Credit Crunch between 2007 - 2009 - Essay Example

?Credit Crunch Between 2007–2009 Table of Contents Introduction 3 Economic Impact of Credit Crunch in the US 5 Steps Taken By the US to Resolve the Issues 11 Conclusion 15 References 16 Bibliography 19 Introduction Credit crunch is a financial circumstance in which investment capital is complex to acquire. Banks and investors become wary of providing funds to financial institutions thereby forcefully increasing the cost related to debt products for borrowers. This also affects for individual borrowers as banks become more risk averse towards their loan portfolio. Credit crunches are usually considered to be the predecessor of recessions. A credit crunch makes it almost impossible for business organisations to borrow as lenders are scared of insolvencies or defaults, which produce in high interest rates. The outcome of such scenario is extended slow recovery resulting from the supply of credit having shrunk (Duca & et. al., 2010). Credit crunch was caused in 2006 when the housing market crumpled. At the time of credit crunch, a certain numbers of the mortgages were intended for a division of the market, specifically subprime mortgages, their designed interest payment rates involving to refinance them within undersized phase were tried to be launched to avoid hikes in the mortgage rates. The mortgage refinancing demonstrates the fact that the prices related to housing market would likely to increase. Thus, the disintegration in the housing market defines a flow of the future non-payments in the subprime areas (Acharya & et. al, 2009). The financial crisis of 2007 initiated in the subprime mortgage industry in the United States. Apart from being restricted to the real estate market, the effects of the subprime fall down spread throughout the US economy as well as the global markets. The impact has been mainly severe on the financial industry, as numerous investment banks had a short but wide records of utilising Mortgage-Backed Securities (MBS) as a way to spread risk and free up other capitals (IESE Business School, 2009). The households and the institutions such as pension funds along with life insurance companies and mutual funds are the ultimate lenders investing in support of households. It is worth mentioning that certain credit will be offered to the borrowers directly from the lender, as is the case with municipal bonds and corporate bonds as well as treasury securities. The vastness of the credit financing intermediated in the economy through the banking system, deduced broadly. It is quite significant to comprehend the operation of financial intermediation as well as a way in which the emergence of banking system took place since the past few years. It is also vital to recognise the global financial crisis that took place in the year 2007 and thus generate standards such as short-term and long-term crisis management standards so that a flexible financial system can be generated (Adrian & Shin, 2010). The main objective in this study is to illustrate the economic impact on the US that have taken place due to the credit crunch, economic crisis and to reassess the measures that have been taken by the authorities to address the crucial issues that have generated those events. Economic Impact of Credit Crunch in the US There has been a certain significant economic impact of the credit crunch in the period of 2007-2009 in the US which coincided with the global recession. The economic impacts have been discussed below: Housing Bubble: The bursting of the housing bubble in the US affected banks to write down large losses that had been extremely amplified and also created a large number of confusions in the financial markets, and also resulted in the defaults, the liquidity dry ups, the bailouts of banks and financial institutions. As consistent flow of financing is an absolute obligation for the economic system, the financial disruption caused a growing doubt about the macroeconomic position, a wide-ranging increase in risk aversion and a strong deterioration in the actual economy, with unfavourable consequences for output and service (Adrian & Shin, 2010). House construction led the way to faster economic growth after the year 2001. Federal policies encouraged housing and thus lead to an increase in house price which fed to the explosion. Very Low Household Saving Rates and Debts: There was an outburst of the debt due to economics expenditure in 2005. The debt of the US households almost reached to 140% of Gross Domestic Product (GDP). The debt came out as the only approach to keep the consumption values, given the strong and continuous decline of the income distribution. The low interest rates alleviated the process of the households running into debt. Furthermore, the firms and the financial institutions (banks, investment banks and hedge funds among others) had become too much influenced. Both the stability of payments, current account deficit and the external debt had been very high (Cozzi, 2009). Fig: Fluctuations in the US Home Price Index, Source: (Standard & Poor’s, 2012). Low Interest Rates: The economy of the United States did well in terms of both growth and inflation before the credit crunch. According to Hyman Minsky’s old theory, conditions of growth and financial stability tend to create too much confidence and risk-taking. Due to such a scenario, in consequence it raises irresponsibility and insecurity. The expansion of bank credit feeds and reinforces the economic detonation. In the context of favourable business environment, firms escalate debts relative to equities. Asset and property prices increase in a process of maniac exuberance. When a problem starts, there is an increase in risk and a worsening of the business assurance that lead to a stock market breakdown because the speculators drop off a lot of assets. The entire process goes on in a destructive circle of bad expectations, deteriorating assets and the cost of property, debt liquidation, business retrenchment and borrowers strangled. The similar kind of scenario occurred in the US economy during the financial crisis 2007-2009 (Cozzi, 2009). The image below depicts the comparison of