Credit Crunch and Economic Downturn - Essay Example

Credit Crunch Credit Crunch The economics profession is unclear as to what constitutes a "credit crunch." The crucial differences in definition depend on the cause of the contraction and whether credit is rationed by means other than price. Bernanke and Lown (1991) define a credit crunch as: A decline in the supply of credit that is abnormally large for a given stage of the business cycle. Credit normally contracts during a recession, but an unusually large contraction could be seen as a credit crunch. In their analysis, Bernanke and Lown compare the contraction in credit during the most recent recession to those in the previous five recessions. During a credit crunch, also known as a "liquidity crisis" or a "credit squeeze", the banks won't or can't lend. Investors can't or won't buy debts. Suddenly it's very difficult to borrow money. There is a lack of easy money. Consumers and businesses have less to spend. There could be serious ramifications for an economy. Impacts of Credit Crunch on British economy Even if the credit crunch is narrowly define as something that affects just banks, private equity and hedge funds, there is little out there to suggest that the British economy is out of the woods. Around the world, banks remain reluctant to lend to each other - or anyone else, for that matter, except blue-chip corporations or mortgage customers who can afford to furnish lenders with large up-front deposits. Impacts on Housing Sector: House prices are down 13 per cent year-on-year and rising; the boss of Countrywide, the country's biggest lender, says one in 11 borrowers are falling behind on their home loan payments; house repossessions were up 57 per cent in March compared to the previous year; consumer confidence has hit a 26-year low Almost 7,000 has been wiped off the value of the average British home since October 2007, after house prices dropped for a fifth consecutive month, according to latest survey figures. Britain's average house price fell by a further 0.6 per cent, or just over 1,000, in March, on the heels of a 0.5 per cent decline in February, the Nationwide Building Society's most recent snapshot of market conditions shows (The Times March 2008). Impacts on Interest Rates: in the past few weeks 10 mortgage lenders, including the Royal Bank of Scotland, Alliance & Leicester and the country's biggest building society, the Nationwide, have increased some of their rates, despite the Bank cutting rates from 5.75 per cent to 5.5 in December. Bank of England data shows that the average mortgage rate has been inflated. When interest rates were previously 5.5 per cent - in May last year - the average mortgage rate was 5.66 per cent but when rates moved back down to that level in December the average was 5.93. Credit CRUNCH IN the United States For more than half a century, Americans have proved staggeringly resourceful at finding new ways to spend money. But now the freewheeling days of credit and risk may have run their course in the United States - at least for a while and perhaps much longer - as a period of involuntary thrift unfolds in many households. With jobs shrinking, housing prices plummeting and debt levels swelling, the same nation that pioneered the no-money-down mortgage suddenly confronts an unfamiliar imperative: More Americans must live within their means. For the 34 million American households who took money out of their homes over the last four years by refinancing or borrowing against their equity - roughly one-third of the nation - the savings rate was running at a negative 13 percent in the middle of 2006, meaning they were borrowing heavily against their assets to finance their day-to-day lives Employment and credit crunch in UK Indications of the severity with which the credit crunch is likely to hit working people in Britain are contained in a number of recent reports and press articles. These focus, firstly, on the impact of credit becoming more difficult to obtain and, secondly, on the cost of mortgages. According to the National Institute of Economic and Social Research, the ratio of household debt to national income is 1.62 in the UK, the highest for a major economy. Economic Growth and Creidt Crunch in UK Businesses should brace themselves for a 'long slog' before the credit crunch is over, with the economy set to be even weaker in 2009, the British Chambers of Commerce warns. When it published its last economic forecast three months ago, the BCC was still hoping for a short-lived, 'V-shaped' downturn, but David Kern, its economic adviser, said the Bank of England's gradual approach to cutting interest rates meant a longer-lasting 'U-shaped' slowdown was now more likely (Stewart, May 2008). 'crunch will not bring ruin, but change' Among other things, credit crunch has brought a change in the overall economic environment of developed as well as developing economies around the world. Some of the charges that this crunch is bringing and will continue to bring include: China and other emerging economies have seen huge increases in investment in recent months and years. The dislocations caused by the credit crunch will also provide an even more attractive investment environment for special situations managers. Retiring investors looking to buy an annuity could be one of the very few groups to significantly benefit from the fall out of the credit crunch. One effect has been that the income obtainable from company loans - corporate bonds - has become substantially bigger for investors. As the income - also known as the yield - from corporate bonds has become much higher, the corresponding annuity rates that are offered have soared. This is almost 11% more than what could have been bought just two years ago. Rising investment returns have sparked a price battle in the most competitive parts of the annuity market. The companies are desperate to grab their share of the market, and rate changes are occurring at unprecedented levels. The financial markets have already priced an awful lot of further bad news into their price, thus pushing up the income stream for corporate bond investors. analysis of the graph The graph represents an interesting picture of estimates of mispricing on sub-prime mortgage-backed securities. The data in the graph are proved by the Bank of England. It is based on actual prices - model-implied price (percentage of par). The data in the graph provide information about the estimates on mispricing on sub-prime mortgage-backed securities for 13th July 2007, 12th October 2007, and 14th April 2008. As it is reflected from the graph, when the values on horizontal axis where AAA the prices went into negative at touched as low as -24 on 14th April 2008. Same was true for other two days mentioned above. However, on the other hand, it is important to note that the when it was BBB- the prices were positive and as high as +6. This explains an interesting patter and shows a relation between the value on y and x axis. They are correlated and directly proportional. Conclusion A credit crunch is not a necessary consequence of an economic downturn. Lending declines during an economic downturn, but primarily because of decreases in business and consumer loan demand. Since there are multiple causes of the credit crunch, the solutions to the credit crunch need to be multifaceted. Some causes are temporary in nature and will correct themselves over time. Other causes, however, are structural and will not be eliminated with economic recovery. Some causes are the unintended side effects of policies addressing other societal problems. Simply addressing the financial condition of the banks is unlikely to generate a quick solution. Bibliography 1. Credit crunch may hit UK growth, BBC News, 13th September 2007. 2. Stewart, Heather. 2008, 'BCC warns of tough 2009 as economic growth falls', The Observer, 11th May, [Online] Available at http://www.guardian.co.uk/business/2008/may/11/creditcrunch.economics 3. Bernanke, Ben S., and Cara S. Lown (1991), "The Credit Crunch," Brookings Papers on Economic Activity, no. 2: 205-47. 4. Duncan, Gary, 2008, 'Credit crunch: British house values fall 7,000 since October', The Times Online, 29th March. [Online] Available at 5. http://business.timesonline.co.uk/tol/business/money/property_and_mortgages/article3642753.ece 6. Bizer, David S., (1993), "Examiner's Crunch Credit," Wall Street Journal, March 1, A14. 7. Board of Directors of the Federal Reserve Bank of Dallas (1991), "The Credit Crunch: Statement of the Problem and Proposed Solutions," transmitted to John P. LaWare, Board of Governors, December 30. 8. Federal Financial Institutions Examination Council (1992), "Study on Regulatory Burden," Washington D.C., December 17. 9. Pare, Terence P. (1993), "Why Banks Are Still Stingy," Fortune, January 25, 73-5. 10. Owens, Raymond E., and Stacey L. Schreft (1992), "Identifying Credit Crunches," Federal Reserve Read More