5 minute guide: credit crunch

Last Modified: 08 Apr 2008

The global economy has been in throes of a credit crunch since the middle of last year, principally linked to the collapse of the US sub-prime mortgage market. But what exactly does it mean?

What is a credit crunch?

A sudden cut in the availability of credit or loans, including in the form of mortgages, credit cards and crucially, interbank lending, as banks worry about a lack of liquidity. As credit becomes harder to obtain it becomes more valuable, hence more expensive.

As credit becomes harder to obtain it becomes more valuable, hence more expensive.

When did the current crisis hit?

The current credit crunch is largely seen to be a result of the 2007 US sub-prime mortgage crisis, when people with poor credit histories were leant money they could barely afford to repay. A slight change in economic conditions caused a large number of this group to default on loans, forcing banks to write-down large sums of money due to these bad debts.

Some might argue, however, that a credit crunch is the natural conclusion to an economic cycle which has been booming for more than a decade

Why does it happen?

A credit crunch can be the end result of a long period of cheap credit, possibly given to unreliable borrowers, like the sub-prime mortgage crisis in the US.

The availability of easy money also contributes to the inflation of prices in a particular market, in this case the housing market, creating a 'bubble'. In this instance a large group of people were leant money that they might not reasonably be expected to be able to repay because of poor credit histories or simply insufficient income to service the loans they were being sold.

This means that a change, even a small one, in the fundamentals of the economy, like a rise in unemployment, quickly unbalances the lending model.

Most commentators are agreed that this probably isn't the end of the credit crunch.

What happens next?

Most commentators are agreed that this probably isn't the end of the credit crunch. With house prices continuing to fall and the banks still making big write-downs, it is not clear that we have seen the worst of it.

Where has the credit crunch hit hardest?

Northern Rock

Chancellor Alistair Darling was forced to table emergency legislation in parliament earlier this year to nationalise Northern Rock after the Bank of England gave it an unlimited loan last September in order to avoid a run on the lender.

The Northern Rock bank specialised in mortgages but had only a small deposit base. This meant the liquidity crisis prompted by turmoil in the US sub-prime sector hit it particularly hard.

Citigroup

The CEO of the world's biggest bank, Charles Prince, called his decision to step down last November as "the only honourable course" after the bank racked up billions in losses and write-downs from exposure to sub-prime mortgage debts.

Bear Stearns

The governor of the Federal Reserve, Ben Bernanke, has admitted that Bear Stearns was America's Northern Rock.

In March Bear Stearns was forced to sell to rival JPMorgan Chase. The intial offer was for $2 a share, valuing it at $236.2m, or one per cent of its value just a couple of weeks earlier. Ultimately JPMorgan Chase payed $10 per share.

UBS

At the beginning of April UBS became the biggest European victim of the US sub-prime mortgage crisis after writing-down £9.6bn on top of the £9.3 bn it write-down during 2007. As a result of these losses chairman Marcel Ospel was forced to quit.