualify for loans, arousing fears that the anti-recession monetary policy might not succeed.