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Credit Crunch


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									Credit Crunch
Author: PhD. Student Macoveiciuc Pastorel, Academy of Economic Studies-Bucharest Abstract: Credit crunches are usually considered to be an extension of recessions. A credit crunch makes it nearly impossible for companies to borrow because lenders are scared of bankruptcies or defaults, which results in higher rates. The consequence is a prolonged recession (or slower recovery), which occurs as a result of the shrinking credit supply. In simple terms, a credit crunch is a crisis caused by banks being too nervous to lend money to us or each other. Where they will lend, they charge higher rates of interest to cover their risk. In the real world, that means more expensive mortgages, dearer credit cards, pain for pension savers and other investors as stock markets fluctuate wildly, and in the worst cases repossession and bankruptcy. Offtenly there is often confusion between the recession and the credit crunch but they are not the same. A recession is usually taken to mean two successive quarters of negative economic growth. A credit crunch can be separate to or part of a recession. The origins of this term is unclear, but it was used in a study by America's Federal Reserve bank as far back as 1967. The causes of the actual credit crunch are the years of lax lending inflated a huge debt bubble as people borrowed cheap money and ploughed it into property. Lenders were free with their funds, especially in the US, where billions of dollars of so-called Ninja mortgages - no income, no job or assets - were sold to people with weak credit ratings (called sub-prime borrowers). The barmy notion was that if they ran into trouble with their repayments rising house prices would allow them to remortgage their property. It seemed a good idea when Central Bank interest rates were low; the trouble was it could not last. Interest rates hit rock bottom in America in 2004 at just 1 per cent, but in June that year they began to rise. As interest rates jumped, US house prices started to fall and borrowers began to default on their mortgage payments sparking trouble for us all. The way the debt was sold on to investors gave the crisis global significance. The US banking sector package sub-prime home loans into mortgage-backed securities known as CDOs (collateralised debt obligations). These were sold on to hedge funds and investment banks who decided they were a great way to generate high returns (and big bonuses for the oh-so-clever bankers that bought them). When borrowers started to default on their loans, the value of these investments plummeted resulting in huge losses for banks globally. Key words: credit crunch, economic growth, money supply, interest rate, investment. Jel Classification: G11, G15 A financial crisis occurs when there is a disorderly contraction in money supply and wealth in an economy. It is also known as a credit crunch. It occurs when participants in an economy lose confidence in having loans repaid by debtors. This causes lenders to limit further loans as well as recall existing loans. The credit crunch is also known as the credit crisis and is represented by a reduction in the general availability of loans which leads to sudden tightening of the conditions required to obtain a loan/credit from banks.


