Credit crisis refers to a situation where there is a significant reduction in the amount of money to be lent out to the public in form of loans. In situations of credit crisis, the correlation between the availability of credit and interest rates collapses in that credit may seize to exist at any given interest levels or unclear relationship may be formed between the availability of credit and the official interest rate. Therefore, a credit crisis can be defined as a situation where the banks and other financial institutions slow down in their lending activities (Grant, Pittsburgh Post-Gazette). This essay will analyze some of the causes of credit crunch especially the 2008 credit crunch. In analyzing the credit crunch, the essay will discuss how the crisis spread and the efforts made by the Federal government in combating the crisis.
The causes of the credit crisis
The main cause of the 2008 credit crisis can be attributed to the careless lending system that many financial institutions adopted that led to accumulation of bad debts in their financial statements. As a result of the increasing debts some financial institutions opted to reduce on their lending rates while other financial institutions increased on the interest rate charged to acquire credit. U.S being a country whose investments greatly rely on loans from various lending financial institutions was easily affected by the reduction in credits hence leading to the credit crunch.
Secondly, the credit crisis in the U.S can be attributed to the reduction in market price of various assets such as mortgages which caused a lot of losses to the investors. It should be noted that these assets were previous estimated at a higher market price and were mainly financed by credit acquired from various financial institutions. Consequently, the reduction in their market values meant that the owners incurred losses and failed to repay their loans thereby making the financial institutions to have a shortage of cash to lend out further. As a result of the prolonged loss of market value of the assets, the credit crisis occurred. Lastly, the crisis can be attributed to speculation by various banks on the regulatory measures that would have been adopted by the Central bank. Therefore in the anticipation of a further reduction in the reserve requirement, the banks eased on their lending rate thus leading to the credit crisis (Soros 135).
The spread of the credit crisis
What began as a simple crisis within the sub mortgage market gradually picked paced and spread to other sector that serious affected the whole of US economy. It should be noted that the accessibility to loans for mortgages was easy and banks wrote cheques carelessly with the confidence that the loans would be repaid within the stipulated time. However, this was a misconception and it turned out that there were creditors who unable to repay their loans and thus pushing down on the mortgage prices and as a result leading to losses in this market. These losses were then transferred to other sectors through what may be referred to as the negative multiplier effects.
As a result of the huge loans that had been taken to finance these mortgages, the banks underwent a credit shortage as a result of recording bad debts in their financial statement. Consequently, they became unable to lend money to the public thus paralyzing other sectors of the economy that relied on credit to finance their investments. Therefore, the credit crunch spread to other sectors such as automobile industry, stock market and the general performance of the economy. The credit crunch led to the slow down in various economic activities due to inadequate investments caused by shortages of credit. As a result of the spread in the credit crisis, the economy went into recession (McCarrick, Pesso, and Boisblanc, Mondaq).
Efforts made by the US government and the Federal Reserve
To combat the credit crisis, the Federal Reserve has taken various steps towards stabilizing the market and the economy from further deterioration. The first step towards containing the credit crisis came in December 2007 when the Federal Reserve decided to reduce on the interest rate charged on overnight leading to 4.75% to encourage interbank lending. The time period for the loan term was also extended to 30 days thereby providing a humble ground for repayment of the loans. An additional 40 billion was also made available in the same month to provide accessibility to cheap loans for various financial institutions. As the situation continued to persist, the Federal Reserve reduced on the interest rates and reserve requirements that were charged to banks. This was intended to provide the financial institutions especially the banks with the higher reserve that would encourage them to lend money to the public. On the part of the U.S government, it has tried to combat the crisis through various bailouts to various institutions faced with the crisis. The bailout to the US mortgage firms and auto industry in order to keep them in business is an example of an effort the US government has made in combating the crisis (Soros 138).
European Central Bank Policies on the Crisis
Initially, the European Central Bank decided to take a different route in addressing the credit crisis basically because it’s a different monetary governing body with the FED. Even as inflation soured in 2008, it opted not to change its interest rate with the hope that inflation would eventually reduce thus reducing the credit crisis. Consequently, the rates were able to be maintained at a stable level and thus strengthening the Euro. The main reason as to why ECB took a different route in addressing this problem is that; ECB believed that as US economy slows down, the Euro would eventually gain value in relation to the US dollar and thus strengthening the European Union’s economy in relation to US. In defending his policy, the ECD President Jean-Claude Trichet said that this policy was essential to the European Union’s economy unlike the US economy since the European economy has no single market like the one in US. However, as the crisis increased, the ECD has somehow changed its policy to include the intervention in the forces of the market. This change was done after the realization that the crisis in Europe was not a liquidity problem as was initially thought but an insolvency problem which requires government’s intervention (Soros 140).
It can thus be concluded that the credit crisis of 2008 was mainly self induced due to the carelessness of the financial institutions especially the banks in awarding huge amount of loans to unworthy creditors. It can be said that if careful attention had been made in awarding these loans, this crisis would have been avoided. However, the crisis is somehow under control especially with the coming in of the new administration of President Obama who has promised to stabilize the economy.
Grant, Tim. Pittsburgh Post-Gazette. 2007. The credit crunch: How did it happen and where do we go from here? First in a special six-part series on coping with the financial crisis. Web.
McCarrick, John F., Pesso, Maurice and Boisblanc, Peter. Mondaq. 2009. United States: Sub prime/Credit Crisis And Government Bailouts: Impact On D&O/E&O Coverage. Web.
Soros, George. The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means. Public Affairs, 2008, pp 135-140.