Credit Crunch in Usa-Causes and Solutions Essay Example

Credit Crunch in Usa-Causes and Solutions Essay Contents Credit Crunch in USA2 Causes of the Credit Crunch2 Housing Bubble2 Financial Product Innovations5 Sub Prime and Alt-A Lending5 Shadow Banking System6 Other Factors7 Solutions for the Credit Crunch7 Nationalization7 Regulation of the Shadow Banking System8 Regulations on Mortgage Lending8 Capital Reserve Requirement9 Government Initiatives10 Conclusion11 References12 Appendix14 Glossary14 Table of Charts Federal Funds vs Mortgage Rates3 USA Home Price Indices4 USA Property Foreclosures 20075 USA subprime Market Share6 Mortgage Foreclosures Factors.. 9 Credit Crunch in USA â€Å"USA† is facing a shrinking supply of credit in the credit market which is often termed as a â€Å"Credit Crunch†. A credit crunch has made it difficult for companies to borrow because lenders are scared  of bankruptcies or defaults, which results in higher rates. The credit crunch has done a lot of damage to the US economy by stifling economic growth through decreased capital liquidity and the reduced ability to borrow (Keara, 2009). This crunch coupled with the  recession, has led to many corporate  bankruptcies. Causes of the Credit Crunch Housing Bubble The central element in the Credit Crunch was the â€Å"Housing Bubble†. The real estate prices in US were unchanged for almost a century until 1995(Baker, 2008). The period between 1995 till 2002 showed an increase of 30 % in the house prices which grew up to 124% by 2006 (The Economist, 2007). The house prices were being driven by a speculative bubble rather than the fundamentals of the housing market (Baker, 2008). We will write a custom essay sample on Credit Crunch in Usa-Causes and Solutions specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Credit Crunch in Usa-Causes and Solutions specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Credit Crunch in Usa-Causes and Solutions specifically for you FOR ONLY $16.38 $13.9/page Hire Writer Adding fuel to the fire were the lower interest rates offered by the Federal Reserve System. The country was grappling back to normalcy after the 2001 recession. To ease out the pressures on the potential home buyers, the federal fund rates were slashed drastically to 1. 0 percent by the end of 2003, which was a 50 year low. The 30 year fixed rate was also reduced to 5. 25 %. Chart 1 gives us the trends for the 30 Year fixed rates and the mortgage rates across 2001-2008. Chart 1. Federal Funds vs Mortgage Rates(Freddie Mac,2008) These extra ordinarily low interest rates accelerated the house prices. Alan Greenspan, the Federal Reserve Board chairman encouraged people to buy adjustable rate mortgages instead of fixed rate mortgages (Baker, 2008). This  housing bubble also resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out  second mortgages  secured by the price appreciation. This bubble began to burst in 2007, as the construction boom led to so much over-supply that prices could no longer be supported. By the end of 2007, the housing prices had started to fall in most parts of USA. The prices had declined to almost 20 % of their peak value since mid 2006(Standard`s Poor`s, 2008). This dramatic fall in the house prices put the borrowers in a ‘negative equity’ where the appraised value of the mortgage was far lower than the actual amount owed to the financial institution. Chart 2 shows the Home Price trend in USA until 2008. Chart 2. USA Home Price Indices(Standard Poor`s,2008) The Federal fund rates were raised significantly between July 2004 and July 2006  . This contributed to an increase in 1-year and 5-year  adjustable-rate mortgage  (ARM) rates, making ARM interest rate resets more expensive for homeowners(Mastrobatista,2009). People were unable to cope with the higher interest rates offered by the adjustable rate mortgages in the latter periods. Refinancing became more difficult, once house prices began to decline. Borrowers who could not afford the higher monthly payments by refinancing began to default. During 2007, lenders started the foreclosure proceedings on nearly 1. million properties, a 79% increase over 2006 (RealtyTrac, 2008)  which further increased to 2. 3 million in 2008, an 81% increase vs. 2007 (RealtyTrac, 2009). A survey by MBA (2008) showed that 9. 2% of all mortgages outstanding were either delinquent or in foreclosure. The Economist (2009) predicts that up to 9 million homes may enter foreclosure over the 2009-2011 periods leading to a loss of more than $450 billion. Chart 3 shows the U. S. Household Prope rty Foreclosure in 2007. Chart 3. USA Property Foreclosures Chart 2007(Realty Trac,2009) Financial Product Innovations The housing bubble was supported by a variety of financial product innovations such as; 1. Adjustable Rate Mortgages in contrast to Fixed Rate Mortgages which were more common before. 2. Mortgage Backed Securities. 