Such a credit crunch is considered to be a manageable part of any meaningful economic trough. It’s not fun, but it is a necessary part of a healthy capitalist economy. Credit gets more expensive and marginal projects get put on hold; the free market is applying appropriate checks and balances, creative destruction, the discipline of the market, etc. Eventually, demand for credit falls and rates come down, allowing the cycle to eventually repeat.

A credit “crisis,” however, is a slang term for a severe, unmanageable version of a credit crunch. A credit crisis is a situation in which the tightening of credit and the ability of firms to ride out the economic downturn goes well beyond the ability of normal market forces (and central banks) to nudge the system back in the right direction.

That seems to be where we are right now. But why aren’t the banks lending? Didn’t we just inject hundreds of billions of dollars into the banking system?

Why is this Happening?

The man on the street will tell you that too many banks made too many bad loans, that the government was too lax in enforcing its rules, and that too many Wall Streeters got drunk on leverage. That all seems to be perfectly true. But what about the “Troubled Asset Relief Program” or “TARP”? At least $350 billion were already “injected” into US banks to prop up shaky balance sheets and get the banks to lend—with more on the way.

Banks are faced with a fundamental problem. Despite very attractive lending spreads, despite weak balance sheets, and despite short term deflation which actually increases the “real” profit for lending money, banks are simply terrified to loan money in an environment filled with riskier and riskier credits. Who knows who will go bust next?

Spreads may be high, but credit risk appears crippling. Rapidly climbing default rates make lending a very tough game for a solid bank. Weak banks simply don’t want to play. Credit standards have gone up, interest rates have gone up and the “price” of credit has gone up in every form. But despite seemingly huge spreads available to anyone willing to lend, good companies will still go wanting.

No, this one really is different.

The textbooks explain how the history of banking and credit is interwoven with the history of economic cycles, macroeconomic sine waves with frequencies that can span decades. Such expansions and contractions are nothingnew. As far as we know, they’ve existed as long as people have participated in credit or lending anywhere. The milder parts of the wave (lower amplitudes) are generally called “the business cycle” and the big ones (high amplitude) are called “booms and busts.” The peaks and troughs have many names: highs and lows, easy credit and tight credit, optimism and pessimism, greed and fear, etc.

One key feature of these cycles is that they are irregular and unpredictable, both in magnitude and duration. Many statistical tools have been developed to measure them (GNP, GDP, CPI, M1, M2, unemployment rate, etc.) and many regulatory and governmental tools have been developed to try to mitigate their rampages (central banks, reserve ratios, government lending/borrowing, wealth redistribution, various forms of fiscal stimulation, etc.) Yet the business cycle is still considered as basic to capitalism as fleas to a dog.

But this credit crunch has broken out of the amplitude range we associate with a normal, even deep trough. This crisis starts with the “popping” of the biggest housing and credit bubble in history. America’s home prices are down by more than 21% since their peak in 2006. (Source: CaseSchiller Housing Index) Many analysts expect another 10% drop across the country, which would bring the cumulative decline in nominal house prices close to that during the Depression. Worldwide losses on debt originated in America (primarily related to mortgages) is expected to exceed $1.4 trillion. Statistics from third quarter, 2008 showed that $760 billion had been written down by the banks, insurance companies, hedge funds and others that own the debt. The IMF’s “base case” is that American and European banks will shed some $10 trillion of assets, equivalent to 14.5% of their stock of bank credit in 2009. (Source: Economist and IMF)

It’s going to take a long time to get ourselves out of this one. But nearly every pundit we see has come to the same conclusion: This banking crises cannot be solved without public money. Whether we choose to continue recapitalizing banks through brute-force federal investment or use some RTC-style “bad bank” scenario, decisive government action will be required to minimize the damage to the economy. This one really is different.

Eric Wanger, JD, CFA is President of Wanger Investment Management, Inc & the Manager of the Wanger Long Term Opportunity Fund.

It’s Not the Credit Spreads: A bank generates loan profits from the “spread” or difference between the interest it pays on deposits and funding sources vs the interest it receives from lending. Banks can currently make plenty of money loaning money to customers that will pay it back. (Source of Data: Bloomberg)