Loosening Credit Sdandards - Research Paper Example

LOOSENING CREDIT STANDARDS (An essay in economics theory) of (affiliation) Location of March 15, Introduction The use of credit helps trade tremendously in the sense it promotes trust in other people. It is a good tool to enhance trade and facilitate the exchange of goods and services in modern economies. Credit actually comes from the Latin word “credere” which literally means to trust. To use credit is therefore to rely on trust; this trust works both ways in that the lender (creditor) trusts the borrower (debtor) will make good on his promise to pay an obligation at a later date. Credit can be financial in terms of money (a specific unit of account) or goods and services that implies some form of consumer credit (meaning the credit extended is for eventual consumption) by the borrower and the lender expects to be repaid either in money or in kind later on. Credit had been used since immemorial times back to Biblical periods or even extending back to antiquity as shown by the Hammurabi Code of ancient Babylon in which there was the provision for punishment for people who do not pay their debts or try to escape their financial responsibility by absconding or running away. The purpose of credit had always been the same; it is used to facilitate the exchange of goods and services long before modern economics came into being as a distinct academic discipline and as a legitimate profession itself. The Hammurabi Code consisted of about 282 laws with approximately half of these laws dealing with commercial contracts in which there is a graded punishment for contract violators. In modern free-market capitalist economies today, the sanctity of contracts is always upheld to help promote trade and commerce by creating conditions of trust in which parties to a transaction are assured of payment and other stipulations by which to ensure compliance by the other party. The loosening of strict credit standards can lead to serious, unforeseen, and dire consequences for an entire economy because it causes higher credit default rates as borrowers cannot pay. Discussion Credit is used in perhaps ninety percent of all commercial transactions compared to the use of cash. This is because cash can be limited at times which can hinder the completion of any contemplated transaction; credit provides the necessary link for the transaction to push through despite the absence or lack of sufficient cash on the part of the buyer. If the seller is willing to be trusting or take a risk as to the trustworthiness of a buyer, then credit is extended. People trusted other people to honor financial obligations in such ways as a mere handshake to seal a deal. Back then, it was far more important for a person to keep his word of honor, so to speak; this was before modern written contracts came into being and used extensively in legal courts. In olden times, most transactions were done on credit due to the severe limitations of any hard or value-specific currency. Money such as coins were difficult to produce back then, it has to be mined, minted, or the metal coinage itself may lack a uniform value or lack any accurate purity of the metal such as copper, silver, or gold. Banknotes came into use much later when printing was invented and right kinds of paper were used which were more durable as these get passed around per transaction. Coins and notes become legal tender if ordered by government. Before money was invented independently at around 700 B.C.E. (before current era) in three different areas (Lydia, now part of modern-day Turkey, India, and China), barter was used and so credit was also extensively utilized for commercial purposes. Today, credit is now utilized more than ever as a way to pump prime an economy; credit is one of the best tools that a government, through its central bank authorities, can use as instrument to revitalize an economy by spurring recovery from a recession or depression, to control inflation rates, stabilize the volume and velocity of money (liquidity), and other ways to raise or lower the interest rate. Various types of credit – the kind of credit to be extended can be quite varied such as the more common ones like bank credit, consumer credit, investment credit, international credit, and commercial credit. With the rise of modern banking practices, bank credit has taken many forms such as credit cards as a form of consumer credit and likewise, the extension of real estate credit such as for housing construction, home improvements, or mortgages to purchase a new home. The real estate industry is a major industry in any economy as the amounts needed to finance it are quite huge and the repayment period or the horizon is quite long, extending for years or even decades as people work and start to pay off monthly (amortize) their housing loan mortgages. Criteria for extending credit – creditors and lenders (especially the banks and the other financial intermediaries) usually do a credit evaluation for any potential borrower. The lenders follow the so-called six Cs of credit in making a decision whether to give credit or not: a. character – this is the sum total of the credit officers evaluation of a potential borrower on whether this particular debtor is creditworthy or not based on his character, reliability, and a very honest intention to pay. This is otherwise termed as a borrowers willingness to pay. b. capacity – this refers to the ability of an individual to repay the loan based on present income and future earnings. This is different from character, as a person could be rich or fully capable of making a repayment but is unwilling to make that payment, putting a lender at risk. c. collateral – any item of value (an asset) pledged by a borrower as security for the loan; it can be anything of value such as stocks, bonds, government securities, jewelry, painting, bank savings, real estate (a piece of land or a constructed building), or even an insurance policy. d. credit – the word credit here pertains to the credit history of an individual, whether he has a bad history of unpaid debts or misused credit lines or mismanaged cash flows in the past. e. capital – although the word capital is normally associated with a business entity like a partnership or a corporation, capital used in an individual sense is the net worth of that person as his personal debts or liabilities are deducted from all personal assets; the result is the net worth. It can be shown and computed in a personal financial statement like any balance sheet. f. conditions – this refer to prevailing economic conditions at the time of grant of the credit. This is essentially a case of good timing as banks generally do not extend credit in a recession or when there is a credit crunch in downturn economic cycle. Other factors can come into play such as new lending regulations imposed by the central bank, a new entrant in the industry creates stiff competition among industry players, or any legal, political, environmental, and technological trends which influence in one way or another a particular industry. The federal policy allowing mutual savings banks and the savings or loans associations to extend mortgages was bad because the institutions had no prior experience in mortgage evaluations (Leigh, 1983). Credit instruments – besides the types of credit available which were mentioned earlier, a variety of credit instruments have been