The Credit Crunch of 2007-2008 - Essay Example

?Eco202 CA The US is currently recovering from its worst recession in over 25 years. Most economists consider the rapid rise in housing prices (the bubble) and the subsequent collapse in that market to be the primary cause of the recession. Explain what housing market circumstances were responsible for the collapse of that market. The rise in acceptance and popularity of securitized products in early 2000s resulted in a torrent of low-priced credit as lending standards fell. One of the prime reasons for the relaxation in regulations for loan seekers were public policies encouraging people to legally own their houses and hence improving security of the area. As shown in the diagram underneath, this led to rising housing prices since decades. In 2000, the rate of increase of house prices was rising at unsustainable levels, much faster than they had in the last decade. Sub-prime mortgages (mortgages to high risk customers) began to rise due to availability of cheap credit (Mizen). The low interest rate environment stimulated upsurges in mortgage backed financing and hence considerable increases in house prices. It encouraged investors (financial institutions, such as pension funds, hedge funds, investment banks) to design instruments that offer yield enhancement such as subprime mortgages. The bullish attitude of Wall Street led to creation of complex structured products such as collateralized debt obligations (CDOs) and a lot of repackaging of high-risk mortgage backed securities. The credit and house price bubble led to a real-estate boom and eventually to a surplus of unsold homes, which triggered U.S. housing prices to peak and before declining and bursting in mid-2006. Subprime borrowers began to default on their loans as real estate prices decreased further. The default on a significant ratio of subprime toxic assets produced cascade effects in financial markets via the securitized mortgage derivatives into which these mortgages were bundled, to the balance sheets of investment banks and hedge funds. The vagueness about the value of the securities collateralized by these mortgages spread chaos and concern over the soundness of loans for leveraged buyouts. That led to the freezing of the interbank lending market in August 2007, collapse of key financial institutions such as Lehman Brothers and triggered the credit crunch crisis. 2. Economists classify macro-economic indicators as leading, lagging, or coincident. Define each classification and give two examples of each, relating them to the recession that began in 2007 and the recovery that is now under way. ? Economic indicators are periodical statements by the government and private institutions that describe the health of a country's economy. Economist classify these indicators into leading, lagging or coincident kind that are described below in detail: Leading Indicators: Leading indicators are economic indicators that predict future events. They are foreign exchange indicators that change beforehand the change in the market or economy has occurred. Examples of leading indicators may include bong yields, inventory variations, stock prices and insurance claims. Economic establishments and central banks study leading indicators in expectation to fluctuations in expected interest rates. A forex-leading indicator is a pointer that advises the trader to buy or sell before a new trend in the market commences. Leading indicators, however, are difficult to recognize and could lead to misleading results or interpretations if not analyzed by an experience trader. Two examples leading indicators for the financial crisis of 2007 are stock prices (500 common stocks) that reduced by 8% in 2007 (The Conference Board) and Building permits that reduced by 16% leading to a 40% decline in US Home Construction Index. Lagging Indicators: Lagging indicators are indicators that follow an economic event. These indicators usually exist three to twelve months after the economy. Lagging economic indicators are the confirmation to outline the peaks and troughs that happened, to be used in approximating the course of the next business cycle. Possibly the most controlling lagging economic indicator is the unemployment rate. If corporations foresee business environment getting worse, unemployment will increase. If they are more positive, then unemployment will decrease. Examples for lagging indicators relevant to current crisis are unemployment rate and real personal consumption expenditures. In 2008, the average duration of unemployment (weeks) increased from 16 to 19 weeks by the end of the year as the US unemployment rate grew to 10% in 2009 from 5% in 2007. There was a 3.1% drop in real personal consumption expenditures during 2008. Coincident Indicators: Coincident indicators are indicators that vary with economic events. These indicators move at the same time as the economy and hence can serve as a confirmation to business cycle turning points. Examples of coincident indicators relevant to the 2007 financial crisis are Industrial production index that reduced by 4% in 2008 and employees on non-agricultural payrolls that reduced by 0.3%. 3. All major economic indicators show the United States is recovering from the recession but that the process is not as strong as previous recoveries have been. If you were the President what would you do right now to help the economy recover so that the unemployment rate decreases faster than it has over the past two years? Create jobs in small and medium sized businesses: It is important to boost entrepreneurship amongst small and medium sized businesses, as they are the backbones of US economy and mobilize the labor market. Innovative business ideas that can initiate these businesses are promises of a better future for US. Government should provide cheaper capital for the set-up of start-ups and incentivize investors and venture capitalists to invest in start-ups. There should be special provisions such as healthcare insurance coverage and tax benefits for small and medium sized business owners. Creation of jobs should be encouraged in emerging sectors such as clean energy, technology, consulting for SMEs etc. Encourage multinationals to increase their presence in US: The president should also engage with multinational corporations to set up more offices in US by lowering the barriers to entry such as reducing corporate tax rates, nominal minimum wage provisions. Manufacturing companies should be able to produce goods at a much lower costs that can be done by vertically integrating the supply chains. Works Cited Mizen, Paul. "The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses." October 2008. Stern School of Business. 18 June 2011 . The Conference Board. "U.S. LEADING ECONOMIC INDICATORS." 20 October 2008. The Conference Board. 18 June 2011 . Read More