A credit crunch occurs when there is a lack of funds available in the credit market, making it difficult for borrowers to obtain financing. This happens in one of three scenarios: when lenders have limited funds available to lend, when they are unwilling to lend additional funds, or when they've increased the cost of borrowing to a rate unaffordable for most borrowers.
Let's take a look at the anatomy of a credit crunch.
When lending institutions have suffered losses from previous loans, they are generally unwilling or unable to lend. This occurs when borrowers default and the properties underlying a defaulted loan decline in value. In this situation, as borrowers default, banks foreclose on the mortgages and attempt to sell these properties, in order to regain the funds they loaned out. Consequently, if home prices fall, the bank is left selling the property at a loss. Because banks are required to retain minimum levels of liquidity (capital), when they suffer losses their capital positions are reduced, which reduces the amount they are able to lend out.
Credit crunches can also occur when regulatory bodies increase capital requirements for financial institutions. Banks and other lenders are required to maintain a set amount of capital liquidity based on their risk-weighted level of assets. If this requirement increases, many banks will need to increase capital reserves. To comply, banks will cut lending, reducing the availability of loans for individuals and companies.
Also, if banks perceive a greater risk in the market, they will often raise their lending rates to offset this risk. This increases the cost of borrowing and makes it more difficult for borrowers to access financing. If borrowers aren't willing to borrow at these rates, the bank is unlikely to lend at all.
A credit crunch can do a lot of damage to the economy by stifling economic growth through decreased capital liquidity and the reduced ability to borrow. Many companies need to borrow money from lending institutions to finance and/or expand operations; without this ability, expansion is not possible; in some cases, companies will need to cease operations. When coupled with a recession, a credit crunch will often lead to many corporate bankruptcies. This increases the crunch's economic impact by stifling the economy's ability to recover.
For related reading, see How Will Your Mortgage Rate?
(For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.)