Background to the study
The credit crisis started to be experienced in US in the middle of 2007 and into 2008. This crisis came about after the economy had enjoyed a relative period of economic boom. The credit crisis was brought about by the US sub-prime mortgage market and the downturn in housing market in US and other large economies such as the UK. Though the crisis had it source in the US it quickly spread to other nation in Latin America, Asia, Africa and Europe leading to a global financial crisis.
In Asia most countries were not affected by sub-prime mortgage market but due to globalization which has made the world to be inter-connected the knock-on effect has exposed most Asian countries to problems stemming from US and other western country. These countries have experienced a decrease in currency value and stock price. Countries like Japan, china and India relies to a greater extent on export and due to the effect of credit crisis the most of there export to Europe and America will reduce which mean that production will decrease and this will hurt the economy (Felton, 2008).
In Africa due to it weak integration with the rest of the world this crisis will have less impact. However most countries in Africa depends on grant and aids from the developed nations and due to the crisis then the flow of direct investment and aids in Africa will decrease and this will affect most countries who depend on aids to fund development project and deficit in the budget. Furthermore most nations who own foreign debt will be pressurized to pay as banks seek fund to replenish their capital. A half of the export from Latin America is absorbed in US economy therefore the credit crisis will affect their economic growth particularly Mexico due to it proximity and close relationship via signing of NAFTA (Madeleine, 2008).
The credit crisis was caused by the US sub-prime mortgage market and the downturn in the housing market in US and other large economies like UK. There were other preceding condition that led to housing boom and the sub-prime mortgages. One of them was an increase in demand for financial asset which was rare to find in many places. Therefore as part of supply response to increase in demand for financial assets the speculative bubbles came on board to rescue the situation. The other condition was availability of excess capital globally which led to more fund finding their way into US mortgage market (Johnson, 2009).
Securitization of loans also played a major role in bringing about the sub-prime crisis. Banks pooled their loans into sellable assets and offloaded the risky one onto others. The security buyers benefited by having regular payment while on the other hand the benefit to the bank was off loading of risk. This was seen as the greatest innovation in the financial system and it quickly spread from US to other market. Banks resulted to more borrowing to create more securitization. Sometimes bank did not rely on savers as they could borrow from other financial institution and sell those loans as security. The bank did not consider the issue of bad loans as the risk was to be borne by the buyer of security (Reynolds, 2009).
Most investment banks like the Lehman brothers moved from their core activities of trading in risk and joined the mortgage market and home loans. The main objective of most investment bank was to buy this mortgage and latter securitize them and sell them as securities. Banks on the other hand gave out more loans in order to have those loans securitized. With time this loans flooded the market and bank could hardly find client to give loans so they turned to the poor i.e. the sub-prime and riskier loans (shiller, 2008).
Due to increase in house price lenders could to see the problem related with such loans since default in payment would mean repossessing a high valued property. The sub-prime mortgages were pooled together and latter sub-divided and grouped into various financial instruments with such names as CDO, CMO, SIV and MBS.
The main problem with this financial instrument is that they did not consider the systematic risk therefore the pricing did not account to this risk not until people started to default in payment. As Evan Davies a former BBC economic editor and presenter noted, rating agencies were paid to rate this products (risking a conflict of interest) and invariably got good ratings, encouraging people to take them up (Joseph, 2008).
When the problem associated with the system started to unravel the people started to loose trust and confidence in the system. Lending by bank and other financial institution slowed down and in some instance ceased. There was a drastic decrease in asset value which led to many lenders to demand their money but on the other hand investment bank had not secured the retail funding and had little deposit which led to their collapse.
The magnitude of the problem was so large that even large banks run out of their capital reserves and had to rely on government support through the bail out plan. Further more banks in their effort to rebuild their capital base suck money from the economy and are slow to give loans. As household and businesses depend on loan for effective operation then the credit crunch has resulted to a spiral of problems (Paul, 2008).
In my opinion there should be re-regulation of the mortgage market and more control on the financial sector since it the crisis has proved that the two markets can cause the economy to slide into recession. Furthermore the regulatory body that oversees the transaction of bank should be given more powers and should be more vigilant in performance of duty to ensure transparency in financial system. The credit rating agencies should be more regulated or replaced by another public body to avoid another occurrence of such crisis.
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