What is the difference?
Leading up to the 2008 financial crisis, the market was rapidly growing for financial securities based on mortgage loans resulting in generous lending. Subprime mortgages i.e. mortgages offered to those at high risk of default, were on the rise. Widespread confidence in these assets was then presented with a ‘Minsky Moment’, being the point of a sudden decline in market sentiment leading to and resulting in a crash.
As the US housing market began to decline, many borrowers simply defaulted leaving its lenders with large debts; triggering a crisis.
A crisis therefore occurs where financial assets suddenly lose large amounts of its nominal value and where financial institutions experience liquidity shortages.
Credit is key to economic activity as firms often borrow to invest in the business, and individuals take out loans to fund education or to purchase a house. Subsequently if credit is less accessible, this impacts the economy. During a credit crunch, credit becomes more difficult to obtain as the terms & conditions tighten.
By way of example, during the 2008 credit crunch, financial institutions realised that the loans provided to home buyers were de facto worthless, as there was very little analysis of the borrower’s credit worthiness. To reduce the risk, these institutions suddenly began tightening their conditions and restricting credit. Credit crunches are therefore often caused by market failures.
A financial bubble occurs when the prices of assets rise upwards and above the fundamental value of the asset. Bubbles often occur due to economic irrationality as people ‘follow the crowd’ when investing in an asset, rather than making a decision on the asset’s true value.
Example: with the emergence of the internet being utilised for commercial use, hopes were high for internet entrepreneurs. Investment funds were heavily investing in tech corporations with largely inflated pricing. As many of these companies failed, the bubble burst and stocks became worthless; impacting the stock market and investors suffered huge losses.
The frenzy or ‘hype’ over an asset inflates the price, however the activity eventually slows or stalls and the market crashes, ‘bursting the bubble’.
By: Sibel Vurdu – LLM Law & Economics QMUL, Trainee Solicitor & Founder of BeComAware.
Video Production by: Salih Karakis, Videographer.
All BeComAware content is reviewed and approved by a professional in industry.