The mysterious credit crunch

There is something mysterious about this credit crunch. When you look for it in financial sector data, it is often not there. Even when you can find it, it is surprising how limited its effects have been so far.

Take, for example, the housing market in the United States. Since 2006, foreclosures have exploded, and real estate prices have crashed. There is no doubt something really bad hit the US market. However, real estate loan data shows and much more moderate slowdown. As late as August 2008, the dollar value of real estate loans increased by a surprising 4.5 percent.

From a long-term perspective,the recent decline in real estate lending activity is quite unremarkable. Since 1970, there have been no fewer than seven credit crunches, when lending to the real estate sector fell below five percent a year. The most severe credit crunch was in the early 1990s, when the savings and loan crisis led to credit growth falling to around 1 percent a year. The current credit crunch is nowhere near that bad, at least not so far.

The savings and loan crisis was definitely a bad one, with a huge number of bank failures, and a substantial slowdown in economic growth. Nevertheless, the five other periods of declining real estate credit growth were much more benign and did not result in a catastrophic failure within the financial system. In many respects, these five benign credit slowdowns look a lot like the current one, so why is the current crisis so much more dangerous?

The answer is found in the shockingly inadequate levels of bank capital. In previous downturns, the US financial system was more capable of absorbing shocks. Today's financial institutions are far more brittle.

Indeed, it is disturbing to think that only modest increases in default rates led to the collapse of such famous names as Freddie Mac and Fannie Mae, Leeman Brothers, Bear Stearns, Indymac and Washington Mutual. All these institutions were essentially undercapitalised and it only took a slight increase in bad loans to send them under.

This is the great lesson of the current credit crunch. Banks need sufficient capital to absorb any increase in default rates. This requires stringent supervision, which has been so lacking in recent years.