The current financial crisis is often described with sound bites such as “Executive Bail Out,” “Wall Street Bail Out,” “Credit Markets Collapse,” or “Failed Economic Problems.” None of these labels or sound bites helps the average person understand what is happening and, more importantly, how it affects them. Granted there are many pieces to this puzzle, but the one that may impact the average person the quickest is the collapse of the credit market.

It’s helpful to understand how the credit market works, especially at the bank level.

When a dollar is deposited into a bank, the bank keeps a portion as a reserve so that it has cash to meet day-to-day business needs. This is called its reserve. Let’s assume that regulations require that 20% be kept by the bank. That means that the bank can use 80% for their usual business of making loans—loans that are the bank’s primary source of profits. The 80% used for loans results in additional deposits, which result in additional loans.

For example, if $1000 is deposited, $200 is kept in reserve, and $800 is used for new loans. The $800 in loans is deposited in banks. The banks kept 20% or $160 in reserve and loan $640 to other people and businesses. The $640 new deposits allow 80% to go to additional loans of $512. This process is continually repeated until $1000 is held in bank reserves, and $5000 of new loans has been made. Thus, for every $1000 of new deposits, the bank can make $4000 of new loans.

If the reserve requirements were 5% instead of 20%, as is the case in some home mortgages, then a $1000 deposit (or home collateral) could provide loans of $19,000.

When the public and banks have confidence in their loans, the system works great. The bank has cash reserves to mean day-to-day demands, and makes a nice profit on the loans. The loans mean that we can buy new homes and cars without having to pay for them in cash. We can send our children to college and spread the payments out to make them affordable. Business can expand and develop new products, whose profits will provide the repayment of the development costs. Businesses can expand and build new offices and factories and create new jobs. Many businesses use a line of credit to be sure that payrolls can be met each week, regardless of cash flow.

But what happens when a loan goes bad? If a loan defaults, then the whole process is reversed. For example, if a loan for $1000 defaults, the bank has to use its reserves to cover it. As we saw in the above example, if the reserve requirement were 20% then $4000 of available credit would be lost; if the reserves were 5%, then $19,000 of available credit would be lost. Not only does the bank lose its reserves and available credit, confidence is lost and people and businesses are afraid to make additional deposits. Thus, available credit becomes even less.

What happens when the banks lose almost all of their available credit? Remember that it is the available credit that is the “product” banks use to make a profit. Without credit, a bank is like a car dealership without cars—no product to sell.

But, banks have a large amount of unused, available credit in the form of credit card limits. Your credit card bill is $3,000 but you have $10,000 available credit, so you don’t think twice about buying your liquid gold, I mean gas, and paying for it with your credit card. However, if banks cannot find available credit elsewhere, they may reduce your credit card limit in order to have credit for larger clients such as businesses. If your limit were reduced to $3,000, your card will no longer be accepted until you pay some of your bill.

The credit crisis is now personal—your credit cards don’t work, your employer may need to defer your paycheck, as developments, buildings, and expansions stop your employer may need to lay off employees. Your bills and expenses continue as your sources of cash and credit have suddenly evaporated. This is why the credit crisis today should be seen as a personal crisis.

Today’s financial crisis has many dimensions, not just the credit issues. However, it is the collapse of the credit markets that is likely to have the most immediate effect on your personal finances. Correcting the collapse of the credit market and the resulting personal crisis in the lives of most Americans is imperative. Why it has happened, who is responsible, or how we solve this problem are not the important issues: the important issue to every American is that confidence in our financial systems is restored, and credit markets return to normal to prevent individual personal financial crisis on “Main Street, America.”

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