3. Collateral Debt Obligations. 4. Credit Default Swaps. The use of these products expanded dramatically in the years leading up to the crisis. Sub Prime and Alt-A Lending Sub Prime Lending refers to loans issued to people who have poor credit histories. Owing to government and competitive pressures, the sub-prime mortgage market exploded during the housing bubble. Most of the major investment banks and government sponsored agencies such as Fannie Mae and Freddie Mac were involved with this high risk lending (Wallison Calomiris, 2008). Before 2004, the Sub Prime market accounted for less than 10 % but increased to 20 % by 2006 (Alexander et al, 2008). The relaxation of â€Å"Net Capital Rule† encouraged the investment companies to increase their financial leverage and aggressively promote the Mortgage Backed Securities (Labaton, 2008). In addition to this the issuance of Alt-A loans also aggravated the problems for the nations` economy (Baker, 2008). These loans were of a questionable quality and came up with incomplete documentations. Many of these loans were falsely purchased for the sake of investments. These loans had high loan to value ratio. In some cases, buyers got the full value of their purchase price. The subprime and Alt-A categories together comprised more than 40 percent of the loans issued at the peak of the bubble (Baker, 2008). Chart 4 shows the US Subprime Market share and the Home Ownership percentages. Chart 4. USA Sub Prime Market Share(US Census Bureau,2008) The delinquency rates for the Subprime loans had reached 25% by the end of 2008 (Bernanke, 2008). Shadow Banking System Lack of regulatory controls over the parallel or shadow banking system played a major role in the credit collapse. The parallel banking systems are nothing but the securitization markets. These entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets (Geithner, 2008). This meant that disruptions in credit markets made them subject to rapid deleveraging, selling their long-term assets at depressed prices. Major USA conglomerates, Bear Stearns and Lehman Brothers are the examples of parallel banking systems whose collapse signalled the start of the financial crisis. These financial institutions benefited from the existing easy credit conditions . They borrowed and invested large sums of money through a practice called as leveraged lending (The New York Times, 2010). The high leverage ratios of these organizations put them under heavy debts. Blackburn (2008) in his research article â€Å"The Subprime Crisis† reveals that the debts for these Organizations were 113. 8% of the GDP in 2007. Such high financial leverages made these organizations highly susceptible to the market setbacks. Other Factors In addition to the above mentioned factors, the lenders were also involved in unscrupulous activities of advertising risky loans. Countrywide Financials was actively involved in unfair business practices and advertising low interest rates for home refinancing. Incorrect appraisals of the owners’ property, inaccurate credit ratings by agencies, extremely low down payments offered to the borrowers, NINJA mortgaging also contributed to the downslide of the economy. Solutions for the Credit Crunch The credit crunch could have been avoided if the regulatory bodies had taken the necessary precautionary measures. The early signs of a crunch were ignored and not paid attention to which led to a very aggravated condition. Leading financial advisors worldwide have recommended some key solutions to safeguard the economy in the future. Nationalization Nationalization has been a very rare occurrence in the economic history of USA. But it is one the best possible solutions for the Credit Crunch. The failing companies must be bailed out by the government and exercised control upon. All the insolvent financial institutions must be injected with fresh capital from private investors in an order to survive. Roubini(2009), a popular economist also advocates a temporary takeover of the financial organizations which are on the verge of bankruptcy by the government. Regulation of the Shadow Banking System The Shadow Banking Systems do not follow the rules and regulations which are applicable to banks. The financial regulations and the safety nets should also be extended to these organizations. Krugman (2010) suggests that the regulators must have the authority to take control of the falling shadow banks. The  FDIC  has the authority to takeover a struggling depository bank and liquidate it but it lacks this authority for non-bank financial institutions. Geithner (2009) testifies that the FDIC needs to expand its regulation to these non bank financial institutions also. Stiglitz (2008) advocates that there should be strict regulations with regards to the financial leverages that these intuitions undertake in order to get short term benefits. He suggests that companies must not be allowed to grow very big and must be broken into smaller entities. Financial institutions must not be allowed to go rampant in selling the riskier products such as the mortgage backed securities and CDOS`. Regulations on Mortgage Lending During the period preceding the credit crunch, there were minimal regulatory acts for mortgage lending. As a result there was an increase in subprime mortgages which were one of the major causes of the crisis. The following regulations should be put in place in order to avoid the recurrence of this situation, 1. Minimum down payment amount. Buffett (2008) suggests of doing the â€Å"Income Verifications† and maintaining minimum 2 down payments of 10 % for every loan which is issued. 