What Caused the Credit Crisis and the Banking Crisis in 2008 - Coursework Example

What caused the credit crisis and the banking crisis in 2008? By Between the years 2007 and 2008, the world experienced ahighly detrimental financial crisis that is considered to be the worst ever to happen after the Great Depression. This financial crisis is believed to have originated in the United States and spread to other world countries, thus the global economy was eventually affected. The economies of most countries have however recovered from the effects of this financial crisis. There are some countries that are still grappling under a slight influence of this financial crisis today. The 2007-2008 recession was accompanied by a credit crisis and banking crisis which increased the severity of the situation. The focus of this paper is on the 2008 credit crisis and banking crisis and seeks to explain the factors that caused these two phenomena to occur. A credit crisis, also known as credit crunch, happens when the availability of loans or credit becomes limited, and when there are tight conditions that individuals and businesses are supposed to fulfil in order to be eligible for a loan from banks and other financial institutions. This situation arises when banks and other financial institutions in a country are incapable of making many loans as before, and they attach higher rates of interest to the little loans they make, and have these loans available only to those individuals and businesses that possess great credit and several assets that can act as collateral for the loans (Murphy, 2009). On the other hand, a banking crisis occurs when there is a high level of withdrawal of finances from banks and other financial institutions. Therefore, in this case, individuals and businesses will make more withdrawals of finances and less or no deposits of finances in depository institutions. Eventually, this makes banks and other financial institutions in any country to have an increased level of liabilities. A banking crisis in a country highly contributes to a financial crisis and economic downturns and equally worsens existent economic downturns as its effects are experienced both at the household and organizational levels (Sanches, 2014). There are different factors that caused the credit crisis that was experienced in 2008. First, the decline in home prices can be considered in different ways to have been a significant trigger to the credit crisis. Throughout history, the price of homes was higher, and it was believed that it was impossible for home prices to fall in future. This belief is the one that guided most investment firms as far as their structuring of mortgages was concerned. However, there was a turn of events in the few years that preceded 2008 as with regard to home prices. Starting 2006, home prices began to fall at a rate that had never been witnessed before, even during the Great Depression. Home prices fell at a rate of 20% or more in some areas (Arner, 2009). When this happened, it was impossible for several home owners that had planned to sell their homes at a profit to do so. In this case, the market value of homes of homeowners became lower as compared to their mortgages. In this regard therefore, homeowners were unable to remit their mortgage payments to banks. The defaulting on loans by a large number of borrowers forced the concerned banks to foreclose on the homes of the individuals. The banks repossessed homes and lands of the loan defaulters as a way of recovering their finances. However, although this move was critical on the side of the banks and other financial institutions, it did not save them from the losses that they experienced. This is because the repossessed assets were now at a lower value at the then current market as compared to the time that they were originally loaned out by the banks. This resulted in most banks experiencing a liquidity crisis on their side. This liquidity crisis in banks made them to restrict the provision of loans to individuals and businesses, as the banks had experienced losses (Arner, 2009). The sub-prime mortgages offered by banks to many individuals also was a contributing aspect to the cause of the 2008 credit crisis. Sub-prime mortgages are those mortgages that are given to individuals and households that have a poor income history and low credit. Normally, such mortgages are expected to be more risky as compared to the prime mortgages. During the real estate boom and the period preceding the recession, many people took the sub-prime mortgages hoping to sell the houses for greater profits since they believed that the home prices would continue to soar. Brokers also lured many people to take sub-prime mortgages by offering them low initial payments. The decline in home prices made it impossible for the sub-prime mortgagers to repay their payments hence forcing banks to repossess their assets however at a loss (Lewis, n.d). The mortgage-backed securities market was put at risk due to the defaulting of mortgages at a higher rate. Most of the mortgages that banks gave out to people during this period were securitized and resold in the market. Although this was a good way to disperse risk, it also meant that any losses that would result were equally widely spread. The high level of mortgage defaults therefore led to greater losses. Many of the participants including investors in the mortgage market were scared and began avoiding the market