Explaining the credit crunch

The current economic downturn – the worst in at least three decades – began with the bursting of the U.S. housing bubble, when mortgage delinquencies forced banks to write down several hundred billion dollars in bad loans. But those overall mortgage losses, while large on an absolute scale, are modest relative to the $8 trillion lost in U.S. stock market wealth between October 2007 and October 2008, says the National Bureau of Economic Research (NBER).

In "Deciphering the Liquidity and Credit Crunch 2007-2008," Markus Brunnermeier describes how those lesser and larger losses were linked and shows how economic mechanisms amplified losses in the mortgage market into broad dislocation and turmoil in the financial market.

Brunnermeier's study identifies four distinct economic mechanisms that played a role in the liquidity and credit crunch now hobbling the financial system.

First:
 

• The effects of the hundreds of billions of dollars of bad loan write-downs on borrowers' balance sheets caused two "liquidity spirals."
   
• As asset prices dropped, financial institutions not only had less capital but also a harder time borrowing, because of tightened lending standards.
   
• The two spirals forced financial institutions to shed assets and reduce their leverage.
   
• This led to fire sales, lower prices, and even tighter funding, amplifying the crisis beyond the mortgage market.
  
  Second, lending channels dried up when banks, concerned about their future access to capital markets, hoarded funds from borrowers regardless of credit-worthiness.
  
  Third, runs on financial institutions, as occurred at Bear Stearns, Lehman Brothers, and others following the mortgage crisis, can and did suddenly erode bank capital.
  
  Fourth, the mortgage crisis was amplified and became systemic through network effects, which can arise when financial institutions are lenders and borrowers at the same time; because each party has to hold additional funds out of concern about counterparties' credit, liquidity gridlock can result.
  
  Network credit risk problems can be overcome if a central authority or regulator knows who owes what to whom, Brunnermeier notes. Then the system can stabilise. But the opaque web of obligations in the financial system that is currently characteristic of securitisation tends to be destabilising, leading to heightened liquidity and credit problems.
  
  Source: Sarah H. Wright, Explaining the Credit Crunch, NBER Digest, March 2009; based upon: Markus K. Brunnermeier, Deciphering the Liquidity and Credit Crunch 2007-08, National Bureau of Economic Research, Working Paper No. 14612, December 2008.
  
  For text: http://www.nber.com/digest/mar09/w14612.html
  
  For working paper: http://www.nber.org/papers/w14612.pdf
  
  For more on Economic Issues: http://www.ncpa.org/sub/dpd/index.php?Article_Category=17
  
  FMF Policy Bulletin/ 24 March 2009