Credit crunch refers to the severe shortage of money or credit, which stems from the unusual economic situation in the country during the recent decade. United States had experienced a long period of low nominal short-term interest rates, low inflation and fairly steady growth. Also debt to disposable income ratios were at a high level. Household net saving rates (savings to disposable income) had been falling for a decade and were close to zero in 2006.
Many reasons can lead to credit crunches. Accounting to Owens and Schreft(1995). political or regulatory interference with the credit allocation process causes credit crunches. In addition, securitization of bank loans also has a significant influence. The securitization of consumer credits, mortgages and commercial and industrial loans was growing in 1990s. These assets did not show in the bank's balance sheet and are not considered to be bank loans. In fact, the credit slowdown could be the spurious result of increased securitization processes in banking institutions. Consumer credit securitizations are small compared to the total bank lending and commercial and industrial loans in fact decreased. Overzealous regulation is another factor of credit crunch. That refers to the examination practices that have forced banks to make high capital charges against loan losses and to have a more cautious approach to accepting new credit risk. Bernanke and Lown concluded that the evaluation of the capital charges was difficult to execute and thus did not found it to be an explicit reason for a lending slowdown. A data on allowances for loan losses and charges to capital proved that neither of these experienced a discontinuous jump. Thus Bernanke and Lown saw no clear connection between overzealous regulation and lending slowdown. Although the securitization had an effect to bank lending, the fundamental factor of lending slowdown, was a fall in the bank capital. Accounting to Bernanke and Loan, as a result of regulatory capital standards, banks had to sell assets and reduce lending. This situation was called the capital crunch.
To understand more about the credit crunch in 2007-2008, it is important to comprehend the concepts of market and funding liquidity. The credit crunch in 2007-2008 is a fine example of an event where market illiquidity turns into funding illiquidity. According to Brunnemeier and Pedersen (2008) market liquidity is the ease with which an asset is traded and funding liquidity is the ease with which traders can obtain funding. A trader cannot use the entire value of the security as collateral because she must pay a margin which is financed with the trader's own capital. A margin is a difference between security 's price and collateral.
The rationale of Brunnermeier and Pedersen (2009) is explained that when traders' are having difficulties in acquiring funding, that is , the funding liquidity is tight, the traders' are not willing to invest in high-margin securities which would require a lot of capital. This reduces market liquidity and increases volatility because asset is not traded as smoothly. When the market liquidity is low, it might increase the risk of financing a trade, meaning that higher margins are demanded which worsens traders' funding constraint even more. The phenomenon described above is called a margin spiral. A loss spiral is formed when speculators have a large initial capital position that is negatively correlated with the customer's demand shock. That increases market illiquidity and induce higher speculator losses on their positions. Speculators are finally forced to sell more of their assets which cause a further drop on the price of an asset.
In short, funding problems of investors forces the leveraged investors to reduce their positions, which causes more losses and higher margins, which in turn worsens the funding problems and so on.
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