Credit Crunch of 2008 in the World Financial Markets

Introduction

Any large business house, consumer expenditures or government schemes may borrow public money in the form of selling shares.¹ It is the function of large financial institutions, such as banks, to issue or generate credit transactions. A smooth inflow of credit between the borrower and the lender is what establishes ideal market conditions. A credit crunch occurs when there occurs a lack of obtainable credit in the market and the borrowers cannot find adequate finance. Usually such a phenomenon happens when the creditors are unwilling to invest more money or hike up their interest rates to such exorbitant levels that it becomes virtually impossible for the lender to borrow.²

The central question, then, is why do the creditors suddenly refuse to invest more money? Actually, far from being an isolated fact, it is a part of a complex chain reaction. The lenders reel under deficit money supply when they fail to realize the interest or even the actual capital they had invested on companies or institutions, which accrued a disastrous amount of losses. Such loss incurring companies cannot return the money they had borrowed from the creditors and have to default payment.

However, when the prices begin to fall, even the bank has to sell out at considerably lower prices and suffer huge losses. Consequently, their ability to lend money is severely crippled. In certain cases, the banks are required to raise the level of capital reserves and to comply with this have to restrict lending. Even when banks perceive a risky market, interest rates may shoot up to discourage lending to credit crunch.³

There are multi-strata perspectives of history and history without these layers becomes meaningless academic foliage. These layers of history could be defined as perspectives and perceptions related to politics, economic, sociology, cultural and religious. Without the intervention or analysis of these subjects and subsequent incorporation and investigation in accordance to these subjects history would be wrongly incepted. Therefore, to understand whether the present crisis has a purpose or not it is important to analyze these subjects within the perspective of economic history as a whole.

Main text

The present crisis originating in America is similar to the 1980’s savings crisis. The subprime crisis grew from the saving and loan (S & L) balance sheets under the Carter Administration when funds in this account took a battering from high interest rates during the period… This made Congress loosen regulatory standards in order to divert S&L funds into more profitable real estate stocks. Commercial real estate investments were riskier. To buffer this initiative, federally backed amounts up to $100,000 were deposited into insurance funds. This instantly had the effect of attracting yet more funds and what is more, encourage risk taking.⁴

All this made regulatory standards lax. S&L funds were free to choose between state or federal regulations. Predictably, states relaxed fiduciary regulations in order to attract these funds, because they stood to earn large fees by registering these funds. In the ensuing race to financial destruction, states lowered regulatory barriers even more. The brunt was taken by American taxpayers. Consumers took the rap on other fronts as well.

The nation has seen such crisis in the past and incorporated different methods as bailout plans. The 1932-53 crises called for reconstruction of Finance Corporation and the trigger was Great depression. The 1989-95 crises needed Resolution Trust Corporation and the trigger was savings and loan crisis. Here 747 small companies were affected and the cost was $300 billion where the initial cost estimation was $50 billion. In other countries too, like Sweden (1992-96) and Japan (1996), the resolution was in form of Bank Support Authority in Sweden and Resolution and Collection Corporation in Japan and in both the cases, the trigger was fallout from a real estate bubble.⁵

Since a Credit Crunch arises when the banks themselves are unable to get proper funds, if someone wanted to buy a simple house in the USA today or just a conventional mortgage, one may not be able to get it as the banks do not have enough funds in them. People are even facing problems renewing their mortgages nowadays. Almost one third of the banks in USA have lessened their real estate lending, as they are unable to get credit. Rate cuts in the interest amounts become irrelevant if the banks have no money to lend to the people. The Federal Reserve is lending money to other banks so that they do not say they don’t have money to lend. In such a case the term liquidity is being used.

The Federal Reserve helped finance J.P.Morgan take over Bear Stearns when it collapsed. The Federal Reserve has also devised means to fight off depression and is attempting to stop the various feedback loops, which could cause runs in the financial institutions, finally leading to their collapse. For instance, these financial institutions do not even have to run out to affect the country’s economy.

If their capital is diminished enough to stop them from further lending, it will cause more economic weakness producing more stress for the financial institutions. Most economists are under the impression that this depression in USA’s economy will sustain for quite a long period of time as it may continue till mid 2009. They are advising the retail investors not to panic and to reconsider their portfolios so that they do not have to sell out at rock bottom prices.⁶

Rising unemployment has prompted the Federal Reserve to cut down its lending rates. USA’s unemployment rate rose sharply around June this year. Just after this news was reported, the Federal Reserve immediately responded by lowering its interest rates so as to encourage the drooping economy. According to the analysts, the Federal Reserve had no other choice but to do so, even if it meant bowing down to the political considerations. The percent of jobless people in the nation rose from 7.5% in May to 7.8% in June this year.

