This report discusses what cause the credit crunch and how to improve it by explorng the 2007-08 credit crunch. It indicates that sharp increase or decrease in interest rate, speculative investment in real estate, rapid increase in mortgage securitization and faulty process of rating mortgage-backed securities by credit ratings agencies are the major factors of the credit crunch. As the credit crunch lead to the recession and other serious economic problems, effective solutions for it seem important. According to the nature of 2007-08 credit crunch, this report argue that providing liquidity to the markets, enhancing regulation of ratings agencies and carrying out successful fiscal policy to stimulate spending are the best ways to improve the crisis.
1 Introduction
The concept of a "credit crunch" (known as a credit crisis) has a long history and can trace back to the Great Depression of the 1930s (Mizen, 2008). Clair and Tucker (1993) considered that the "credit crunch" has been used to explain reduction of the credit supply in response to the decrease in the capital value of banks. A credit crunch which emerged in August 2007 and began to spread to the world in August 2008 is considered by many economists the most serious since the Great Depression of the 1930s (BusinessWire, 2009). The massive crisis has led to a series of global problems - an increasing number of bank failures, a significant decrease in economic activity, continuing rise in the unemployment rate, falls in various stock indexes, huge decline in the market value of stocks and so on. According to the research of economists, it could be proved that the root of the global credit crunch starting in 2007 is the dot-com bubble, US housing bubble, US subprime crisis, interest rate policy, etc. Therefore, the aim of the report is to analyze these major contributing factors and then bring up some effective solutions of the financial crisis.
2 Causes of credit crunch
2.1 Decrease and increase of interest rate:
The dot-com and tech bubble of the late 1990s resulted in the stock market crash and recession in 2001 and 2002. In order to decrease the economic damage and keep the economy strong, the Federal Reserve cut short-term interest rates from 6.5% to 1%. The historical lowest rate reduced the cost of borrowing, increased the demands for homes and caused a rise in housing price. Therefore, most people borrowed money to purchase a home. However, as can be seen in the figure 1, the increasing rate of housing prices was more than the growth rate of household income since 2000, hence between 2004 and 2006, the Federal Reserve raised interest rates from 1% to 5.25% to curb an out of control housing market. With this policy, the housing price also began to drop. As the falling price brought about the worth of homes less than the mortgage loan, the number of default and foreclosure cases increased and which is the major factor of the credit crisis because it reduced the wealth of people, damaged the operation of banking institutions and made credit markets freeze.
Figure 1: Real Home Prices and Real Household Income (1976=100); 30-year Conventional Mortgage Rate
Source: OHFEO; Federal Reserve; Bureau of the Census. Home Prices and Income are deflated by CPI less Shelter.
2.2 Speculative investment
Speculative borrowing for house purchase has been considered a significant factor to the financial crisis. Although the use of financial leverage assisted the investors in getting huge profits during the period of low interest rate, low inflation and steady growth, this kind of investment led to the root of subsequent credit crisis. The table 1 shows that 22% of people who bought homes were for investment and 14% were for vacation during 2006. During 2005, the percentages were 28% and 12%.That is to say, there were only 60% of the purchases were for primary residences. When the real investors took the profits off the table and left the market in 2006, the investment sales began to fall faster than the primary market (Christie, 2007).
Table 1: Share of Home Sales intended Use
Source: NATIONAL ASSOCIATION OF REALTORS
2.3 Securitization
Securitization practices also play a significant role in the global credit crisis. The traditional mortgage model is that banks finance their mortgage lending through the savings deposits of retail customers and retain the credit risk. However, under the old system, the banks could only make a limited amount of mortgage lending based on the size of their balance sheet. In recent years, banks have designed and implemented a new model that could allow them to sell mortgages which are bundled with other loans, bonds or assets to the global investors, take it off their books, and use the money to make more additional borrowing (Baily, et al., 2008). By doing this, the banks no longer have the motive to check carefully the mortgages they issue and continue to provide loans to people who have poor credit histories because they realized that the credit risk has been transfer to the investors. Therefore, as can be seen in the figure 2, the volume of subprime mortgage origination increased sharply from 2003 to 2005 and reached the peak in 2005. However, when the dropping housing prices and rising interest rates brought about a large number of homeowners who cannot repay their loans, investors began to suffer losses and then credit markets frozen as banks reduced the amount of loans offered to borrowers. The lack of credit to banks, companies and individuals brings recession, job losses, bankruptcies, repossessions and a rise in living costs (BBC, 2009).
