The Credit Cycle: Why Do Banks Trigger Booms and Crashes?

The Analysis: Credit — Fuel and Time Bomb

There is an invisible force that drives almost every modern economic cycle. It is not corporate earnings growth, nor central bank speeches, nor trade wars. It is the credit cycle.

The principle is simple: when banks and financial institutions are optimistic, they lend more freely and on easier terms. More credit means more investment, more consumption, and rising asset prices. The economy accelerates. Then, inevitably, borrowers find themselves over-indebted, defaults appear, panic sets in. Banks turn off the tap. The economy contracts.

This mechanism is as old as banking capitalism — and yet, every generation seems surprised by it.

The Concept: Pro-Cyclicality of Credit

The technical term is pro-cyclicality: credit amplifies the economic cycle instead of dampening it. When everything goes well, banks lend more, which makes things go even better. When things turn sour, they lend less, which worsens the downturn.

This is the exact opposite of what we would want: a financial system that would lend more in recessions (to cushion the shock) and less in expansions (to prevent bubbles). But human nature works against this: a banker who refuses a loan when everyone is making money takes a huge reputational risk.

Howard Marks, founder of Oaktree Capital and one of the world's best credit managers, puts it this way in his famous memos: *"Credit is not a fixed resource. It is created and destroyed according to the collective psychology of lenders."*

The Anecdote: Howard Marks Sees the Crisis in 2007

In July 2007 — more than a year before the Lehman Brothers bankruptcy — Howard Marks sent his clients a memo titled *"The Race to the Bottom"*. He described with clinical precision what he observed: banks lending to borrowers who should never have qualified, complex financial products (the famous CDOs and MBS) masking true risk, and credit markets completely ignoring prudence.

His method was not to predict the exact date of a crash. It was to observe credit conditions: spreads (rate gaps between risky bonds and safe bonds), junk bond issuance rates, and the rigor of loan underwriting standards.

When spreads compress dangerously and any borrower can get a loan without solid collateral, Marks knows the cycle is in an advanced euphoria phase. He then reduces risk exposure. No need to predict exactly when it cracks — just knowing you're at the top of the cycle is enough.

The Historical Fact: 2008, the Explosion of the Cycle

The 2008 subprime crisis is the most documented example of a credit cycle going up in smoke. And yet, almost no one seemed to see the wall coming.

From 2002 to 2007, US banks granted mortgage loans to insolvent households (the famous "subprimes"), then packaged these bad debts into complex financial products sold to investors worldwide. The credit-creation machine ran at full speed, fueled by historically low Fed rates and widespread greed.

In 2007, first defaults appeared in the riskiest loan segment. Banks panicked. The interbank credit market — where banks lend money to each other — seized up within weeks. In September 2008, Lehman Brothers went bankrupt. The global credit cycle entered a brutal contraction phase.

The result: a global recession, millions of unemployed, and central banks forced to intervene with historically unprecedented amounts to re-liquefy markets. All of it had been visible well before for those watching credit signals — as Marks had done.

The Lesson for the Investor

The credit cycle is not just a theoretical curiosity. It has direct consequences for every portfolio.

In expansion phase: risky assets rise, bond spreads compress, IPOs and M&A explode. This is the time to benefit — and to start watching for excesses.

In contraction phase: risky assets fall, cash and safe bonds outperform. This is also when the best buying opportunities appear for those who kept liquidity.

Two simple indicators to monitor:

• Credit spreads (gap between junk bond rates and US T-Bonds): low in expansion, they explode in contraction
• Credit underwriting standards published quarterly by the Fed (SLOOS survey): when banks tighten lending criteria, the cycle is starting to turn

At Axone Capital, we systematically integrate these macro signals into our market reading. Understanding where you are in the credit cycle means understanding the bottom of the wave — before it sweeps you away.

*Axone Method: Macro · Technique · Mindset. Macro first — context takes precedence over everything else.*