The discount rate of the Federal Reserve was 3.5% to 3%. This has been its lowest rate since 1963. They have also reduced the Federal Funds Rate, which is the rate the different banks charge each other for taking overnight loans, from 3.75% to 3.25%. This action was also followed by several other banks, which also cut down their prime interest rates.

These cuts in the interest rates help the economic growth as it lets the people doing business borrow more money for their investments. It also makes it cheaper for the consumers to borrow while spending. The Federal Reserve said that the actions they had taken were due to the weakness in the money and credit growth, irregular progress of the economy’s recovery and for continuous progress towards price stability.

As there was a slow growth in the money supply, there was not enough money available for giving loans in order to increase the nation’s economic growth. Analysts have further said that the Federal Reserve should lower their rates more as feeble money supply could cause the economic recovery to slow down, just as a slow monetary growth caused the economy to descend low last year.

It is also being said that these rate cuts may be too late to help as the time lag before the lowered rates seep into the economy to encourage growth, investment and spending, is about six months. Economists argue that the economy’s recovery has been held back due to the huge debts of the customers and business expenses.⁷

It would be relevant to mention that the current account is an extremely important tool that can determine the entire business cycle of a country as current account can be determined in according to trade balance as the difference of import and export of tangible goods and services like consulting and legal. Current account is also instrumental in determining the overseas factor incomes like dividend and income along with the net overseas Unilateral Transfers like gifts, grants, and aids.⁸

In US, five of the leading banks of the world, including the Federal Reserve Bank of USA came together to invest huge amounts of fresh money into the global market to combat international credit crunch failing economy with about one trillion dollars.⁹ This move is largely stimulated by the concern of leading economists who were predicting a recession in US markets as a slowing down or decline of US and British housing markets. In an emergency set of solution seeking procedures, the Federal Reserve Bank drastically diminished interest rates, splurged out innovative lending programs, sought to modify the poor condition of Bear Stearns and provide loans to boost the nearly crippled mortgage agencies of Fannie Mae and Freddie Mac.

The most innovative plan to diminish the credit crunch has been to increase lending with the motivation to restore liquidity to troubled markets and look after the demands of the inter-bank loaning facilities.¹⁰ The current crisis made the Federal Bank to decrease the interest rates on lent amounts and lengthen the time limit for the repayment of the loan. “Term Auction Facility” was adapted as a scheme for slow banks through which loans at a cheaper rate could be made available from discounts windows and the deals were guaranteed anonymity.¹¹

Under such parameters the fundamental bailout plan “Hank Paulson’s $700 million no-strings-attached proposal” was disapproved by the US House of Representative.¹² There is however, a second bailout plan. It is referred to as Plan B. The Federal Reserve endorses this plan after the failure of the Plan A. It has been reported, “tax credits for the production and use of renewable energy sources, like solar energy and wind power have been. Possible other inclusions originating in the House bill are an extension of the unemployment benefits, protection from foreclosure for individuals, and tax credits for low and medium income households.”¹³ Under such parameters, it can be stated that this plan was initially supposed to be workable but a Plan C was initiated to be effected as a proper bailout method.

Plan C includes an additional input of US$800 billion by the Federal Reserve. The amount of US$800 billion would be instrumental in buying the debts related to mortgage and the credits of the consumers in order to instrument a lending free up. At this point of time it appears that there are two major problems related to this Plan C. The first one is the fact that there is not enough retail economy spending in relation to consumers. Secondly, there is a lack of consumer credit and there is no presence of a sound economy to sustain this amount. It is reported that “the Federal Reserve and US Treasury are pumping a jaw-dropping $800 billion directly into the credit markets, buying up $600 billion worth of mortgage debts”.¹⁴

Under such parameters, if the plan B is taken into consideration, it can be stated that this plan appears to be a very slow process. This could be a very dangerous ploy and the result could be devastating for the economy. It should be noted that a very fast and effective measure is needed and Plan B lacks that speed of operations that is required in this case. As per implecation of Plan B is concerned it can be mentioned, “Pressure is also mounting from constituents for Congress to take action to stop the extreme volatility in the markets as their investments have plummeted. While stiff opposition to a bailout of Wall Street is apparent, direct damage to the net worth of individuals has prompted a call for action”¹⁵ Thus, it appears that Plan B is not workable at all.

On the other hand, Plan C has its own faults. Henry Paulson, Treasury secretary, indicates, “This lack of affordable consumer credit undermines consumer spending and as a result weakens our economy“.¹⁶ Thus, it is difficult to implement this plan on a large scale. The market appears frozen and the credit system is crippled as investors pulled out $240 billion out of the market particularly from the field of auto loans and credit card market. The Federal Reserve bailout plan of $180 billion could be instrumental in luring investors into the market.