housing price changes and Fed interest rates during 1975 to 2007. It can be seen that during initiation of the financial crisis housing prices significantly altered. Source: (The Federal Reserve Board, 2010). Uprising Banking System: The possibility of reselling the loans was at the origin of the massive increase in subprime lending, from about 5 percent of the mortgage in the late 1990s to around 20 percent in 2006. Usually, the interest rates were high during the period crisis or to be reset upward at the later date. The greater payments to flow were not clearly advertised but instead almost obscured. The borrowers were attracted by the lenders on the very high probability of continuous increasing rates on house prices (Cozzi, 2009). Bank Risk Taking: The subprime mortgage market was comparatively small in size till the year 2000 and it was undertaken by commercial and investment banks whose main objectives were to purchase these mortgages from underwriters. They were further required to repackage them into Mortgage-Backed Securities (MBSs) and sell them further while backed by the payment of principal and interest on the mortgages. These MBSs were structured by classes with the same collateral but a different level of risk. They were later bought by investors whose interest was the return in the form of interest payments on the mortgages aided by the mortgage owners. The crisis originated in the United States in the housing and the mortgage market where people were buying and selling houses in the hope of making a profit. They invested mostly borrowed money into buying real-estate as the safest possible investment whose price was constantly increasing (Vukovic, 2009). Mortgages both prime and subprime appeared to be reasonably safe investments because a borrower in distress could refinance or sell the property for a sufficient amount to repay the mortgage. As house prices levelled off in 2006, and adjustable rate mortgages which were taken out in the low interest rate environment of 2003-2004, began to adjust up and the defaults began to rise, and in the mid of 2007, certain firms faced trouble financing their positions (Poole, 2010). Government’s Steps and Political Causes for the Financial Crisis: The Treasury and the Federal Reserve were slow to recognize that the problem were much more than liquidity. Markets were cutting off funding to banks and other financial firms, because investor feared that the firms might be insolvent. There should have been earlier recognition that house prices were going to decline, because prices were out of line with fundamentals. The Treasury and the Federal Reserve can also be criticized for being incapable of involving in proper emergency planning after the Bear Stearns release (Poole, 2010). Government Policies Encouraging Borrowing: Borrowers were endorsed to take mortgages as per the government strategies to increase the number of home ownership and promoted the availability of mortgage credit. It comprises tax incentives, housing finance programs sponsored by the government and consumer education that promote home buying on credit (American Bar Association, 2009). Regulation and Systemic Risk: The two most significant reasons behind the uncertain behaviour of the financial institutions were greed and corruption. The policies of the legislative and functioning government were made for political goal of increasing the number of voters. The systemic risk had taken place due to combining both aspects i.e. an increasing influence of client and different interest groups. Systemic risk was built in by regulatory decisions such as activities that government sponsored in the mortgage market, reasonable housing guidelines, rating an oligopoly towards evaluating the agencies as well as by the supplementary regulations compelled on banks’ capital. The formulation of systemic risk in such a way was not a consequence of bad motives; it was obscured behind wishes to restructuring the business by eliminating the risk and uncertainty. The source of increased risk-taking lays in the informational and cognitive basis of regulatory decisions which have a large amount of constricted consequence then when they are impulsively created by the market regulation. The efficiency of the financial market was reduced with rising regulation imparted upon it, thus its system risk increased (Vukovic, 2009). Mismatch of the Maturities: In this context, the maturity mismatch is one of the vital issues to be generated due to the credit crunch crisis in the year 2007 to 2009. In order to deal bilaterally with numerous creditors the financial institutions could not carry out a comprehensive maturity structure when entering debt contracts with its creditors. The maturity structure must be at equilibrium in order to avoid mismatch of maturities. A model of balance maturity framework for financial institutions that deal with various creditors need to be present. A contractual externality between the long-term and the short-term debt holders can lead to an uneconomical shortening of the maturity structure because the financial institutions transact with the creditors on a mutual basis and are unable to presume to a cooperative maturity formation (Brunnermeier & Oehmke, 2010). Steps Taken By the US to Resolve the Issues The US government had taken a number of steps in the midst of the financial crisis and credit crunch in the period of 2007-2009 to deal with one of the most rigorous financial crises faced by the country. The crisis was initiated in America’s real estates and banking as well as the other financial institutions which extended to the world economy (Burtless, n.d.). The government of US attempted to recover the financial structure and also adopted certain steps for the prevention of such a scenario in the future. An emergency legislation was passed by the US assembly in the year 2008 and early of 2009. The steps that were considered in the legislation included: (1) to avoid the breakdown of major financial institutions of the country; (2) to reduce the impact of the limitations of the US financial institutions; (3) to provide instant incentive to consumer spending by raising after-tax household income