The Credit Crunch - Literature review Example

The Credit Crunch A reduction in the general availability of loans is known as a “credit crunch.” Its occurrence is usually related to the onset of economic recession, when the prices of previously valuable assets (e.g. real estate) start to collapse. Banks perceive a greater risk and therefore tighten the conditions required for obtaining a loan, thus dropping the overall number of approved loaners. The result is greater market fluctuation, which can lead to negative effects, such as more expensive mortgages, problems for pension savers, and even bankruptcy. Apart from that, credit crunches can occur even without an evident recession. “Credit crunch” has been the most commonly used new term over the past few years. In fact, due to its major significance, the term was included in the latest edition of the Concise Oxford English Dictionary, meaning “an economic condition in which it suddenly becomes difficult and expensive to borrow money” (Oxford University Press,n.d.). A credit crunch is characterized by a shortage of funds in the credit market, resulting in decreased possibilities for credit agreements and increased levels of official interest rates. Economist John Hull (2009) argues that the origins of the credit crunch (which started in the US) can be found in the housing market. “The U.S government was keen to encourage home ownership. Interest rates were low. Mortgage brokers and mortgage lenders found it attractive to do more business by relaxing their lending standards (…) Banks thought the “good times” would continue and (…) chose to ignore the housing bubble...” Simply put, people were spending more money than they actually had – an inconsistency that grows into what economists call a “bubble” – the inflation of global property prices. A vicious circle is formed – prices rise, causing the amount of credits to rise as well, which in turn makes prices rise even more. At some point, a large number of credits started to default. Property prices began to drop and so the “bubble” burst. On a related note, Mizen (2008, p. 564) points out that the most recent credit crunch was preceded by a prosperous period, which generated a certain degree of carelessness throughout the economy. “Financial innovation had (…) introduced greater complexity, higher leverage, and weaker underlying assets based on subprime mortgages.” Mizen defines a subprime mortgage as a riskier bank product – a loan given to a person with non-standard income or credit profile, which was often mispriced. They provide good returns, compared to other asset classes, and therefore receive high ratings. However, they are not as safe as they seemed because they are tied to house prices. When prices drop, foreclosures become more frequent. Losses escalated and banks took measures by lowering credit availability. White (2008, p. 2-3) states that “Borrowers with inadequate income relative to their debts, many of whom had either counted on being able to borrow against a higher house value in the future in order to help them meet their monthly mortgage payments, or on being able to “flip” the property at a price that would more than repay their mortgage, began to default. Default rates on nonprime mortgages rose to unexpected highs. The high risk on the mortgages came back to bite mortgage holders, the financial institutions to whom the monthly payments were owed. Financial institutions that had stocked up on junk mortgages and junk-mortgage-backed securities found their stock prices dropping. The worst cases, like Countrywide Financial, the investment banks Lehman Brothers and Merrill Lynch, and the government-sponsored mortgage purchasers Fannie Mae and Freddie Mac, went broke or had to find a last-minute purchaser to avoid bankruptcy.” Evidently, poor planning and lack of foresight promoted the occurrence of the credit crunch. Credit institutions chose to focus on short-term gains, disregarding the related risks and potential long-term consequences. A possibility for avoiding such situations in the future would be tighter control and more careful consideration of potential developments in the credit market. If financial institutions are willing to sacrifice a small portion of their potential profit, they should be able to avoid creating yet another “bubble” and maintain their stability. Dillon (2008) summarizes measures taken by the government as placing unrealistic targets on local governing bodies to provide affordable housing, which may be problematic in a time of housing market depression. Dillon recommend innovation and a more pragmatic approach. Furthermore, authorities tend to increase liquidity in the markets so that the housing sector and the security market could receive more support. Furthermore, what started as a household mortgage market collapse in the United States quickly turned into worldwide global financial crisis, due to the repackaging of sub-prime home loans into mortgage-backed securities, later sold on to US, European and Asian markets. Inevitably, when the crisis spread, investments of this kind devaluated or became impossible to valueprecisely, leading to huge losses for banks globally. The lack of reliable information about the investments’ security resulted in banks increasing interest rates and imposing strict loan policy rules, furthermore avoiding the purchase of any investments linked to mortgages and thus causing both mortgage and stock market to freeze. What about the general effect on the common people? David Budworth (2008, Times Online) observes that the credit crunch results in dearer mortgages and credit cards, high pressure on pension savers and investors, general lack in good value mortgages, as lenders become more considerate about who they lend money to. People’s personal wealth continues to shrink, as their financial assets and home worth less. As a result consumers abstain from substantial purchases and spend their money mainly on bare necessities, thus putting even higher pressure on the striving economy. Unemployment has also reached drastic levels, as a result of the major decline in economic activity, bankruptcy and following recession. Future research into the matter may focus on consumer behavior with regard to rational spending. Other areas of interest include ways of encouraging saving, rather than credit-taking, developing safeguards to make the economy less vulnerable to the ill effects of credit crunches, as well as better understanding of risk. The future tendency is that the economics recovery will commence not earlier than the beginning of 2010, presumably followed by at least 2 year period of financial slowdown. Further on, the reasons behind the credit crunch and serious discussions about prevention of future repetition of the crisis are still a question of present interest. References: Budworth,D.,2008. The credit crunch explained. Times Online. Available at: http://www.timesonline.co.uk/tol/money/reader_guides/article4530072.ece [Accessed date:06.12.2009] Dillon, J 2008, Innovate to get through the credit crunch, The Guardian, 31 October 2008, < http://www.guardian.co.uk/society/2008/oct/31/regeneration-localgovernment > (viewed December 6 2009) Federal Housing Finance Agency,September 7 2008.Statement of the FHFA Director James B. Lockhart Available at: http://www.docstoc.com/docs/1290664/Statement-by-James-B-Lockhart-director-of-the-Federal-Housing-Finance-Agency [Access date:08.12.2009] “How the bubble burst” 2009 (viewed December 6 2009). Hull, JC 2009 “The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can Be Learned?” (viewed December 6 2009). Mizen, P 2008, The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses, Federal Reserve Bank of St. Louis Review, vol. 90, pp. 531-567. Oxford University Press, Word of the Month Available at http://www.oup.com/elt/catalogue/teachersites/oald7/wotm/wotm_archive/credit_crunch?cc=global [Accessed date:06.12.2009] White, Lawrence H.,2008. How Did We Get intoThis Financial Mess?, No. 110 [PDF] Available at: http://www.cato.org/pubs/bp/bp110.pdf [Accessed date:06.12.2009] The White House, Office of the Press Secretary, 2008. Declaration of the Summit on Financial Markets and the World Economy [PDF] Available at: http://www.iasplus.com/crunch/0811g20declaration.pdf [Accessed date:07.12.2009] Read More