Did Lenders Cause Their Own Credit Crunch?

It seems lenders forget basic facts about lending every so often and create a new financial bubble. Perhaps they succumb to the pressure of the investment community or their own shareholders, or perhaps they just start believing their own "innovation" marketing pitch and forget the basics of sound lending practices.

Borrowers have a unique way of telling lenders they have created an unstable loan program: they default. When lenders begin to experience high default rates, they begin to lose money. Once they start losing money, they curtail lending and tighten lending standards. This tightening is the credit crunch.

There are necessary recessions at the end of a business cycle. These pathologic lending practices must be purged from the system or else they will survive to build an even bigger and costlier bubble. Although it is difficult to imagine a bubble bigger than the Great Housing Bubble, it is still possible.

In the aftermath of a financial fiasco, lenders return to the practices that did not fail them in the past. The only program lenders know empirically to be stable is a 30-year, fixed-rate, conventionally amortizing loan based on 80% of appraised value taking no more than 28% of a borrower's gross income (36% maximum total debt).

The credit crunch facilitated the decline in housing prices after the Great Housing Bubble. Large downpayments came back, and government assisted financing became widely used by first-time homebuyers to overcome the high equity requirements. The credit crunch was not caused by some unexpected or unknown factor; it was caused by the failure of lenders. Credit continued to tighten until lenders stopped making bad loans. The bad loans did not disappear until lenders returned to the stable loan programs with a proven track record. That is how the credit cycle works.

Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall? Learn more and get FREE eBooks at: www.thegreathousingbubble.com/ Read the author's daily dispatches at The Irvine Housing Blog: www.irvinehousingblog.com/ Visit Did Lenders Cause Their Own Credit Crunch?.

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