A credit crunch generally involves a reduction in the availability of the credit independent of a rise in official interest rates. In such situations, the relationship between credit availability and interest rates has implicitly changed, such that either credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability (i.e. credit rationing occurs). Many times, a credit crunch is accompanied by a flight to quality by lenders and investors, as they seek less risky investments (often at the expense of small to medium size enterprises). Background and causes: There are a number of reasons why banks may suddenly stop or slow lending activity. This may be due to an anticipated decline in the value of the collaterals used by the banks to secure the loans; an exogenous change in monetary conditions; the central government imposing direct credit controls on the banking system; or even an increased perception of risk regarding the solvency of other banks within the banking system. A credit crunch is often caused by a sustained period of careless and inappropriate lending which results in losses for lending institutions and investors in debt when the loans turn sour and the full extent of bad debts becomes known. These institutions may then reduce the availability of credit, and increase the cost of accessing credit by raising interest rates. In some cases lenders may be unable to lend further, even if they wish, as a result of earlier losses. The crunch is generally caused by a reduction in the market prices of previously "overinflated" assets and refers to the financial crisis that results from the price collapse. This results in the widespread foreclosure or bankruptcy for those investors and entrepeneurs who came in late to the market, as the prices of previously inflated assets generally drop precipitously. In contrast, a liquidity crisis is triggered when an otherwise sound business finds itself temporarily incapable of accessing the bridge finance it needs to expand its business or smooth its cash flow payments. In this case, accessing additional credit lines and "trading through" the crisis can allow the business to navigate its way through the problem and ensure its continued solvency and viability. It is often difficult to know, in the midst of a crisis, whether distressed businesses are experiencing a crisis of solvency or a temporary liquidity crisis. In the case of a credit crunch, it may be preferable to "mark to market" - and if necessary, sell or go into liquidation if the capital of the business affected is insufficient to survive the postboom phase of the credit cycle. In the case of a liquidity crisis on the other hand, it may be preferable to attempt to access additional lines of credit, as opportunities for growth may exist once the liquidity crisis is overcome. A prolonged credit crunch is the opposite of cheap, easy and plentiful lending practices (sometimes referred to as "easy money" or "loose credit"). During the upward phase in the credit cycle, asset prices may experience bouts of frenzied competitive, leveraged bidding, inducing inflation in a particular asset market. This can then cause a speculative price "bubble" to develop. As this upswing in new debt creation also increases the money supply and stimulates economic activity, this also tends to temporarily raise economic growth and employment. Often it is only in retrospect that participants in an economic bubble realize that the point of collapse was obvious. In this respect, economic bubbles can have dynamic characteristics not unlike Ponzi schemes or Pyramid schemes. As John Maynard Keynes observed in 1931 during the Great Depression: “A sound banker, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him”. The history of the financial markets has shown that panic in the markets can often lead to a crash. Please see below some of the most notorious market bubbles and fell-downs around the world: 399

Early Market Crashes Perhaps the most famous example of an early market bubble is the Dutch tulip craze of the 1630s. Tulips had been introduced into the country 30 years earlier, and were widely sought after for their beauty as well as the scarcity of certain unique color patterns. As more and more speculators began crowding into the market, prices rose and a market bubble built to the point that some rare tulip bulbs were worth as much as a house on a canal. As some speculators began selling their tulips, prices fell, and as more tulip owners rushed to lock in their profits, a downward spiral occurred. In short order, tulips were once again priced similarly to other plants or vegetables, but the sharp decline resulted in large losses for many people and caused an economic depression. In the early 1700s, Great Britain experienced a bubble of its own when the South Sea Company purchased a monopoly on trade in the Orient and the company saw its share prices rise exponentially. When it was later discovered that company officials had sold all of their personal holdings, prices plummeted and the government was forced to step in to stabilize the market. These government interventions have become a hallmark of financial crises. In 1907, the United States suffered a panic of its own. Prompted by a recession, a declining stock market, and the failure of an attempt to corner the stock of the United Copper Company, customers began to question the safety of the New York trust companies. Anxious depositors rushed to their banks to withdraw their savings, but because the banks didn't have enough money on hand to satisfy all their customers, panic ensued and banks began to fail. This run on the banks was only mitigated when J.P. Morgan personally organized an effort to stabilize the banking system. The Bank Panic of 1907 prompted the U.S. government to create the Federal Reserve System (FRS) several years later. Stock Market Crash of 1929 Perhaps the most well-known market fall occurred in 1929 in the United States. Following an enormous run-up in stock prices during the Roaring '20s, valuations were at extreme levels and speculation was rampant. Panic set in as the market declined throughout the months of September and October, culminating in Black Tuesday on October 29, 1929. News accounts famously tell of bankrupt stockbrokers leaping from the roofs of buildings. Ultimately, the market would fall 89% from its highs and would still be lower in the 1950s than it had been before 1929. Economists debate how much of an influence the market fall-down had on the ensuing economic slowdown, but October 29, 1929, is commonly cited as a starting point for what would become the worst global depression of the twentieth century. The 1980s In the 1980s, bubbles and crashes began to occur with greater frequency. As oil prices soared in the 1970s, oil exporting nations deposited their newfound wealth in international banks, which turned around and lent the money to rapidly developing Latin American countries. When interest rates rose in the early 1980s, investors began to suspect that the Latin American countries would have difficulty repaying their debts. These fears were confirmed in 1982 when Mexico informed the United States that it would be unable to repay its debt. Banks subsequently refused to refinance other Latin nations' debt, leading to more defaults. These defaults threatened the solvency of some of the largest U.S. banks, prompting the U.S. government to assist in restructuring Latin American debt. The 1980s also saw the savings and loan (S&L) crisis in the U.S. Following deregulation in the industry, S&Ls began paying higher interest rates on short-term deposits and investing in riskier assets. In particular, the S&Ls invested heavily in questionable real estate deals, which appeared attractive during the bull market of the 1980s. As losses in the industry mounted, the federal government formed the Resolution Trust Corporation (RTC) and orchestrated a rescue of 400