2. A strong credit history check of the borrower. Only clients with a high FICO score should be granted loans. 3. Maintaining a strong documentation for all the loan cases. This will keep a check on the Alt-A category of loans. 4. Less performance pressure on the appraisers. This will enable them to assess the property correctly and come up with realistic value for the same. 5. Less pressure on the borrower for purchasing the ARM. Economist Stan Leibowitz (2009) states that the positive equity of a home owner determines foreclosures. His study reveals that 2008 saw 47% of homes which had negative equity to face foreclosures. He has advocated a relatively high minimum down payment. He is of the opinion that the intensity of the housing bubble could have been minimised if substantial down payments had been acquired. This would have also led to a very small negative equity existing amongst the home buyers. Chart 6 highlights the fact that negative equity was the major cause of all the mortgage foreclosures. Chart 6. Mortgage Foreclosures Factors (Wall Street Journal,2009) Capital Reserve Requirement The investment banks had limited capital reserves to deal with the declines in mortgage backed securities and other innovative financial products such as collateralised debt obligations. Limited financial cushion meant that these companies couldn’t support themselves in the credit default derivative insurance contracts which led to their downfall. Leading economist Stiglitz (2008) suggests a Minimum Capital Reserve Requirement Strategy to overcome the crisis. Raghuram (2009) suggests institutions to maintain a contingent capital. This will include paying insurance to the government when the economy is on an upswing. This same insurance amount can be used during the downslide. Greenspan (2009) advocates a stronger capital cushion for banks and a more regulatory capital requirement. Government Initiatives The Federal Reserve System has taken steps in association with  other central banks  around the world to increase the liquidity in the market. It has introduced various programs such as TALF which focuses on providing short-term funding to various institutional borrowers. The Fed can expand the money supply through open market operations  which provides cash to member banks for lending. The Fed can also provide loans against various types of collateral to enhance liquidity in markets. The Troubled Asset Relief Program  (TARP) proposal initiated by the government for purchasing the toxic assets of a company was a failure because of the long timeline involved in successfully valuing, purchasing, and administering such a program. The government is also focussing on bail outs of large organizations facing bankruptcy. The famous AIG bailout has been described by Bernanke (2009) as a necessary step in protecting the stability of the economy. Conclusion The solutions outlined above aim to establish a proper regulatory system for the global finances. We have to progressively transform the very nature and functioning of the financial organizations worldwide. There should be a global system of financial regulations. The shadow banking system must be controlled and regulated to put new rules and principles in place. The G-20 leaders worldwide should take the necessary steps in order to evade another financial crisis. The costs incurred and the time required for the changes in the system are high, but these have to be incorporated considering the potential future setbacks. The global economic meltdown has already hit the countries badly. The non-depository banking institutions have had a major hit to their market standings. At the end of the day it is the human psyche and the greed which needs to be controlled. Practicality needs to be prevailed and a more radical and transformative approach be taken to tackle the hurting consequences of the â€Å"CREDIT CRUNCH†. All Central Banks are responsible for internal stability and external stability of the currency. They have a variety of means at their disposal to achieve those aims, including interventions, changes in key interest rates or fixing reserve requirements for private banks (Lietaer, 2001). CDO CDOs, or Collateralized Debt