What Is a Credit Crisis?
A credit crisis is a breakdown of a financial system caused by a sudden and severe disruption of the normal process of cash movement that underpins any economy. A bank shortage of cash available for lending is just one in a series of cascading events that occur in a credit crisis.
Key Takeaways
- A credit crisis is a breakdown of a financial system caused by a sudden and severe disruption of the normal process of cash movement that underpins any economy.
- A credit crisis is caused by a trigger event such as an unexpected and widespread default on bank loans.
- A credit crunch becomes a credit crisis when lending to businesses and consumers dries up, with cascading effects throughout the economy.
- In modern times, the term is exemplified by the 2007–2008 credit crisis that led to the Great Recession.
Understanding a Credit Crisis
A credit crisis has a triggering event. Consider the potential impact of a severe drought where farmers lose their crops. Without the income from the crop sales, they can't repay their bank loans. Without those loan payments, the bank is short of cash and has to pull back sharply on making new loans. The bank still needs cash flow for its ordinary operations, so it steps up borrowing in the short-term lending market. However, the bank itself has now become a credit risk and other lenders cut it off.
As the crisis deepens, it begins to interrupt the flow of short-term loans that keeps much of the business community running. Businesses depend on this process to keep operating as usual. When the flow dries up, it can have disastrous effects on the financial system as a whole.
In the worst-case scenario, customers get wind of the problem and there's a run on the bank until there's no cash left to withdraw. In a slightly more positive scenario, the bank stumbles through but its standards for loan approvals have become so constricted that the entire economy, at least in this drought-stricken region, suffers.
The modern banking system has safeguards that make it more difficult for this scenario to occur, including a requirement for banks to maintain substantial cash reserves. In addition, the banking system has become consolidated into a few giant global institutions, making it unlikely that a regional drought could trigger a system-wide crisis. But those large institutions have their own risks. This is where the government steps in and bails out institutions that are "too big to fail."
The modern banking system has safeguards in place to prevent a credit crisis from occurring, although there's still a risk that loan availability and the circulation of cash in the economy could dry up.
The 2007–2008 Credit Crisis
The 2007–2008 credit crisis is most likely the only severe example of a credit crisis that has occurred within the memory of most Americans.
The 2007–2008 credit crisis was a meltdown for the history books. The triggering event was a nationwide bubble in the housing market. Home prices had been rising rapidly for years. Speculators jumped in to buy and flip houses. Renters were anxious to buy before they got priced out. Some believed prices would never stop rising. Then, in 2006, prices hit their peak and started to decline.
Well before then, mortgage brokers and lenders had relaxed their standards to take advantage of the boom. They offered subprime mortgages, and homebuyers borrowed well beyond their means. "Teaser" rates virtually guaranteed that they would default in a year or two.
This was not self-destructive behavior on the part of the lenders. They did not hold onto those subprime loans, but instead sold them for repackaging as mortgage-backed securities (MBS) and collateralized debt obligations (CDO) that were traded in the markets by investors and institutions.
When the bubble burst, the last buyers, who were among the biggest financial institutions in the country, were stuck. As the losses climbed, investors began to worry that those firms had downplayed the extent of their losses. The stock prices of the firms themselves began to fall. Inter-lending between the firms stopped.
The credit crunch combined with the mortgage meltdown to create a crisis that froze the financial system when its need for liquid capital was at its highest. The situation was made worse by a purely human factor—fear turned to panic. Riskier stocks suffered big losses, even if they had nothing to do with the mortgage market.
The situation was so dire that the Federal Reserve (Fed) was forced to pump billions into the system to save it—and even then, we still ended up in The Great Recession.
FAQs
The 2007–2008 credit crisis was a meltdown for the history books. The triggering event was a nationwide bubble in the housing market. Home prices had been rising rapidly for years. Speculators jumped in to buy and flip houses.