the industry. While the government's actions prevented a financial collapse, more than 500 S&Ls ultimately failed and the country suffered a severe recession in 1990 and 1991. The 1980s witnessed two of the greatest bull markets of the century in U.S. equities and in Japanese equities and real estate. The U.S. bull market crashed on Black Monday in October 1987 as the stock market suffered its worst ever one-day loss, falling 22.6%. The cause of the market falling is still debated, but excessive valuations and overconfidence among market participants played a role. The crash itself was exacerbated by new computerized trading programs and margin calls. Although the one-day decline was extremely severe, aggressive actions by the Federal Reserve helped assure the solvency of the financial system. The U.S. economy avoided a recession and ultimately, the falling proved to be a momentary pause in a long-term bull market. Japan's crisis was less dramatic but the results were far worse. The Japanese bubbles were so enormous that by the late 1980s it was estimated that the real estate underneath the Royal Palace in Tokyo was worth more than the entire state of California. Although Japan's markets never suffered a short-term decline of the magnitude seen in the United States in 1987, when the equity and real estate markets reversed course, the country's banking system was severely damaged and the economy entered into a prolonged recession. In 2008, Japanese stocks remain more than 75% below the highs seen in 1989. The 1990s also saw a number of market down-turns. In 1994, Mexico again experienced financial difficulties after devaluing its currency. Economic chaos threatened Mexico, but Treasury Secretary Robert Rubin worried about the effect this might have on the United States, and engineered a controversial bailout for Mexico. A more severe emerging market crisis unfolded in 1997 after Thailand defaulted on its currency, the Thai baht. Panic swept across Asia as speculators attacked the region's currencies and sold its stocks. Many Asian countries entered a severe recession and the crisis soon spread beyond Asia, eventually reaching Russia in the summer of 1998. As Russia's economy hovered on the edge of bankruptcy, the International Monetary Fund (IMF) put together a bailout package designed to save the former superpower. In the United States, the 1990s proved to be a remarkable bull market in stocks. In particular, the technology-heavy Nasdaq market soared. U.S. taxi drivers quit their jobs in order to become day traders. However, the crisis in Asia reached the United States when the hedge fund Long-Term Capital Management (LTCM) began to fail in 1998. It was believed that LTCM's collapse could threaten the stability of the international financial system. The New York Federal Reserve gathered the heads of the largest Wall Street banks and orchestrated a bailout of LTCM, thereby averting the danger of a systemic collapse of the financial system. The late 1990s and early 2000s also saw another debt crisis in Latin America when Argentina, at the time one of the biggest borrowers of emerging market debt, defaulted on its obligations. The default led to a depression in Argentina and prompted large losses for emerging market investors. Today Much of the money that left the stock market after the Nasdaq crash eventually found its way into the real estate market, prompting the speculative housing bubble in the United States that occured during 2003-2006. The bursting of that bubble precipitated the credit crisis of 2007-2008 and presented the greatest threat of systemic failure of the global financial system since the 1930s. Impacts of the financial crisis: I: On Large Businesses 401

