The Crisis of Credit
Updated: Mar 26, 2021
What is the credit crisis? A credit crisis is a situation wherein loans including short term debt between the financial institutions are limited to such an extent that the operations of the financial system are at risk of coming to a halt. The term credit crisis if often used in reference with the 2007-08 financial system crisis.
How did the crisis of credit originated? The crisis originated when in the wake of the Dotcom Bust and 9/11 attacks, the US Federal Reserve Chairman Alan Greenspan lowered the interest to only 1% to keep the economy strong. 1% is a very low return on investment so the investors were not interested in investing in treasury bills anymore. On the other hand, this means that the banks in United States can borrow from the Federal Reserve for only 1% and this was followed by general surpluses from Japan, China and the Middle East and hence when there is too much of money supply there is an abundance of cheap credit. Also the investors (stock market) took advantage of low interest rate and speculated on the real estate market because at that point of time the National Association of Securities Dealers Automated Quotations (NASDAQ) was tremendously hit, so all the investors also shifted from stock market to real estate.
How did the crisis work? Since there was so much availability of credit for the banks repayable at only 1% rate of interest, this made borrowing money for the banks easier and caused them to use leverage. In simple terms, leverage is borrowing money to enhance the outcome of a deal. Leverage turns good deals into great deals. The crisis brings two groups of people together, home owners and investors. Home owners represent their mortgages and investors represent their money. Now, The mortgages represent houses and the money represents a group of banks known as Wall Street and they are closely connected to each other. So Wall Street took a ton of credit, made a great deal out of it and grew tremendously rich and then payed it back. So now Wall Street had an idea to amplify their money. They can connect the investors and the homeowners through mortgages. So, a family wants a house and they save for a amount known as down payment and contact a mortgage broker. The mortgage broker connects the family to a lender who gives them a mortgage. The broker makes a commission on this deal and it is good for both of them because in that scenario housing prices were continuously rising. Now, one day the lender who holds the mortgage is contacted by a investment banker who wants to buy that mortgage. The lender sells the mortgage to the investment banker because he wants to shift his burden and he also sells it for a nice fee. The investment banker then contacts more lenders and buy many mortgages. Now, since the investment banker holds so many of the mortgages, it is a income for him as he receives payments from the homeowners of all the mortgages. Now the investment banker further wants to shift his burden. So, he puts all the mortgages together and call it a Collateralized Debt Obligation (CDO). He sells the mortgages to investors according to the risk involved in the mortgages and the preference of the investors. The investment banker repays his loans and makes millions. Now the investors are happy because they finally have a return better than the 1% rate of interest given by the Federal Reserve. The investors now want more mortgages so they contacted the investment banker, who contacted the lender. The lender calls the broker for more mortgages but the lender cannot find anyone because all those who were eligible to buy a mortgage already has one. So they started to add risk with the mortgages, no down payments , no documents and no proof of income at all and gave the mortgages to a less responsible home owners. These are known as the Sub-Prime mortgages.
What is the housing bubble? In the simplest terms, a bubble is a overheated market in which there are too many buyers who are too keen to buy. So what happens when demand for a commodity is greater than the supply for it? The price for the commodity rises. But the whole process goes into reverse direction rapidly as more and more homeowners default on their payments and the investment banker holds a valueless mortgage and put the house for sale, and the bubble bursts, with people selling in panic so that the prices plunge.
Why did the bubble burst?
Home prices reached their peak in the second quarter of 2006. They did not drastically fall at first. They fell by less than 2% from the second quarter of 2006 to the 4th quarter of 2006. The foreclosure start rates increased by 43% over these two quarters, and increased by 75% in 2007 compared to 2006. This implies that mortgage default rates began to rise as soon as home prices began to fall. Just like the continuing rising of home prices there was a continuous decline in the home prices. The increase in foreclosures added to the inventory of homes for sale. This further worsened the scenario and putting more homeowners into a negative equity and leading to more foreclosures. This made difficult for the banks to issue a new mortgage backed securities, eliminating a major component of finance in the mortgages and again contributed to the declining home prices. This bursting of the bubble will have negative impacts on the economy for primarily two reasons. First, home construction is a part of the economic activity as it is for one’s own welfare and the decline in home constructions would reduce the Gross Domestic Product (GDP). Second, the decrease in house prices will also reduce the household consumption due to the wealth effect. As mentioned previously most of the losses were faced by the financial system, not by the homeowners. The bursting of the housing bubble sent a shock wave through the entire financial system.
Impact of the crisis
• The major financial institutions in the United states started going bankrupt. 3 of the 5 biggest wholesale banks in Wall Street are changing hands in a few months. • In March 2008, Wall St investment banks Bear Stearns dies and was purchased by JP Morgan Chase. • In Sept 2008, Lehman Brothers collapses, Merrill Lynch is purchased by Bank of America. • In Sept 2008, AIG collapses as it could not afford to pay for all of these US mortgage defaults. The US government nationalizes AIG by becoming 80% shareholder. • Government sponsored Fannie Mae and Freddie Mac either directly owed or guaranteed nearly $5 trillion in mortgage obligations.
IMPACT ON INDIA The foreign banks started divesting their securities in INDIAN EQUITIES resulting in fall in the stock price and weakening the domestic country .Hitting the IT enabled services since a majority of firms derive 75% of their revenue from US. Manufacturing sectors had to ramp up scale economies and improve productivity and operational efficiency. Jobs Holocaust due to unemployment. There were several implications for the banking sector Indian banks had to follow stricter norms while giving loans, which created problem for people in India. Also on the trade front, US was a big trading partner of India at that point of time so it would cause decline in the exports from the Indian economy. Decline in Indian Exports thus declining in export income and foreign currency, Balance of Payments deficit leading to a budgetary deficit.
If this situation would not have been controlled this would have turned to a big worldwide financial fiasco because if the United States would have collapsed, the World economy would have collapsed and the United Nations would have disintegrated.