Understanding the Economy

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We’ve heard the term credit crunch over and over again—but what does it mean? In the simplest terms, a credit crunch means that it may be more difficult for you to get a loan for a home or for a car, and the interest rate that you have to pay may be higher. It may also be more difficult for a business to get a loan to pay for a new building, a truck, or a computer.

However, from an economic perspective, we can look a bit deeper in order to understand why a credit crunch occurs. Let’s revisit the basics of financial markets. Suppose that you go into a bank and take out a loan to buy a home or a car. Where does the bank get that money from? There are three possible sources for the funds (see figure) First, virtually all banks have depositors, who have put their money into savings accounts or into certificates of deposit. The bank can then lend that money to borrowers.

A second source of funds: The bank can borrow money itself by issuing bonds to investors. That is, the bank can borrow the money and lend it out again at a higher interest rate. Many banks did that in recent years.

Finally, the third source of funds for loans is called securitization. Securitization is a fancy word for saying that the bank can make mortgage loans to home buyers, package them up into what is called a mortgage-backed security, and sell the mortgage-backed security–that is, the bundle of loans–to investors. It can do the same with other types of loans, like auto loans.

In all three of these cases, the bank is a financial intermediary. That means it helps direct money from suppliers of capital—that is, depositors and investors—to the users of capital, borrowers.

When the financial markets are working well, this flow of money from depositors and investors to borrowers is free and easy, like water flowing through a pipe. If you want a loan to buy a home or a car, you go into the bank, which checks your qualifications—do you have enough income to pay back the loan, do you have a history of paying your debts on time. Then if you are qualified, the bank offers you the loan at the going market rate.

A credit crunch occurs when the banks—the financial intermediaries—are wounded or broken in some way. Investors and depositors still have their money, but the flow of funds to borrowers is interrupted. You can think of it as being blocked, like a broken pipe.

Today, the banks have been wounded because they are absorbing enormous losses on mortgages they have made, as more and more homeowners default. Because so many of their existing loans are going bad, banks are afraid to make new loans. Instead of lending to households or businesses, banks are investing their deposits in safe government securities–that is, they are lending to the government.

In addition, it is harder to raise money to make loans.  Savers are still willing to put money into banks, because up to some level  it is guaranteed by the government.  But investors are less willing to lend money to banks, because they fear that if a bank goes out of business, they could lose their money. And securitization is tougher, too, because investors are less willing to buy loans which might go bad.

The result: Because loans are more expensive and harder to get, households buy fewer cars and homes, while businesses do less capital investment.