Credit cycle vs. economic cycle
Credit cycles occur as liquidity availability increases until its abundance pushes the bargaining power to the borrower. The borrower commands terms that are very favorable and shops the loan until finding a lender willing to make it they are price seekers. Eventually a multitude of bad loans cause a cascade of delinquencies and defaults and less disciplined lenders go out of business (see Subprime lending). At the point where the more disciplined lenders are the ones remaining standing, the borrower has very little bargaining power and become price takers.
Too many dollars chasing too few loans leads to entrepreneurs seeking big risk and big return. Before the credit crunch occurs, people start business where 85-90% of the start up funds come from loans. Even though the business may be good, it may not be able to keep up with debt servicing payments. Frequent reasons for delinquency or default are:
and a multitude of normal things which are not economically dependent.
With high amounts of borrowing, the delinquent company may not be able to refinance its debt. In the tight lending environments that usually follow a credit cruch the start up business may only be able to borrow 60-70%. If there is a rough patch, the company will usually be able to refinance and stay afloat.
Economic cycles measure the change in GDP or Gross Domestic Product. A recession is a 6-9 month period in which GDP is lower in the current year than the previous year. A depression is a 12 month period in which GDP is lower than in the prior year.
It is important to recognize that while an economy may not be growing, it still exists. Businesses continue though expansion may not occur and investments in growth may bear no fruit in the immediate future. Properly run companies will be able to service their debt even though profits may be lower.
The same principles apply to residential mortgages. The same hard lessons are being learned again. Unfortunately the majority of unconventional loans were packaged together and sold as a bundle, or securitized. As the mortgage is owned by the security it is prohibited from being altered so that the resident can keep the home. There is nothing anyone, including Ben Bernanke, can do to help.
We are part of the way through the tough segment of the credit cycle now (October 2007). Even though the business may really be a good business, it may not be able to keep up with debt servicing payments.
Credit cycles and economic cycles are related, but one does not drive the other. The influence of one on the other is mostly seen at the extremes. Over the next several quarters, a multitude of people will fall on hard times and detract from GDP. Maybe we will have a small recession, maybe it will just be a period of slow growth. But we are definitely seeing major problems for those improperly positioned for this part of the credit cycle.