due to the risks that this market bore. The increased losses in mortgages led to the evaporation of liquidity of different securities and this led to uncertainty about the value of these securities, including all securitized and fixed-income securities (Murphy, 2009). The losses experienced by banks and financial institutions as a result of the sub-prime mortgages and the lending bubble burst were the major cause of the banking crisis experienced during this period of recession. This scared away investors and participants in the mortgage market, and this was a bad sign for banks and other financial institutions. Because of the immense losses and withdrawal of investors from the market, there was no or limited trading activities in banks and other financial institutions (Lewis, n.d). For this reason, it was impossible for banks and other financial institutions to utilise actual market prices for valuing their holdings as they had done previously. They therefore, were forced to adopt computerized models in order to approximate their holdings. Investors began to express their uncertainty about the accuracy of the computerised models that the banks were using, hence leading to their loss of confidence in the market and in financial institutions. The banking crisis was also exacerbated by the new market-to-market accounting rules that implemented during this period of recession. These rules required that banks report all their losses on securities whether or not they planned to sell the securities. This rule was implemented at the wrong time, as during this period, most banks and financial institutions were experiencing great losses on their securities. Publicly reporting such great losses on securities was a sure way of driving away investors, as they lose their faith in the bank or financial institution. The high level of uncertainty on the side of investors resulted in rapid falls in the stock prices of many banks and financial institutions. In addition, there was a great unwillingness on the side of investors to bid for assets that were otherwise considered to have a high level of risk. This led to the sharp declines in the prices of risky assets as there were no buyers in the market for such assets, thus culminating in a banking crisis (Murphy, 2009). The preferences of investors shifted because of the loss of faith in the market, from high-yield credit products to investments that can be considered to be simpler and with lower risks such as commodities and market equities. This led to the ceasing to function of complex debt securities markets, and there was loss of confidence in those banks and financial institutions that were previously key players in the complex debt securities markets (Lewis, n.d). For this reason, these financial institutions held many unmarketable and unsold loans and securities, as their market had ceased to function hence making them experience a liquidity and banking crisis. For instance, Bear Stearns, a financial firm in the United States and Northern Rock of United Kingdom were incapable of continuing their operations due to lack of funds and their only resolution had to depend on government intervention. The level of confidence in the market reduced further in the United States when one of the financial institutions, Bear Stearns collapsed in the year 2008. This affected the relationship between financial institutions in an adverse manner. Therefore, it was hard for financial institutions to practice interbank borrowing and lending, whether on long-term or short-term basis, as they lost confidence in one another (Arner, 2009). Many financial institutions also came under sharp public scrutiny, making them face systematic risk. Overall, this did not reflect well on the financial institution and their financial health deteriorated further, as they faced a banking crisis. The major financial institution of Lehman Brothers faced a banking crisis that eventually led to its bankruptcy and closure in 2008, hence triggering the financial crisis in the United States. In conclusion, the credit crisis and banking crisis is the reason that the financial crisis of 2008 was experienced in a higher magnitude. This paper has explained the causes of both credit and banking crisis in 2008 and it can be seen that the identified causes of the phenomena are interrelated. Overall, when the sector of the housing market collapsed, the value of different securities, including mortgage-backed securities went down thus resulting in losses. The losses experienced on the mortgage-backed securities spread to influence other securities and risky assets, thus creating a high level of fear among investors and reduced willingness to provide liquidity in the market due to the high risks involved. The acceleration of the credit crisis and the banking crisis eventually led to the descending of financial markets into a major crisis. References Arner, D. (2009). The Global Credit Crisis of 2008: Causes and Consequences. Asian Institute of International Financial Law. The University of Hong Kong. PDF. Lewis, P. (n.d). The Global Financial Crisis, 2007-2008: Origins, Nature and Consequences. Global Security and International Political Economy, Vol 1. Retrieved from http://www.eolss.net/sample-chapters/c04/e1-68-12.pdf Murphy, D. (2009). Unravelling the Credit Crunch. New York: CRC Press. Sanches, D. (2014). Shadow Banking and the Crisis of 2007-08. 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