A credit shock occurs when there is a swift reduction in the availability of loans (credit) or a sharp increase in the costs of getting new loans from banks. Historically, credit shocks have occurred after long periods of easy and irresponsible lending from the banks, in which the banks make bad loans to individuals who would not normally qualify for traditional loans. As the defaults on these bad loans start to increase, there is a tightening of credit from the banks, which causes a reduction in the prices of over-inflated asset values as the banks try to recover the loss by foreclosing on the properties and auctioning them off. This, in turn, causes a downward spiral as more loans continue to go bad and more properties continue to be foreclosed upon.

Keep reading to find out how these shocks can affect you.

The Causes
There are many reasons why credit shocks occur, all of which are equally important. Let's take a look at a few reasons and draw from some historic examples - including the build up to 2007-2008's mortgage meltdown and credit crunch.

  • Speculation: Because it's so easy to obtain credit from the banks, many individuals and investors think that prices will continue to rise. This causes many people to obtain additional loans with very easy terms (such as little to no initial down payments or requirements for obtaining the loans). The sharp increase in property values causes investors to jump into investments with little or no fundamentals. This creates a mob mentality, where investors feel they are missing out and do not want to be left behind. As more investors continue to pile in, prices of assets rise to unsustainable levels.
  • Adjustable-rate mortgages (ARMs) and subprime loans: With interest rates being low and lending standards very easy, many individuals who normally would not qualify for traditional mortgages (by having a 20% minimum down payment) turn to adjustable rate mortgages (ARMs) or subprime loans. These loans allow you to purchase the property with little or no money down. Factor in greed, and many buyers purchase the biggest and most expensive property possible, instead of asking what will happen to their house payments if interest rates start to rise. This creates a ticking time bomb where many people will be unable to afford their houses once interest rates do start to rise consistently over a period of time. (Keep reading about ARMs in ARMed And Dangerous and Payment Option ARMs: A Ticking Time Bomb?)

  • Lack of regulatory oversight: As many mortgage brokers and bankers continue to write questionable loans, the underwriters, who work for the banks to determine whether a borrower has the ability to repay the loan, turn a blind eye to what is going on so that the banks can see an increase in profits by the number of loans that they have written. (For more, see Brokerage Functions: Underwriting And Agency Roles.)

    The repeal of the Glass-Steagall Act in 1999 (which was a Great Depression–era law that prohibited banks, brokers and insurance companies from participating in each other's businesses) is another example of a lack of regulatory oversight. At the time when the law was repealed, many argued that American banks couldn't compete in the global environment with those argued restrictive regulations. But, if some of the out-of-date regulations were removed, then American banks could police themselves with little to no government regulation and better compete in the market.

  • Historically low interest rates: From 2000 to 2003, the Federal Reserve lowered interest rates from 6% to 1% in an effort to prevent the economy from slipping into a recession following the post dotcom bubble, the 9/11 attacks and the accounting scandals at the time. With low inflation, the Fed felt that by lowering interest rates to such levels, it would only be a matter of time before the economy improved and they could start raising rates.

    A side effect of this action was that it helped create an environment of easy money. Many on Wall Street felt that if the Fed could go in and bail out a large hedge fund, as they did for Long Term Capital Management in 1998, then the government would be there for them if/when they needed a bailout. This created the perfect breeding ground for historically high mortgage applications and refinancing with little to no scrutiny over the questionable loans being written.

  • Politics: Many politicians were going on record saying the higher the rate of home ownership for Americans, the better. However, what they didn't take into account was what would happen to the economy from the perspective of those who could not afford their homes when an inevitable slowdown occurred. This resulted in tremendous pressure on mortgage giants Fannie Mae and Freddie Mac to write mortgages for those whose credit was not good enough to purchase a home. (For more on this crunch on Fannie and Freddie, see Fannie Mae And Freddie Mac, Boon Or Boom?)

To read more about the subprime crisis, check out our in-depth Subprime Mortgages tutorial.

The Effects
There are many ways that a credit shock can affect borrowers. The shock may cause the following:

  • Consumers tighten up spending. As the economy slows and unemployment starts to rise, many consumers either slow or reduce spending to cope with the slowdown. This causes retail sales to fall and consumer confidence to drop. (To learn more about market confidence, see Consumer Confidence: A Killer Statistic.)

    Obtaining credit becomes more difficult as a result of the credit shock, so many purchases of big-ticket items, like vehicles, homes or home entertainment systems, are put on hold due to the tighter lending standards.

  • Interest and foreclosure rates increase.With many borrowers already over their heads in debt, increases in interest rates lead to a cycle of rising foreclosures as homeowners succumb to the added financial pressure. This causes many homeowners to walk away from their homes and file for bankruptcy as a way to reduce their debts. This leads to more write-downs and losses at the banks.
  • A domino effect hits all the other types of loans. The tighter lending standards for mortgages create ripple effects that make it even more difficult to obtain loans for other purposes, such as auto financing and consumer credit lines. This causes retail sales to fall further causing a slippery downward financial slope.

Credit shocks can affect the economy in several different ways. Some of these ways include:

  • Banks tighten credit for all other types of loans. As the credit markets seize up, many banks that were very easy on their lending standards become very cautious on a variety of different loans. The small businesses depending on these loans and lines of credit to fund their day-to-day operations then become illiquid. This leaves small businesses unable to pay their immediate bills, which forces them into liquidation or bankruptcy.

  • Unemployment rises. When businesses are unable to pay their immediate bills, they face the unpleasant task of laying off employees, which creates a situation where unemployment rises in communities nationwide.

  • Banks and brokerage firms are hit hard. As the credit shock runs its course, the effects on banks and brokerage firms can be devastating. Following the repeal of the Glass-Steagall Act, many banks and brokerage firms aggressively jumped into a variety of different loans ranging from home loans to business loans to constructions loans. By doing this, they created a situation in which their overall liquidity could be affected by a series of bad loans, which caused the banks to further tighten their lending standards.

  • A spiraling domino effect occurs. The above mentioned economic effects of a credit crisis can cause the economy to go into a downward free-fall that affects the entire nation. Once the economy starts down this path, it becomes difficult to break the cycle.

Credit shocks are caused by many factors such as subprime loans, lack of regulatory oversight, low interest rates and politics. They have several effects on borrowers, including causing consumers to cut their spending, rising foreclosures on financially squeezed consumers and the domino effect this creates for all other types of consumer loans. However, i
t is important to remember that credit shocks have occurred in the past and have eventually been resolved.

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