What Is a Credit Crisis?
A credit crisis is a situation in which loans, including short-term lending between financial institutions, are so limited that day-to-day operations of the financial system are at risk of grinding to a halt. A credit crisis is essentially an incredibly severe credit crunch where the short term lending that allows businesses to function disappears at the same time as consumer loan issuance tightens.
Credit crisis most often refers to the specific 2007-2008 credit crisis that happened as a result of the mortgage lending market.
In general terms, however, a credit crisis has a triggering event, like a wave of borrower defaults on a particular class of loans. The financial institutions that issued the loans stop receiving payments, which make up a portion of their operational capital. A shortfall in payments coming in forces these banks to pull more heavily on the short term lending market, but these lenders pull back due to uncertainty over the health of the banks' loan portfolios in these troubled times of borrower default. The financial institutions are unable to access credit, and this leads to a period in which financial institutions redefine the riskiness of their own borrowers, making it difficult for debtors to find creditors.
Understanding Credit Crises
A credit crisis results in a situation where no one can access the credit they need to keep operations going, regardless of how sound or risky their business. Much of the business world depends on short term credit to keep companies capitalized while they await payment on the goods and services they sell. When this dries up, it can have disastrous effects on the economy and the financial system as a whole.
The 2007-2008 Credit Crisis
The 2007-2008 Credit Crisis was a credit crunch that got out of hand because of an incredible amount of uncertainty surrounding securitized loans. The loans that made up mortgage-backed securities (MBS) had structural flaws including a lack of proper vetting of lenders and teaser rates that essentially guaranteed default in some cases.
These loans were sliced up into MBSs and collateralized debt obligations (CDO) that rating agencies were far too generous in rating. When balance sheets started to implode in the balance sheets of financial institutions, they realized that no one had been properly pricing in the risks on these derivatives and no one really knew how bad it could get.
Then, the inter-lending between these firms stopped and the credit crunch combined with the mortgage meltdown to create a credit crisis that froze the financial system when its need for liquid capital was at its highest. The situation was so dire that the Federal Reserve had to pump billions into the system to save it—and even then, we still ended up in The Great Recession.
- A credit crisis happens when lending is so limited that it puts the financial system at risk.
- These crises tend to occur after a trigger event, such as quick and widespread default on certain loans.
- The term “credit crisis” usually refers to the 2007-2008 credit crisis, where the risks of MBS and CDOs were not properly identified, leading to the mortgage meltdown.
- Less severe restrictions of credit are labeled credit crunches.