LetsLearnFinance

US CREDIT CRUNCH

A credit crunch is an economic condition, in which loans and investment capital become dearer and difficult to obtain. In such a period, banks and other lenders become wary of issuing loans, so the price of borrowing rises, often to the point where deals simply do not get done. Credit crunch is a modern day economic problem which may occur at micro level (individual level) or even at macro level (country / region). Statistics reveal that USA, though one of the biggest consumer country has been in rough patch due to this credit related problem. Year 2007 has witnessed that employment news of Americans were not good and there has been lesser faith in cash market, panic prevailed all over, that fueled the credit crunch even more.

The credit crunch has become a difficult situation in USA especially for the finance corporate as well as retails investors. In the earlier phase, banks and financial institutions have been giving requisite loans to the buyout firms as the banks were able to re sell the loans to the investors. However the problem increased from mid 2007 when things dried up for several new investors as well as existing clients. Several investors who had previously taken loans could not sell their loans from their portfolio at any price, loaners were losing out the opportunity cost of money, the situation was acute with total disappearance of buyer, banks were hurled into tremendous liquidity problem.

Direct financial field saw backing out of several commercial papers which promises to pay that wide variety of companies issue to acquire short-term funding , $1.2 trillion asset-backed commercial paper evaporated from market.

Going by statistics, we see that housing / real estate boom started from late 90’s, more precisely from 2000 onwards. Fresh from Dotcom bubble burst, real estate became a safer bet for many Americans, especially when the rates of interest were quite low. It created an opportunity for many lenders who became proactive and drew many home buyers alluring them with apparently lucrative deals to buy houses. Increasingly low credit worthy home buyers entered the market and lenders provided them with basket of options like exotic mortgages, such as interest only loans or flexible rate mortgages other wise termed option ARMS. These loans had characteristics of initial low payments and later came with sky rocketing interest rates. Banks had written nearly 15 % ARMS by mid 2006. One important characteristic in this whole process are the brokers who don’t hold the loan nor they maintain a life time relationship with customers rather they are motivated by the commission structure which acts as driving force for them and hence Misselling occurred frequently. Securitization of mortgages became a problem which crawled into several financial tools like Futures and Option trading (Financial Derivatives), high leverage taking hedge fund became more vulnerable being more exposed to risk. However when defaulting eventually took place the situation worsened and Financial institutions and banks faced the heat of credit crunch which became more and more complex leading to many big shots succumbing to the credit crunch pressure .

Thanks

Pamela