Obligations, are sophisticated financial tools that repackage individual loans into a product that can be sold on the secondary market. These packages consist of auto loans, credit card debt, or corporate debt. They are called collateralized because they have some type of collateral behind them (Amadeo,2010). CDOs are called  asset-backed commercial paper  if the package consists of corporate debt and  mortgage-backed securities  if the loans are mortgages. If the mortgages are made to those with a less than prime credit history, they are called  subprime mortgages. CDS CDS are a financial instrument for swapping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bond The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument is defaulted. The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap (Economicshelp,2010). Credit Crunch Credit Crunch is defined as an economic condition  in which  investment capital is difficult to obtain. Banks and  investors become wary of lending funds to corporations, which drives up the price of debt products for borrowers(Investopedia,2010). A  credit crunch  occurs when there is a  lack of funds available  in the credit market, making it  difficult for  borrowers to obtain  financing. This happens when lenders have limited funds available to lend or are unwilling to lend additional funds, or have increased the cost of borrowing to a  rate  that is unaffordable to most  borrowers. Credit  crunches are usually considered to be an extension of recessions. A credit crunch makes it nearly impossible for companies to borrow because lenders are scared  of bankruptcies or defaults, which results in higher rates. The consequence is a prolonged recession (or slower recovery), which occurs as a result of the shrinking credit supply (Investopedia, 2010). Credit market Investopedia (2010) explains a credit market as the broad market for companies who are looking to raise funds through debt issuance. The  credit market encompasses investment-grade bonds and junk bonds, as well as short-term commercial paper. The credit market also involves the debt  offerings as seen by investors of bonds, notes and securitized obligations such as mortgage pools and collateralized debt obligations (CDOs). Fannie Mae The Federal National Mortgage Association or Fannie Mae is a government-sponsored enterprise (GSE) chartered by Congress with a mission o provide liquidity, stability and affordability to the U. S. housing and mortgage markets which operates in the U. S. secondary mortgage market. (Fannieaae, 2010) FDIC The Federal Deposit Insurance Corporation (FDIC) preserves and promotes public confidence in the U. S. financial system by insuring deposits in banks and thrift institutions for at least $250,000; by identifying, monitoring and addressing risks to the deposit insurance funds; and by limiting the effect on the economy and the financial system when a bank or thrift institution fails. An independent agency of the federal government, the FDIC was created in 1933 in response to the thousands of bank failures that occurred in the 1920s and early 1930s. Since the start of FDIC insurance on January 1, 1934, no depositor has lost a single cent of insured funds as a result of a failure. The FDIC receives no Congressional appropriations – it is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in U. S. Treasury securities. The FDIC insures more than $7 trillion of deposits in U. S. banks and thrifts – deposits in virtually every bank and thrift in the country. Federal Reserve System The â€Å"Federal reserve System† or â€Å"The Fed† is the central bank of the United States of America. It was originally conceived in the year 1910 and enacted in 1913 with the passing of the Federal Reserve act (Whitehouse, 1989). This was a result of the previous financial panics that the country had experienced. Its duties today, according to official Federal Reserve documentation, fall into four general areas(Federal Reserve , 2010): * Conducting the nations monetary policy by influencing monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates. Supervising and regulating banking institutions to ensure the safety and soundness of the nations banking and financial system, and protect the credit rights of consumers. * Maintaining stability of the financial system and containing systemic risk that may arise in financial markets. * Providing financial services to deposit ory institutions, the U. S. government, and foreign official institutions, including playing a major role in operating the nations payments system. Financial Leverage Financial leverage (FL) is a  loan  or other  borrowings  (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return than the cost of interest. It is the degree to which an  investor  or  business  is utilizing borrowed  money. Companies  that are highly leveraged may be  at risk  of  bankruptcy  if they are unable to make