As sales revenues and profits decline, the manufacturer will cut back on hiring new employees, or freeze hiring entirely. In an effort to cut costs and improve the bottom line, the manufacturer may stop buying new equipment, curtail research and development and stop new product rollouts (a factor in the growth of revenue and market share). Expenditures for marketing and advertising may also be reduced. These cost-cutting efforts will impact other businesses, both big and small, which provide the goods and services used by the big manufacturer. Dividends may also slump, or disappear entirely. Shareholders may become upset. They and the board of directors (B of D) may call for a new CEO and/or an entirely new senior management team. The manufacturer's advertising agency may be dumped and a new agency hired. The internal advertising and marketing departments may also face a personnel shakeup. When the manufacturer's stock falls and the dividends decline or stop, institutional investors who hold that stock may sell and reinvest the proceeds into better-performing stocks. This will further depress the company's stock price. The sell-off and business decline will also impact employer contributions to profit-sharing plans. Also impacted by the recession is the accounts receivable (AR). The customers of the company that owe it money may pay slowly, late, partially or not at all. Then, with reduced revenues, the affected company will pay its own bills more slowly, late, or in smaller increments than the original credit agreement required. Late or delinquent payments will reduce the valuation of the corporation's debt, bonds and ability to obtain financing. The company's ability to service its debt (pay interest on the money it has borrowed) may also be impaired, eventuating in defaults on bonds and other debt, further damaging the firm's credit rating and preventing further borrowing. Debt will have to be restructured and/or refinanced, meaning new terms will have to be agreed upon by creditors. If the company's debts cannot be serviced and cannot be repaid as agreed upon in the lending contract, then bankruptcy may ensue. The company will then be protected from its creditors as it undergoes reorganization, or it may go out of business completely. The business may cut employees, and more work will have to be done by fewer people. Productivity per employee may increase, but morale may suffer as hours become longer, work becomes harder, wage increases are stopped and fear of further layoffs persists. As the recession increases in severity and length, management and labor may meet and agree to mutual concessions, both to save the company and to save jobs. The concessions may include wage reductions and reduced benefits. If the company is a manufacturer, it may be forced to close plants and discontinue poorly performing brands. Secondary aspects of the goods and services produced by the recession-impacted manufacturer may also suffer. In an attempt to further cut costs to improve its bottom line, the company may compromise the quality, and thus the desirability, of its products. This may manifest itself in a variety of ways and is a common reaction of many big businesses in a steep recession. As firms impacted by the recession spend less money on advertising and marketing, big advertising agencies which bill millions of dollars per year will feel the squeeze. In turn, the decline in advertising expenditures will whittle away at the bottom lines of giant media companies in every division, be it print, broadcast or online. As the effects of a recession ripple through the economy, consumer confidence declines, perpetuating the recession as consumer spending drops. II: On Small Businesses


The impact of a recession on small businesses that have annual sales substantially less than the so called “multi-nationals” and that are not public companies is similar to large businesses. Without major cash reserves and large capital assets as collateral, however, and with more difficulty securing additional financing in trying economic times, smaller businesses may have a harder time surviving a recession. Bankruptcies among smaller businesses may therefore occur at a higher rate than among larger firms. The bankruptcy or dissolution of a small business that serves a community - a franchised convenience store, for example - can create hardships not only for the small business owners, but for residents of the neighborhood. In the wake of such bankruptcies or dissolutions, the person who wanted to go into such a business may take a hit, discouraging, at least for a while, any risky business ventures. Too many bankruptcies may also discourage banks, venture capitalists and other lenders from making loans for startups and may leads to bank losses until the economy turns around. When banks suffer losses, they stop lending, creating a credit crunch. The american economist, Milton Friedman, suggested that the way to avoid a liquidity trap is by bypassing financial intermediaries and giving money directly to individuals to spend. This is known as "helicopter money", because the theory is that a central bank could literally drop money from a helicopter. Conclusion: The recessions come and go and the markets can and do recover if given enough time.

References: 1: George Cooper, The Origin of Financial Crises (2008: London, Harriman House) ISBN 1905641850 2: Graham Turner, The Credit Crunch: Housing Bubbles, Globalisation and the Worldwide Economic Crisis (2008: London, Pluto Press), ISBN 9780745328102

3: Rowbotham, Michael (1998). The Grip of Death: A Study of Modern Money, Debt Slavery and Destructive Economics. Jon Carpenter Publishing ISBN 9781897766408.


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