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
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 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.
What caused the credit crisis of 1772? ›
Sparked by the flight of the Scottish banker and speculator Alexander Fordyce, panic broke out on June 9, 1772, in London, with the experimental Ayr Bank in Scotland an important casualty soon after.
How did the credit crisis affect everyone? ›
In a 2018 study, the Federal Reserve Bank of San Francisco found that, 10 years after the start of the financial crisis, the country's gross domestic product was approximately 7 percent lower than it would have been had the crisis not occurred, representing a loss of $70,000 in lifetime income for every American.
How was the credit crisis solved? ›
Central banks lowered interest rates rapidly to very low levels (often near zero); lent large amounts of money to banks and other institutions with good assets that could not borrow in financial markets; and purchased a substantial amount of financial securities to support dysfunctional markets and to stimulate ...
What was the worst economic crisis in history? ›
The Great Depression of 1929–39
The Depression lasted almost 10 years and resulted in massive loss of income, record unemployment rates, and output loss, especially in industrialized nations. In the United States the unemployment rate hit almost 25 percent at the peak of the crisis in 1933.
Which statement best summarizes the financial crisis of 2008? ›
The statement that best summarizes the financial crisis of 2008 is that problems in the US economy caused the global economy to slow down, which made it harder for the United States to recover.
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 basic explanation of the financial crisis in 2008? ›
Predatory lending in the form of subprime mortgages targeting low-income homebuyers, excessive risk-taking by global financial institutions, a continuous buildup of toxic assets within banks, and the bursting of the United States housing bubble culminated in a "perfect storm", which led to the Great Recession.
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 is the definition of crisis in history? ›
juncture, exigency, emergency, contingency, pinch, strait (or straits) crisis mean a critical or crucial time or state of affairs. juncture stresses the significant concurrence or convergence of events. an important juncture in our country's history.
What triggered the emergence of the credit crisis? ›
market excesses that led to the current credit crisis was the sustained rise in house prices and the perception that they could go no- where but up. Indeed, over the period 1975 through the third quarter of 2006 the Office of Federal Housing Enterprise Oversight (OFHEO) index of house prices hardly ever dropped.
When was the US credit crisis? ›
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 was the credit crisis in the Great Depression? ›
A series of financial crises punctuated the contraction. These crises included a stock market crash in 1929, a series of regional banking panics in 1930 and 1931, and a series of national and international financial crises from 1931 through 1933.
What is the crisis in crisis summary? ›
The crisis in crisis from this point of view is the radical presentism of crisis talk, the focus on stabilizing a present condition rather than engaging the multiple temporalities at stake in a world of interlocking technological, financial, military, and ecological systems.
What is the credit crisis in the United States? ›
The collapse of the United States housing bubble and high interest rates led to unprecedented numbers of borrowers missing mortgage repayments and becoming delinquent. This ultimately led to mass foreclosures and the devaluation of housing-related securities.
What was the impending crisis summary? ›
'The Impending Crisis of the South' argued that slavery was incompatible with economic progress. Using statistics drawn from the 1850 census, Helper maintained that by every measure the North was growing far faster than the South and that slavery was the cause of the South's economic backwardness.
What is the main message of the crisis? ›
The main idea of Thomas Paine's 'Crisis No. 1' is to inspire courage and patriotism in the American colonists and encourage them to resist British rule and fight for their independence.
