US Credit Crunch - Essay Example

US Credit Crunch by of the of the Concerned Professor 10 November 2008 US Credit Crunch Since the great depression of the 30s, American economy has more or less been a saga of sustained growth and prosperity. The American masses peculiarly seems to be apt at taking undue advantage of the national affluence by inventing innovative new ways of splurging wealth on gross consumerism and senseless consumption. This instinct of temperamental spending was awesomely augmented by the introduction of credit cards in the late 5os. However, with the entrance of credit crunch in a market buoyed by low interest borrowings and stock market gains, US has been faced with an urgent problem of dealing with unprecedented hard times that are defined by large scale job cuts, soaring debts and plummeting real estate prices. This scenario portends dire consequences for an economy that till now relied on consumer spending for sustenance and growth. Astute analysts and financial strategists had started predicting since the first quarter of 2007 that US economy was on the verge of facing a severe credit crunch (Mishkin & Eakins, 2009). This doomed prophecy became a glaring reality by the end of the year 2007. Earlier the US banks were more then willing to lend loans to corporate concerns because the banks were in a position to resell these loans to the more then willing investors in the credit market. However, since July 2007, the investors started exhibiting a marked aversion for investing in corporate buyout loans. Thus the US banks were left with massive corporate buyout loans that failed to attract the investors in the market. This shrinking of markets for the corporate buyout loans left the US banks with a precarious situation. Also the investors who had already invested in such loans found to their surprise that they were unable to dispose off these loans in the credit market for any amount that would have been reasonable or acceptable (Whalen, 2007). As per the Business Weeks September 3 issue, the banks in the US were left with a mindboggling backlog of deals worth $ 300 billion. At the same time the promises to pay sold by the US companies to acquire short term loans by relying on offering mortgages as collateral also showed signs of stagnation. This dire situation was further complicated by the hedge funds run by financial institutions that mostly catered to wealthy investors and were most of the times devoid of any regulatory attachments and were secretive in their operations (Whalen, 2007). Theses huge hedge funds backed by reputed financial institutions ruled the roost in the US markets. Theses hedge funds had become habitual of relying on the practice of issuing the promises to pay since the last couple of years. The investors also showed a great predilection for such funds and preferably extended large loans to them. Such funds were predominantly invested in financing the mortgages purchases in the US that sold like hot cakes. . However, when it became evident to most of the investors that lent profusely to hedge funds, that most of the real estate owners in the US were not in a position to responsibly deal with their mortgage liabilities, the investors started shying away from the hedge funds on a mass scale. Consequently such funds were left with massive losses by the mid of 2007. All theses factors debilitatingly shook the investor's confidence in the US financial markets and economy and contributed liberally to the credit crunch that became more acute with the passage of time. It is the housing and the real estate boom in the American economy that gave way to the concept of subprime mortgages in the American economy. Owing a house of one's own is an integral part of the American dream. From the investment point of view, the traditional investors always considered the real estate investments as being highly lucrative and profitable in the long run. However, the problem is that all the real estate buyers are not in a position to buy a house and hence they resort to borrowing money from the banks, believing that the prise of their houses will appreciate in the long run. Ideally speaking, a bank or a financial institution should only extend loan to a customer who has a sound credit rating. However, the banks in the US mostly resorted to the financially unsound practice of extending housing loans to such people who had unworthy credit ratings. Actually this practice of granting loans to the people with doubtful or limited credit ratings is referred to as subprime lending or subprime mortgage. Subprime loans have nothing to do with the interest rates charged on a loan and are solely defined on the basis of the credit ratings of the beneficiaries. Subprime alludes to the credit rating of a borrower. "Subprime borrowers generally have a credit score of 620 on a scale of roughly 300 to 900 (Bryant, 2007). The banks usually extend the subprime loans motivated by the greed of extracting higher interest rates from their customers. The subprime rates charged by a bank depends on a variety of factors like the credit rating of a borrower, the nature and the total number of delinquencies and the scope of the final down payment. Subprime loans accounted for nearly 20 percent of the total loans finalized by the US banks in the year 2006. The problem is that subprime loans are mostly unsafe and it is the subprime borrowers who are often more inclined to default. Such a trend could expand to exponential proportions over a period of time and may jeopardize an entire economy. This is what actually happened in the US. The subprime loans constituted roughly 5 percent of all of the housing loans in the year 1994. However, the economic straits became risky when the proportion of subprime loans augmented to more then 20 percent of all of the housing loans extended by the US banks in the year 2005. At the same time the situation was further worsened by a marked change in the nature of US banking policies and lending preferences in the year 2005. Earlier the traditional banks in the US believed in the maxim of serving the masses and the community and following sound and ethical financial practises. Thus they used to lend loans at fixed rates to the real estate buyers. However, in the year 2005, the interest rates slightly appreciated and the real estate prices also rose as a result of this change. The potential buyers started moving away from the real estate options and the mortgage financing firms were left with the twofold dilemma of attracting customers to the markets and at the same time they had to compete with the traditional banks. Such a situation forced the mortgage financing companies to come out with innovative and more risky packages and extending subprime loans was a part of the same strategy. When the credit crunch struck, the subprime buyers were not left with many options. They could neither bear the burden of paying the high bank interests nor could they dispose off their houses in the market which had already depreciated in price by immense amounts. The subprime borrowers also could not resort to the much touted and common practise of taking further loans from the banks to pay their past loans. Banks struck with a sharp fall in the investor trust and scarcity of credit could not afford any more to grant loans to delinquent investors or the borrowers who already had a dubious credit standing. This credit crisis blew up into a vicious spiral that brought down the entire economy to a difficult situation. It is not that the US economy is not in a position to meet this challenge. The problem is that the investors trust in the US markets has shaken immensely and this is worsening the credit crunch (Economy Watch, 2008). The US government is trying to meet the challenge by extending the state funding to the affected banks and financial institutions and the things are expected to improve, but it will take time. However, with the passage of time the notion that the US credit crunch is a local phenomenon is proving to be wrong. Had this occurred a couple of decades ago, the things would not have spiralled to such global proportions. However with the integration of the world financial institutions with the US economy, the damage has percolated to the European and Asian markets. The reason is that the banks hailing from the foreign countries had invested a lot in the US market and a significant chunk of these investments went to fund the subprime mortgages. Thus the crash in the US credit market and the fall in the investor confidence have turned out to be communicable and is slowly but surely gripping all the major and developing economies. The credit crunch is expected to stay for quiet a long time and nobody is in a position to predict when it will end. Total Words: 1,508 List of References Bryant, CW 2007, How Subprime Mortgages Work. How Stuff Works. Viewed 10 Nov. 2008, Mishkin, FS & Eakins, SG 2009, Financial Markets and Institutions, 6th Ed. Pearson Education, New York Smith, A 2007, How a US Credit Crunch Went Global. TIME. Viewed 10 Nov. 2008, US Subprime Mortgage Crisis 2008. Economy Watch. Viewed 10 Nov. 2008, Whalen, C 2007, The US credit crunch of 2007. The Market Oracle, viewed 10 Nov. 2008, Read More