through provisional tax diminution and increase in government transfers; (4) to reduce the need to enhance taxes as well as to reduce the spending during the recession period by providing temporary funds to the state and local governments; (5) to look after the recently laid off workers and members of other economically susceptible populations incomes and health insurance; (6) to make available of Federal endorse for infrastructure investments as well as the research and science and energy production along with development schemes in health care department (The Brookings Institution, 2012). Among the steps that were taken to address the 2007 to 2009 crisis, there were changes in regulation with reference to how mortgage loans were issued and a number of financial stimulus efforts (Extension, 2012). A number of government programs as well as community aid programs, unemployment and disability insurance and the income tax system helped to provide automatic stimulus and protection of household income. Source: (Burtless, n.d.) The unemployment insurance program certainly demonstrates the leading comparative change in spending whenever the financial condition falls into decline. When the financial segment is increasing strongly and unemployment is low down, unemployment insurance assistance presented correspond to only about 0.3 percent of non-refundable personal income. In the financial crisis period that percentage was more than two times mainly because the number of workers collecting benefits rose suddenly. Part of the increase in the number of unemployment insurance receivers is often due to particular measures passed by the Government embassy. Typically, those measures allow laid-off workers to accumulate more benefits for longer than the average stage. However, rise in the rate of unemployment insurance recipient would take place even if the Congress was incapable of taking actions. Federal income taxes and social insurance tax payments also shrunk when the economy contracts (Burtless, n.d.). The Congress of the United States also provided incentives for states to change a few of the qualifying circumstances for unemployment benefits. The goal was to make available the benefits to a few unemployed laid-off people who had formerly been disqualified from getting benefits by the state regulation (Burtless, n.d.). Temporary Tax Reductions: A considerable number of the stimulus packages of 2008 and 2009 were committed to offering one-time or short-term income tax reductions to households and on a smaller scale, to business as well. The earliest Congressional reaction occurred in February 2008 on the financial response to the financial crisis, about six months earlier the US Gross Domestic Products (GDP) started to decline when Congress passed a law which generated income tax to household and more generous tax treatment of investments to the business. The 2008 stimulus package also raised the maximum value of a home mortgage that could be purchased by the ‘Federal National Mortgage Association’ (Fannie Mae) and the ‘Federal Home Loan Mortgage Corporation’ (Freddie Mac). The 2009 stimulus package was more expensive to the US Treasury than the package of 2008 and it enclosed a wider assortment of tax and spending provisions (Burtless, n.d.). Credit Standards: Credit conditions have enhanced creation of getting loans easier for customers and business industries, liberated a restriction on many types of credit sustained expenditures (Elwell, 2011). According to the analysis of the Federal Reserve Broad, bank lending standards and terms sustained to be simpler in the year 2011 and that the demand for industrial and commercial loans increased (The Federal Reserve Board, 2011). Other Direct Income Assistance and Provision of Service: From the viewpoint of social protection, the most important component of the 2009 stimulus package was prerequisite of income supports and social services to households (Burtless, n.d.). Government involvement into the United States financial crisis began with a stimulus package that returned a segment of paid income tax back to the nation. The objective was to get the householders to spend the money and revitalise the economy from the substructure. The estimated plan did not work significantly, as most people had lost confidence in the market and were being more conservative with their spending convention. Certain stimulus packages were spent on bills which in turn affected largely in most households (The Credit Crunch. Info., n.d.). Liquidity Freeze: In the time of financial crisis, it was observed that financial firms were concurrently in quest of liquidity to fund in progress business operations. Tightening of lending standards as well as deleveraging of standards also took place which led to the increase of credit spread (Barth & et. al., n.d.). Nevertheless, while the Federal funds rate declined over this period, the thirty-year fixed mortgage rate had remained relatively flat after the recession and the gap between the two rates have expanded appreciably. A portion of the widening was due to a slight increase in the mortgage rate since 2008 (Barth & et. al., n.d.). Conclusion The United States financial crisis has been one of the most critical incidents after the great depression. While the government had taken actions to provide stimulate packages to encourage spending from citizens and to prevent large industries from falling down. The US economy has been affected from the financial crisis which resulted in millions of job losses, economy imbalances, misperception of risks and financial regulations and deregulations. In spite of certain efforts by the US government, there remain certain other risks that could certainly affect the country in future as well from such a crisis. The main risks for ensuring complete recovery from the credit crunch and financial crisis are related to the premature removal of the stimulus packages, the continuing and emerging imbalances and the challenge of setting an appropriate level of regulation for the financial sector to avoid those mistakes that were made up in the very beginning of crisis in 2007. 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