In a way, this could prove to be the ideal stage to implement Plan C though there are enough risk involved. Nevertheless, Plan C is quite complicated in nature and it the Federal Reserve is reluctant to use it right now and hold it until February 2009.¹⁷

However, serious situation demands serious risks. As it is, it looks like the Plan B would not be effectively instrumental without a long termed result and this is a situation that needs quick response. Thus, the best measure is to wait until February 2009 and implement the Plan C. During this time the drawbacks of the plan would be well sorted out and thus the implementation would be more error free and sustainable. That way, it would be faster and effective than Plan B. Thus, Plan C is the most favorable plan under these circumstances and the government should be instrumental in implementing this plan.

However, very recently, the Federal Reserve announced a very effective rescue policy. Under this policy the Fed would be instrumental in creating a fund for financial companies like Goldman Sachs, Morgan Stanley and Merrill Lynch. This would enable these companies to withdraw funds in accordance to the necessity of the individual management to sustain the organization on a long termed basis.¹⁸ In fact, the surety of its success has led the Federal Reserve to “extended the life of key programs aimed at busting through credit clogs and restoring stability to financial markets.”¹⁹ The basic idea is to formulate a lending facility that would enable investment firms to greater financial liquidity. It is reported, “This category was recently broadened to include any loans that were made to the American and London-based broker-dealer subsidiaries of Goldman Sachs, Morgan Stanley and Merrill Lynch.”²⁰ This is a rescue policy that would help the firms to “temporarily swap risky investments, like shunned mortgage-backed securities, for supersafe Treasury securities also is covered.”²¹

According to Heitfield, “To a large degree, the potential for dramatic falls in ratings and valuations was “baked in” to the securitization process” where “Credit rating and valuation models depended on limited data – could not accurately assess the likelihood of future losses“²²

Thus, these situations should be taken into account for future prospects.

Although banks have been the most popular method of economic growth, they are quickly becoming one of the least reliable sources. Private enterprise is taking a new face in the modern world and is helping to facilitate strong economic growth, even during a time of recession. In this modern day and age, businesses are becoming more personal, which most people enjoy. This gives people a larger sense of trust with companies and allows them to get more loans. When people have more money, the spend more and put more back into the economy. It is plain to see why market based financial systems are the superior method of economic growth.

Whenever you de-regulate how business is run, people tend to show the good side of them more and help each other out more. Laissez faire is an important cornerstone in today’s free world market, and it should stay that way. Banks are still regulated by the government, and obviously have been failing to keep up to par. The choice is obvious and hopefully the government begins to support private financial groups more in the future.

As a bailout plan, the article “In Rescue to Stabilize Lending, U.S. Takes Over Mortgage Finance Titans” by Stephen Labaton and Edmund L. Andrews published in New York times on September 7, 2008 can be very useful for its logical reasoning. This article is a take on the recent credit crunch of US. Huge amount of capital inflow is needed in this case and even if the bailout plan succeeds, it is evident that there would be difficult times. However, in the event of magnifying unemployment and inflation, the Federal Bank cannot afford to sit still. It has to fight for a stable equilibrium in prices and combat unemployment.

The most innovative plan to diminish the credit crunch has been to increase lending with the motivation tom restore liquidity to troubled markets and look after the demands of the inter-bank loaning facilities. The current crisis made the Federal Bank to decrease the interest rates on lent amounts and lengthen the time limit for the repayment of the loan. “Term Auction Facility” was adapted as a scheme for slow banks through which loans at a cheaper rate could be made available from discounts windows and the deals were guaranteed anonymity.²³

However, even in this situation there is a hint of positive aspect. “The economic cycle has clearly shifted into a dramatic downturn, and so a different planning approach is called for. But by knowing where you can take advantage of the situation, it is possible to make the downturn much less painful financially, and in some cases, it may even be possible to take advantage of it.”²⁴