invented precisely to promote the use of credit so people can avail of the many benefits and advantages offered by using credit instead of a cash-basis only in their numerous commercial transactions. Ancient societies used credit differently than today, but the essential features of a credit remained the same. Credit was used in barter economies as a form of exchange and also as a way to offset certain obligations of some individuals. Some credit instruments are quite old while some are relatively new and called as esoteric instruments because of their special features, newness, and ingenuity. A credit instrument is any item that is used in lieu of a currency such as promissory notes (or called as IOU or “I owe you”) and bank cheques while new ones are credit default swaps (CDS) to transfer credit risks, Principles of lending – the three basic tenets in lending and credit extension are safety of capital, profitability (return of investments based on expected interest rates), and liquidity. Safety means there is a reasonable chance of getting repaid while profitability implies a reasonable rate of return based on the degree of risk involved and on the prevailing interest rates. Liquidity means the credit instrument can be traded on open markets and be easily sold and converted to cash at any time. These three criteria can vary in terms of which is more important; a lender may emphasize safety over profitability, for example, or in other cases, the lender may give priority to higher returns (profitability) but with a higher risk(sacrificing safety) to the credit transaction. Some lenders prefer liquidity as they can turn around by selling another credit instrument. Implication of loose credit standards – toying around with established standards of credit has negative consequences for an economy if people lose faith in credit instruments; it will result in destruction of economic value (Barth, 2009). This means a credit instrument as tradeable commodity or asset will lose its value as people shy away from it, driving its price downwards. It happens if a rising economy creates superficial values due to a “bubble” in which the market value of assets are way ahead of corresponding intrinsic values due to increased speculation. Sub-prime mortgage crisis – the recession in the United States of America that started in 2007 and soon spread to the entire global economy originated with badly-structured credit instruments due to a loosening of credit standards. In particular, home mortgage credits rose much faster than other types of credit during this period even in countries such as Indonesia (UN-Habitat, 2008), and developed into a financial crisis as the world’s entire banking system was threatened with massive defaults by big institutional borrowers and lenders which had invested large sums in credit instruments like the collateralized debt obligations (CDO). a. collateralized debt obligation - is a type of credit instrument or asset-backed security (ABS) which promotes investment by people concerned with safety and profitability as the CDO offered higher returns as well as safety (as it is supposedly backed by an asset or a collateral). The CDO was originally developed for the corporate debt market through which a corporation can raise its capital by new borrowings by issuing a CDO but it soon spread into a credit instrument of choice that was also found to be suitable for the home mortgage market. In the early stages, a particular CDO that a company issued was highly diversified to spread the risk of credit default but as competition for funds grew stiffer, a CDO tranche offered higher interest payment in return for lower quality by concentrating its security on only one asset class, which are the home mortgages originated by the banks who sold the CDO to monetize these again. b. credit default swap – this is largely a financial instrument in which the seller of a credit default swap (CDS) promises to compensate the buyer of the CDS in the event of a default by a borrower. The buyer of a CDS pays a premium (fee or spread) to the seller and in the event of a failure to pay by the borrower in the CDO, the seller of the CDS pays the CDS buyer for the full face amount of the defaulted loan and the seller takes possession of the loan in the hope of collecting somehow from the defaulting borrower any amount that can be recovered. Great Recession – a result of the loosening of credit standards was the so-called Great Recession which started in December 2007 and ended around June 2009 as the housing mortgage market collapsed due to the worsening default rates from many unqualified or even in some rare instances, ghost, borrowers. The bubble that was created by loose credit standards shrank the global economy by about $12 trillion and it contracted for the first time since 1945; trillions in value and millions of jobs got destroyed in the ensuing financial meltdown (Brockett, 2014). Figure 1: Composite US Housing Prices Index (Source: Standard & Poor’s). Conclusion An economic bubble in housing prices is shown by Figure 1 above; the prices of houses rose without logic except perhaps for speculation as buyers sought new houses as investments using easy credit, until prices suddenly collapsed. Many of these home buyers were not qualified to obtain housing mortgages at all if the six Cs of credit were strictly applied. This loosening of credit led to many foreclosures as payment defaults rose as a consequence of letting many borrowers who were colloquially termed as NINJA (no income, no job, and no asset) were allowed to avail of housing loans in order to meet loan and profit targets of originating banks. Wise use of credit promotes economic growth while the indiscriminate granting of credit due to loosening the required credit standards for potential borrowers will have adverse results. A good credit manager will always enforce credit standards at all times by denying credit to those who are not qualified borrowers (Durkin & Staten, 2002). The grant of credit also goes through a cycle in which credit is very easy and then after the evil effects are felt, there is a general tightening of credit standards, resulting in a credit crunch (Timiraos, 2014). References Barth, J. (2009). The rise and fall of the U.S. mortgage and credit markets. Hoboken, NJ, USA: John Wiley & Sons, Incorporated. Brockett, M. (2014, March 13). Wheeler heeds U.S. sub-prime lessons to spearhead rate rises. Businessweek. Retrieved on March 15, 2014 from http://www.businessweek.com/news/2014-03-13/wheeler-heeds-u-dot-s-dot-subprime-lessons-to-spearhead-rate-increases Durkin, T. A. & Staten, M. E. (2002). The impact of public policy on consumer credit. New York, NY, USA: Springer Books. Leigh, W. (1983). The housing finance system and federal policy: Recent changes and options for the future. Washington, DC, USA: Congressional Budge Office Printing Press. Timiraos, N. (2014, February 14). Wells Fargo to ease mortgage standards slightly. The Wall Street Journal. Retrieved on March 14, 2014 from http://online.wsj.com/news/articles/SB10001424052702303704304579383180007672774?KEYWORDS=sub+prime+housing+mortgage+crisis&mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052702303704304579383180007672774.html%3FKEYWORDS%3Dsub%2Bprime%2Bhousing%2Bmortgage%2Bcrisis United Nations – Habitat (2008). Housing finance mechanisms in Indonesia. Nairobi, Kenya: UN-Habitat for a Better Urban Future. Read More