Thursday, August 16, 2007

What is a Credit Crunch?

And more importantly, why should you care?

Unless you have been under a rock these past few weeks, you are sure to have heard the term "credit crunch". Let's take a minute and explain what it is, and why everyone is talking about it these days.

Credit is the fuel that makes the financial system go. Just as individuals borrow money, whether through mortgages, credit cards or student loans, so do companies. Like individuals, companies use the loans that they take to finance their operations and growth plans. In recent years, financing was pretty easy to come by. Interest rates were low and borrowing was inexpensive - you know this yourself from all the refinancing SPAM you have no doubt been receiving. However, all of a sudden the financial climate has changed and lenders are much less eager to part with their cash.

Why is this happening? Enter our good friends from the sub-prime mortgage market. When money was cheap to borrow and house prices were booming, lenders made all sorts of questionable loans to people who are now unable to repay them. Many banks and other financial institutions that owned large portfolios of such questionable loans all of a sudden found themselves holding the bag, and the bag is sort of... empty of cash.

So what happens next? As we all remember, financial markets tend to over react. All of a sudden lenders become more cautious. Where before they would throw money at anything that moved, now they may be reluctant to give out loans even to well qualified borrowers and to solid companies. When there are fewer lenders willing to hand out the dough, the price of taking out a loan goes way up. This is because interest rates, like every other commodity in a free market, are subject to the law of supply and demand.

All of a sudden even people with good credit find it harder or more expensive to borrow money, and even companies with solid plans cannot find money to finance their growth. This is known as a credit crunch. When that happens, less money gets invested in the economy, companies hire fewer people because they are not growing, and the economy itself may sink into recession. So even though you may not be a sub-prime borrower yourself, the sub-prime crisis may impact you directly. It may be tougher to find a job, more expensive to buy a house, and much more difficult to start a business. Fun times may be ahead.

So, are we there yet? Has the economy slipped into recession? The experts say that no. Me, I think that we are headed in that direction and we are in for some tough times ahead. For now, people are expecting this to be a short, temporary bump in an otherwise solid economy. I don't believe that is the case. Humans have a tendency towards optimism. This sort of downturn has a nasty habit of starting out small and picking up steam on the way down. It's been a while since our last recession, seems like we may be due for one right about now.

1 comment:

Eric said...

All you can really do is ride it out. It's a typical cyclical pattern that will iron itself out in a few months.