What was the credit crisis of 2008 an overview? ›
It began with the housing market bubble, created by an overwhelming load of mortgage-backed securities that bundled high-risk loans. Reckless lending led to unprecedented numbers of loans in default; bundled together, the losses led many financial institutions to fail and require a governmental bailout.
What is the meaning of financial crisis in history? ›
A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics.
How did the credit crisis begin? ›
The catalysts for the GFC were falling US house prices and a rising number of borrowers unable to repay their loans. House prices in the United States peaked around mid 2006, coinciding with a rapidly rising supply of newly built houses in some areas.
What was the historical background of the financial crisis in 2008? ›
The credit markets that had financed the housing bubble quickly followed housing prices into a downturn as a credit crisis began unfolding in 2007. The solvency of over-leveraged banks and financial institutions hit a breaking point with the collapse of Bear Stearns in March 2008.
What is the credit crisis summary? ›
A credit crisis is a breakdown of a financial system caused by a sudden and severe disruption of the normal process of cash movement that underpins any economy. A bank shortage of cash available for lending is just one in a series of cascading events that occur in a credit crisis.
What makes the credit crisis of 2007 and 2008 became global contagion? ›
Causes, Outcomes & Lessons Learned. Risky adjustable-rate mortgages and lack of oversight on mortgage securitization created a crisis of global proportions in 2007 and 2008. The worst economic crisis since the Great Depression started with lowly U.S. homebuyers.
What was the financial crisis in 2008 for dummies? ›
The subprime mortgage crisis was triggered by risky lending practices. When interest rates froze and the housing bubble began to collapse, borrowers couldn't afford their payments. As massive foreclosures ensued, the fallout spread to the global financial system.
What was the biggest financial crisis in history? ›
The Great Depression of 1929–39
Encyclopædia Britannica, Inc. This was the worst financial and economic disaster of the 20th century. Many believe that the Great Depression was triggered by the Wall Street crash of 1929 and later exacerbated by the poor policy decisions of the U.S. government.
Which statement best summarizes the financial crisis of 2008? ›
Which statement best summarizes the financial crisis of 2008? Problems in the US economy caused the global economy to slow down, which made it harder for the United States to recover.
The American subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the 2007–2008 global financial crisis. The crisis led to a severe economic recession, with millions losing their jobs and many businesses going bankrupt.
What are the effects of the credit crisis? ›
Some of these negative economic consequences include an increase in mortgage interest rates, loss of confidence in the financial system, and a rise in unemployment. A famous example of a credit crunch in the U.S. economy was during the Great Depression of the 1930s.
What role did credit play in the financial crisis of 2008? ›
A common narrative for the start of the financial crisis suggests that credit agencies downplayed the riskiness of RMBS, drawing in lenders who did not appreciate their intrinsic risk. Some also claim that ratings were less accurate in the subprime market than elsewhere.
What was to blame for the 2008 financial crisis? ›
Everybody involved with the 2007–2008 financial crisis is partly to blame for the Great Recession: the government, for a lack of oversight; consumers, for reckless borrowing; and financial institutions, for predatory lending and unscrupulous bundling and selling of mortgage-‐backed securities.
What are the causes of financial crisis? ›
Various factors contribute to a financial crisis, including systemic failures, unanticipated or uncontrollable human behavior, incentives to take excessive risks, regulatory absence or failures, or natural disasters such as pandemic viruses.
What event sparked the 1980s debt crisis? ›
The crisis began on August 12, 1982, when Mexico's minister of fi- nance informed the Federal Reserve chairman, the secretary of the treasury, and the Inter- national Monetary Fund (IMF) managing director that Mexico would be unable to meet its August 16 obligation to service an $80 billion debt (mainly dollar ...
Why did the 2008 financial crisis happen for dummies? ›
Improper mortgage lending practices played a large role in the crisis. Mortgage lenders relaxed their lending standards and handed out interest-only and adjustable-rate mortgages to borrowers who were unable to repay.