payments  on their  debt; they may also be unable to find new  lenders  in the future. Financial  leverage  is not always bad, however; it can increase the shareholders’ return  on their  investment  and often there are  tax advantages associated with  borrowing. Fixed Rate Mortgage A fixed Rate Mortgage has a fixed Interest Rate for the entire tenure of the loan. Freddie Mac The  Federal Home Loan Mortgage Corporation  (FHLMC), known as  Freddie Mac  is a  government sponsored enterprise (GSE) of the  United States federal government. Freddie Mac has its headquarters in Virginia (Freddiemac, 2010)   Freddie Mac buys mortgages on the secondary market, pools them, and sells them as a  mortgage-backed security  to investors on the open market. This secondary mortgage market  increases the supply of money available for mortgage lending and increases the money available for new home purchases. Net Capital Rule. GDP Gross Domestic Product or GDP refers to the value of all the goods and services consumed in a particular economy (Lietaer, 2001). Greenspan Alan Alan Greenspan was the former chairman of the federal reserve system of United States of America from 1987 to 2006. He is currently working as a consultant and private advisor for firms through his company Greenspan Associates LLC. Krugman Paul Paul Krugman is an American economist and author. He is currently working as a professor in Economics and international affairs at the Princeton university (krugmanonline, 2010) Liquidity Market liquidity refers to the assets ability to be sold without much depreciation in its value and without much price discounts. Liquidity refers to how quickly and cheaply an asset can be converted into cash. Money in the form of cash is the most liquid asset. Assets that generally can only be sold after a long exhaustive search for a buyer are known as illiquid (Investopedia, 2010). Loan to Value Ratio The Loan to value ratio refers to the amount of loan issued to the total appraised value of the mortgage. MBA The Mortgage Bankers Association (MBA) is the national association representing the real estate finance industry, an industry that employs more than 280,000 people in virtually every community in the country. Headquartered in Washington, D. C. , MBA invests in communities across the nation by ensuring the continued strength of the nations residential and commercial real estate markets; expanding homeownership and extending access to affordable housing to all Americans and supporting financial literacy efforts (MBAA,2010). MBS Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization (US Securities and Exchange Commission, 2010). Most MBSs are issued by the Government National Mortgage Association (Ginnie Mae), a U. S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U. S. government-sponsored enterprises. Nationalization Nationalization is a process when the government takes over the privately owned  corporations,  industries, and  resources  with or without compensation. Common  reasons for nationalization include (1)  prevention  of unfair exploitation and large-scale  labour  layoffs, (2) fair  distribution  of  income  from national resources, and (3) to keep  means  of generating  wealth  in  public  control. Nationalization may include the complete changeover of the management of the organization. Once the organization is back on the positive side of the fence, the business is completely handed over to the management (BusinessDictionary,2010) Negative Equity Negative Equity is a situation in which the value of the collateral falls below the outstanding balance of the loan. This usually occurs when loan payments are less than the interest. NINJA. Any type of mortgage loan requires the borrower to show sufficient income proofs and documentations. NINJA refers to â€Å"No income No job No assets†. Such a type of lending ignores the verification process and is considered a part of sub-prime lending. In NINJA mortgages the borrowers are often offered very low initial interest rates which are later adjusted to the market rates. Subprime lending Subprime lending refers to lending to borrowers having a poor credit history. The FICO score of these borrowers is usually very less which doesn’t qualify them for having loans. Subprime loans are issued with higher interest rates and are considered to be more risky than the subprime loans. Securitization Securitization is defined as the process of gathering a group of debt obligations such as mortgages into a pool, and then dividing that pool into portions that can be sold as securities in the secondary market. Shadow Banking System The Shadow banking system is also known as the parallel banking system. This system usually consists of the financial institutions and investment banks which run like a bank but are not subjected to the same regulatory acts like banks. They are more involved in dealing with riskier financial products