Figure 2: Subprime Mortgage Origination Volume
Source: Inside Mortgage Volume
2.4 Credit ratings agencies
The mortgage which banks sell to the bond market can be called mortgage-backed securities (MBS).The major rating agencies, Moody's, Fitch and Standard & Poor's, used complex quantitative statistical models to predict the probable rate of default of the mortgages and then give the rating to MBS which the various banks issued so that the investors can select high rating securities which they considered safe to invest to prevent suffering losses. In other words, the high ratings encouraged a huge number of global investors in putting their money in these securities. However, there were also indications that the process of rating securities which the ratings agencies used was faulty. First of all, Mizen (2008) noted that 'the models for structured finance products were calibrated using short spans of data over a benign period of moderation in financial markets and rising house prices'. They did not have the experiences in evaluate whether these products were reliable when the house prices went down. Moreover, in reality, the banks always find the credit ratings agency which they prefer and discuss how to bundle and structure products with this agency before issuing, and then ask the agency to rate their securities highly. If the securities don't receive the high rating, the issuers would try another agency, which is known as "ratings shopping." Due to the conflict of interests and inappropriate evaluating method, the ratings agencies get the huge profits but lose the principle and justice and then lead to the housing bubble in the U.S and global financial crisis (The Economist, 2007).
3 Solutions of credit crunch
3.1 Increase liquidity
Since the global financial crisis bursted out in 2007, the liquidity problem has deeply influenced the development of global economics. The liquidity problem means cash stop flowing. For example, when the loans to individuals or companies went down to the lowest level, companies cannot easily borrowed money to invest, purchase materials to produce goods and individuals began to save money instead of spending it. In order to increase liquidity, the following two ways are worth mentioning. The first one is lower the interest rate and the second one is purchasing treasury securities.
3.1.1 Lower interest rate
Lower interest rate makes the borrowing cheaper. All central banks in the world could assist general banks in borrowing from the depositors at low interest rate by declining the interest rate so that these banks are willing to increase the amount of loan. Moreover, lower interest rate means that the depositors' interest revenue from the savings decreases and which motivate them to withdraw the money to engage in the investment activities to seek the maximum profits. As the money begins to flow and the economic activities rise steadily, the credit crunch can be improved.
3.1.2 Purchasing treasury securities
The other way to increase liquidity in markets is that the central banks purchase treasury securities. Andrews (2009) stated that 'buying securities as a way of getting more dollars into the economy, a tactic that amounts to creating vast new sums of money out of thin air'. In other words, by implementing this policy, the central banks can provide cash to banks for making loans. Moreover, because of the bulk purchase of the treasury securities, the demand of the securities increases, the price rises and the interest rate declines. Therefore, in order to help improve the weakness of credit markets, the US Fed decided to purchase $300 billion of longer-term Treasury securities during 2009 (The Federal Reserve System, 2009).
3.2 Regulation of ratings agencies
Conflicts of interest are the one reason why ratings agencies have not done a good job. Securities and Exchange Commission (SEC) should enhance the monitoring system of ratings agencies by create a department, the centralized clearing platform. With the effective department, the conflict of interest problem can be solved because the agency is chosen by the regulating body and the flat fee would be assessed appropriately according to the attributes of the security (White, 2009). Unsuitable model to rate the securities are the other reason why the agencies fail to the job. The International Organization of Securities Commissions (IOSCO) has suggested that rating agencies should design and structure new ratings system for the complicated finance products such as mortgage-backed securities because the components and nature of the newest securities were totally deferent from the old ones. By using the proper model, it can be believed that the outcome of rating the financial instruments is reliable.
3.3 Fiscal policy
3.3.1 Stimulus by spending
The policy of deficit spending which governments use for preventing sustained declines in consuming and investment can help to raise the economic activities. As mentioned before, liquidity plays a crucial role to improve the financial crisis and obviously the objective of increasing liquidity can be achieved by this policy. That is to say, the stimulus spending can help to ensure that the economic recession will not become more serious. Although this kind of spending could cause that the government budget deficit become larger, accurate investment which government makes enable the return on investment yield to be higher than the interest rate of debt and can reduce deficit (Stiglitz, 2008).
3.3.2 Tax cut
The policy of tax cut can help to increase liquidity by boosting consuming. Measures to implement this policy include decrease in income tax rate or value added tax rate, the greater provision of unemployment benefits and increases in earned income tax credits .According to the historical experience, this policy successfully resolved the problems of credit crunch and recession, as well as stimulated the development of economy. For example, in 1986, Ireland suffered from credit crisis and the government adopted the policy of tax cut to lower taxes on both individuals and companies. Over the next 13 years, per capita income of Ireland went from only 63% of the UK to surpass it in 2000 (Cloutier, 2008). Ireland now is one of the affluent countries in Europe. There, it is clear that the policy of tax cut is an effective solution for financial crisis
4 Conclusions
In recent years, there had been got more and more complicated investment instrument and investment activities in the investment market, and which resulted in the credit crunch in 2007 and 2008. Governments should enhance regulation of the investment market and regularly monitor the condition of economy in order to avoid next crises. When the governments play their roles well and crisis does not occur, it can be believed that the economy will keep developing and the living standard will keep improving.
