The Financial Crisis and Credit Unavailability: Cause or Effect?

Was the global financial crisis the cause of credit unavailability, or was it the effect? The standard story is that the financial crisis resulted in the loss of credit availability.  To assess cause and effect, consider the timeline of events leading to the financial crisis. As home prices steadily increased, it became common for lenders to make mortgage loans to even risky, or “subprime,” borrowers. Lenders expected that home appreciation would cause collateral values to increase and enable borrowers to repay through refinancing. This model worked well so long as home prices continued to rise. But when prices began declining, the subprime borrowers could not refinance and, in many cases, defaulted. These mortgage defaults caused substantial amounts of investment-grade-rated mortgage-backed securities to be downgraded or default. As a result, investors started losing confidence in credit ratings and avoiding rated debt securities; and many parties stopped dealing with firms, like Lehman Brothers, holding lots of mortgage-backed securities. Lehman’s subsequent bankruptcy added to the panic. Debt markets, which provide the majority of US corporate credit, shut down, depriving companies of money to expand and pay expenses. The economy collapsed.