Credit Crunch - Why Did We Have It?

In 2007, the financial markets were abuzz with talk of a "credit crunch." It was portrayed as some unusual and unpredictable outside force like an asteroid impact or a cold winter storm. However, it was not unexpected, and it was not caused by any outside force. The credit crunch began because borrowers were unable to make payments on the loans they were given. When lenders started losing money, they stopped lending money: a credit crunch.

New Century Financial is the poster child for the Great Housing Bubble. New Century Financial was founded in 1995 and headquartered in Irvine, California. New Century Financial Corporation was a real estate investment trust (REIT), providing first and second mortgage products to borrowers nationwide through its operating subsidiaries, New Century Mortgage Corporation and Home123 Corporation. The company was the second largest subprime loan originator by dollar volume in 2006. On April 2, 2007, the company filed for Chapter 11 bankruptcy protections. The date of their financial implosion is regarded as the day the bubble popped. The death of New Century Financial has come to represent to death of loose lending standards and the beginning of the credit crunch. Subprime lending was widely regarded as the culprit in starting the cycle of credit tightening, and New Century has been linked to this problem, but the scale and scope of the disaster was much larger than subprime.

The massive credit crunch that facilitated the decline of the Great Housing Bubble was a crisis of cashflow insolvency. Basically, people did not have the incomes to consistently make their mortgage payments. This was caused by a combination of exotic loan programs with increasing payments, a deterioration of credit standards allowing debt-to-income ratios well above historic norms, and the systematic practice of fabricating loan applications with phantom income (stated-income or "liar" loans). The problem of cashflow insolvency was very difficult to overcome as borrowing more money would not solve the problem. People needed greater incomes, not greater debt loads.

The response of the Federal Reserve to this mess was to lower borrowing costs as much as possible. The Federal Funds Rate was lowered to zero, and the FED began buying longer term treasuries in a program known as quantitative easing. Unfortunately, lowing interest rates does not force people to borrow or banks to lend. People had already borrowed too much, and banks had few creditworthy customers to loan to who were not already overburdened with debt. The credit crunch could not be solved with monetary policy. The only thing that was going to help was time and people paying down their enormous debt loads.Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
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