How is a credit crunch different from a financial crisis?

The enormity of the challenges posed by the present financial crisis and credit crunch is starkly revealed in its two most basic aspects, firstly, the enormous toll on the United States’ financial system and secondly, the unprecedented scope of the governmental responses, which have been provoked.

The toll
At last count more than 60 financial institutions in the United States went insolvent or had to be rescued in the past six weeks. These include seventeen (17) commercial banks. And, among these casualties were massive banks like Washington Mutual and Wachovia. These two were taken over by JP Morgan Chase and Wells Fargo. The world’s largest insurance company, (the American Insurance Group, AIG) was also overwhelmed. So too were some of the country’s most prestigious investment houses like Bear Stearns and Lehman Bros.

During this period the scale of the sub-prime housing bubble became more and more evident. An estimated twenty-five (25) per cent of housing mortgages had mortgage value outstanding that was greater than the market value of the house. Not surprisingly, even the humongous mortgage institutions, Freddie Mac and Fannie Mae also became victims. The major US Stock Exchanges (Dow Jones Industrial Average, NASDAQ Composite, and the S&P 500) displayed exceptional volatility from hour to hour and day to day. Thus for the week ending October 11 the Dow Jones Industrial Average lost 18 per cent of its market capitalization value for the firms listed there.

On top of all these the slowdown in economic growth became more pronounced. In the third quarter of the year the value of US real GDP fell, reinforcing the widely held view that the country was firmly in the grip of a recession. Recent data on unemployment seem to support this outlook.

If one looked at the unemployment picture in the United States carefully one would have to consider not only the open unemployed, but those who are part-time workers who want to be full-time, as well as those that have given up on looking for work. These categories would cover what in Guyana are termed as the unemployed and under-employed.

Recent data published by the US Department of Labor show that while there are about 9.5 million workers unemployed in the United States, 6.1 million are involuntarily working part-time, in that they are looking for full-time jobs but cannot find them, and 1.6 million are no longer looking for work. This gives us a total of 17.2 million persons unemployed and under-employed, an equivalent of 11 per cent of the work force.

Amidst the carnage of collapsing financial institutions two financial precepts have emerged to the forefront of public discussion. One is the notion of a ‘credit crunch’ and the other is the status known as ‘too big to fail,’ which has been attributed to some financial institutions. Both of these are important technical terms, which I shall briefly elaborate on for the remainder of this column.

Credit crunch
Several readers have queried the title of my column last week, which listed the financial crisis and the credit crunch as separate phenomena. The reason for this is that technically, a credit crunch refers to a situation where there is an abrupt drastic contraction in bank loans or credit. In the present situation this has come about because banks in the United States are running scared over the quality of the assets being offered as collateral by potential borrowers. This phenomenon has become so widespread among banks to meet the standard of a massive credit crunch. Amongst those seeking to borrow are other banks, as well as firms and individuals. As a rule when credit or loans dry up, interest rates rise because of reduced supply. However, even at higher interest banks may still consider it too risky to lend.

Credit crunches can have other causes as we know from experiences in Guyana. Here the central bank and/or the government have in the past imposed sudden direct controls on commercial banks’ lending, restricting the amount and type of loans or credit they are permitted to make. They have also through the use of operations on the money supply and reserve holdings of banks induced credit crunches for broader economic purposes.

At present banks in the United States have become suspicious that other banks would fail because the quality of the assets they are holding is poor and risky. At the peak of the banking collapses indicated earlier, there was a list of about 120 banks in the United States, which investors were speculating would go insolvent or require drastic support from other institutions or the government if they were to survive. One thing stands out in the US situation: the credit crunch was preceded by persistent risky behaviour by banks, particularly in the way they were valuing collateral on which they were making loans or giving credit. This means that their balance sheets were stuffed with overvalued and unrealistically priced assets.

From the description above it is clear that a credit crunch is very different from other types of financial crisis. Thus for example a bank may have a ‘solvency’ crisis with all its assets properly valued because independent of this there is a run on the bank. The credit crunch in the United States is different and entirely due to overpriced or ‘toxic assets.’

Too big to fail
The other financial precept that has emerged into prominence is the notion that some financial institutions are considered as ‘too big to fail.’ In essence this means that the repercussions of their failure and the collateral damage to the broader financial edifice and eventually the real economy would be catastrophic. Government cannot possibly allow this to happen. The contradiction here is that the dynamic basis of the capitalist economy is survival of the fittest. That is, you make a profit or your firm goes under.

Next week I shall continue the discussion from this point by asking the question, what are the implications of this policy response.