References

1. Whybrow, Martin. International Banking Systems Market Report 2007. IBS Publishing Ltd. pp 64.
2. Lamb, Davis; Cult to Culture: The Development of Civilization on the Strategic Strata. (Wellington: National Book Trust. 2004) pp 243-245.
3. Dollard, John; Modern Fiscal Policies: A look into Tomorrow. (New Haven and London: Yale University Press. 2006) pp 89-92.
4. Wolfson, Martin H; Financial Crises: Understanding the Postwar U.S. Experience; M.E. Sharpe; 2007.
5. FT Research; The New York Times; 2008.
6. Doskoch, Bill; Breaking down the U.S. credit crunch crisis; CTV.ca News. 2008.
7. Greenhouse, Steven; Unemployment Up Sharply, Prompting Federal Reserve To Cut Its Key Lending Rate. NYTimes. 2008. Web.
8. GORTON, G. B. PING HE; Bank Credit Cycles; Review of Economic Studies; 75: 4; 1181-1214; The Wharton School University of Pennsylvania and NBER; School of Economics & Management, Tsinghua University; 2008.
9. Grynbaum, Michael M. Persistent Anxiety Over Tight Credit Sends Stocks Plunging. NYTimes. 2008.
10. Cecchetti, Stephen. Federal Reserve Policy Actions in 2007: Answers to More Questions. Brandeis University; Eurointelligence Advisers Limited.
11. King, H; Fiscal Fitness Today (Dunedin: HBT & Brooks Ltd. 2005) pp. 126.
12. Rankin, Kyle; Plan B: Go to Congress, Make a Right; Black and White Program. 2008.
13. 3news; US to try bailout ‘plan C’ to solve credit crisis; 3 News / CBS; 2008.
14. ASSOCIATED PRESS; Fed Extends Some Credit Programs Through 30. New york Times. 2008. Web.
15. Heitfield, Erik; Resecuritization: a Post Mortem; National Association of Business Economics Annual Meeting; Federal Reserve Board; 2008.
16. Labaton, Stephen & Andrews, Edmund L; In Rescue to Stabilize Lending, U.S. Takes Over Mortgage Finance Titans; NY Times; 2008.
17. Ludwig, Ronnie; A silver lining for the credit crunch?. BBC NEWS; 2008. Web.

Footnotes

1. Whybrow, Martin. International Banking Systems Market Report 2007. IBS Publishing Ltd, 2007. pp 64.
2. Lamb, Davis; Cult to Culture: The Development of Civilization on the Strategic Strata. (Wellington: National Book Trust. 2004) pp 243-245.
3. Dollard, John; Modern Fiscal Policies: A look into Tomorrow. (New Haven and London: Yale University Press. 2006) pp 89-92.
4. Wolfson, Martin H; Financial Crises: Understanding the Postwar U.S. Experience; M.E. Sharpe; 2007.
5. FT Research; The New York Times; 2008.
6. Doskoch, Bill; Breaking down the U.S. credit crunch crisis; CTV.ca News; 2008.
7. Greenhouse, Steven; Unemployment Up Sharply, Prompting Federal Reserve To Cut Its Key Lending Rate; NYTimes.com; 2008.
8. GORTON, G. B. PING HE; Bank Credit Cycles; Review of Economic Studies; 75: 4; 1181-1214; The Wharton School University of Pennsylvania and NBER; School of Economics & Management, Tsinghua University; 2008.
9. Grynbaum, Michael M. Persistent Anxiety Over Tight Credit Sends Stocks Plunging. NYTimes. 2008.
10. Cecchetti, Stephen. Federal Reserve Policy Actions in 2007: Answers to More Questions. Brandeis University; Eurointelligence Advisers Limited. 2007.
11. King, H; Fiscal Fitness Today (Dunedin: HBT & Brooks Ltd. 2005) pp 126.
12. Rankin, Kyle; Plan B: Go to Congress, Make a Right; Black and White Program; 2008.
13. Rankin, Kyle; Plan B: Go to Congress, Make a Right; Black and White Program; 2008.
14. 3news; US to try bailout ‘plan C’ to solve credit crisis; 3 News / CBS; Wed, 2008.
15. Rankin, Kyle; Plan B: Go to Congress, Make a Right; Black and White Program; 2008.
16. 3news; US to try bailout ‘plan C’ to solve credit crisis; 3 News / CBS; Wed, 2008.
17. 3news; US to try bailout ‘plan C’ to solve credit crisis; 3 News / CBS; Wed, 2008.
18. ASSOCIATED PRESS; Fed Extends Some Credit Programs Through; New york Time; 2008.
19. ASSOCIATED PRESS; Fed Extends Some Credit Programs Through; New york Times; 2008.
20. ASSOCIATED PRESS; Fed Extends Some Credit Programs Through ; New york Times; 2008.
21. ASSOCIATED PRESS; Fed Extends Some Credit Programs Through; New york Times; 2008.
22. Heitfield, Erik; Resecuritization: a Post Mortem; National Association of Business Economics Annual Meeting; Federal Reserve Board; 2008.
23. Labaton, Stephen & Andrews, Edmund L; In Rescue to Stabilize Lending, U.S. Takes Over Mortgage Finance Titans; NY Times; 2008.
24. Ludwig, Ronnie; A silver lining for the credit crunch?; BBC NEWS; 2008.