Credit Crunch: Definition & Causes

Instructor: Martin Gibbs

Martin has 16 years experience in Human Resources Information Systems and has a PhD in Information Technology Management. He is an adjunct professor of computer science and computer programming.

In this lesson, we'll define credit crunch and explain the causes and consequences of a credit crunch for individuals and governments. A real-world example is included.

What Is a Credit Crunch?

The term credit crunch evokes images of stress and pressure. A credit crunch occurs when there is a shortage of capital for lending. It is a sudden change in certain factors that lead to a shortfall in the amount of money that can be loaned to individuals and businesses.

credit crunch graphic

Causes

We can look to a fairly recent phenomenon, the crunch/recession of 2008, to see how a credit crunch unfolds. We'll explore several of the causes, including investor speculation, risky loans, lack of oversight, and very low interest rates.

Speculation

As home prices began to rise, people took out more and more home loans. These loans had easy terms and conditions. In turn, property values skyrocketed even more. Investors saw an opportunity to get in on the action, which drove prices up even further.

Risky Loans

We mentioned that home loans were on the rise, but it's important to understand that they weren't always the best loans. During the lead-up to the crunch, lenders were handing out loans like candy. This may have been sustainable if all borrowers were able to pay, or the loans were lower risk. But that wasn't the case.

Normally, a bank or lending agency would not give out loans to customers who have a low likelihood of paying back the loan. However, the climate among mortgage brokers was such that these so-called sub-prime loans were sold in huge numbers. Companies offered incentives and created consolidation loans to mask the sub-prime risk factor. They thought they were just spreading out risk, but they were making it worse.

Additionally, adjustable-rate mortgages were all the rage. An adjustable-rate mortgage is a loan in which the interest rate can fluctuate. Consumers were able to get loans with a lower down payment and a lower starting interest rate. This was great for them, but the sheer volume of loans was too much for the system. Furthermore, lenders became greedy, and many companies had incentives to push these kinds of loans to many consumers who could not pay them back. Once interest rates started to rise, loans became less and less affordable.

Lack of Oversight

While the loan parade handed out candy, there was little regulatory oversight. Loan underwriters looked the other way while banks and lenders cleared hefty profits. To make matters worse, a depression-era law had been repealed some years earlier; this law removed some regulations, allowing banks the luxury of self-policing. It didn't work.

To unlock this lesson you must be a Study.com Member.
Create your account

Register to view this lesson

Are you a student or a teacher?

Unlock Your Education

See for yourself why 30 million people use Study.com

Become a Study.com member and start learning now.
Become a Member  Back
What teachers are saying about Study.com
Try it risk-free for 30 days

Earning College Credit

Did you know… We have over 200 college courses that prepare you to earn credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the first two years of college and save thousands off your degree. Anyone can earn credit-by-exam regardless of age or education level.

To learn more, visit our Earning Credit Page

Transferring credit to the school of your choice

Not sure what college you want to attend yet? Study.com has thousands of articles about every imaginable degree, area of study and career path that can help you find the school that's right for you.

Create an account to start this course today
Try it risk-free for 30 days!
Create an account
Support