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.

The 2007-2008 credit crisis is the only severe example of such an event that has occurred within the memory of most Americans.

Understanding a Credit Crisis

A credit crisis has a triggering event. Consider the potential impact of a severe drought: 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. But the bank itself has now become a credit risk and other lenders cut it off.

Key Takeaways

  • A credit crisis is caused by a trigger event such as an unexpected and widespread default on bank loans.
  • The 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.

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 Too Big to Fail Scenario

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," to use a term coined during the 2007-2008 credit crisis.

The financial crisis of our times was the 2007-2008 credit crisis which followed the collapse of the sub-prime mortgage market.

Example: The 2007-2008 Credit Crisis

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 home buyers 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 sold them on 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 were stuck.

Those last buyers were among the biggest financial institutions in the country. 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 was forced to pump billions into the system to save it—and even then, we ended up in The Great Recession.