Contemporary International Business Issues: The Credit Crunch of 2008

According to the BBC (2011) credit crunch Defined as "a severe shortage of money or credit."  Clair and Tucker (1993) highlighted that “credit crunch” as a phrase has been used in the past to explain the limitation of the credit supply in response to both, firstly, a decline in the value of bank capital (Beori and Guiso, 2008).  Secondly, conditions imposed by regulators, bank supervisors, or banks themselves that to require banks to hold more capital than they previously would have held (Beori and Guiso, 2008).  It was started in August 2007 and was due to the sub –prime mortgage business when people with poor credit histories were given high – risk loans (BBC New, 2011; Hull and Rotman, 2008).  Therefore, the houses prices fell and subprime mortgage defaults increased (Mizen, 2008).

 Therefore, many of mortgages had been bundled up and sold on to banks and investors (BBC News, 2011). This caused severe financial market instability on the economy and forced banks to write down several hundred billion dollars in bad loan caused by mortgage failure (Brunnermeier, 2009).  As a result, major banks’ stock market capitalization dropped by more than twice (Brunnermeier, 2009).  However, they are still relatively modest compared to the $8 trillion of U.S. stock market wealth lost between October 2007 and October 2008 (Brunnermeier, 2009).    .

The lending boom and housing frenzy were contributed by two trends in the banking industry: First banks moved to an ‘originated and distribute model’ instead of holding loans on banks’ balance sheet, ie. loans were  repackaged and passed on to different investors “ off-loading risk” (Mizen, 2008 ; Brunnermeier, 2009).  Second, short maturity instruments were employed to finance banks’ asset (Mizen, 2008 ; Brunnermeier, 2009) and therefore, banks exposed to a dry-up in funding liquidity (Brunnermeier, 2009). 

The beginning of “Credit Crunch” 

Credit crunch appeared in early 2007 among lower-quality U.S. mortgage lenders.  Sub prime mortgage defaults in February 2007 increased. However, in March it went to its normal level.  In April, a subprime specialist had filed for chapter 11 bankruptcies and this led to employees’ redundancy.  Another example, in early May 2007, the Swiss owned

Investment bank UBS had closed the Dillon Reed hedge fund after incurring $125 million

in subprime mortgage–related losses.  Moreover, in August two European banks, IKB (German) and BNP Paribas (French), closed their hedge funds.  However, closed hedge funds in difficult time developed into the full scale credit crunch of 2007- 2008 and this has increased corporates’ risk. 

According to Mizen (2008) many economists consider the “Great Moderation” in the United States and the “Great Stability” in the United Kingdom contributed to the credit expansion and in turn low inflation and low short term interest rates. For example, Giovanni, et al. (2008) suggest that lending was excessive—what they call “credit booms”- in the past five years. Beori and Guiso (2008) on the other hand, argued that the seeds of the credit booms were introduced by cutting short-term interest rates in response to the 9/11 attacks and the dotcom bubble.   This might be a reasonable reason, but this is unlikely to be the main reason for the expansion of credit (Beori and Guiso, 2008).

Although the euro zone and the United Kingdom, were not as low in crisis as they were in the United States but credit grew there, too (Mizen, 2008).  When U.S. short-term interest rates steadily rose from 2004 to 2006, credit continued to grow (Mizen, 2008).  It is certainly true that the low real short-term interest rates, rising house prices, and stable economic conditions of the Great Moderation created strong incentives for credit growth on the demand and supply side. However, another important driving force of the growth in lending was found in the global savings glut flowing from China, Japan, Germany, and the oil exporters that kept long-term interest rates down, (Mizen, 2008). 

Other countries also increased its debts by the form of credit card borrowing and increased borrowing by offering mortgages as housing markets across the globe increased.   Additionally, borrowers continued to seek funds to increase their housing market share in the future, thinking that he value of the properties and its demand will continue to rise (Mizen, 2008). 

This resulted in mispricing of risk of any high yield asset classes (e.g., hedge funds, private equity, and emerging market equity) (Robert  and Tucker , 1993). Due to the high return of these assets made them attractive to international investors and therefore, the crisis spread internationally and influencing other financial market (Hull and Rotman, 2008).  Sellers of the assets mispriced risks by using models that assumed house prices would continue to rise while interest rate remained low (Mizen, 2008).  

The risk measures used by regulators and financial institutions are largely based on historical experience (Hull and Rotman, 2008).  For example, value at risk measures for market risk is typically based on the movement in market variables seen on the last two to three years (Hull and Rotman, 2008). Moreover, credit risk measures are based on default experience stretching back over 100 years or often the measure is based on the experience on market movement over the last 10, 20 or 30 years( Mizen, 2008 ; Hull and Rotman, 2008).  There is no doubt that historical data can provide a useful guide in measuring but it needs to be supplemented with human judgment (Hull and Rotman, 2008).    

Therefore, underpriced risk with unrealistic assumptions about rising valuations of underlying assets or commodities (Mizen, 2008 ; Hull and Rotman, 2008).  This continued the crisis where banks found it difficult to assess the exposure to subprime and other low quality loans due to complexity of the structured products (Hull and Rotman, 2008).  Banks could not be able to evaluate the losses and this created uncertainty in the interbank market resulted in banks became reluctant to lend to each other unless they were compensated with higher risk premiums (Boeri and Guiso,  2008).

Reference

BBC New (2011) Timeline: Credit crunch to downturn, Available at: http://news .bbc.co.uk/1/hi/7521250.stm, (Access: 3 May 2011)

Brunnermeier, M.K. (2009) ‘ Deciphering the Liquidity and Credit

Crunch 2007–2008’, Journal of Economic Perspectives, 23,(1)pp. 77–100

Boeri, T. and Guiso, L. (2008) “The Subprime Crisis: Greenspan’s Legacy, in Andrew Felton and Carmen Reinhart, eds., The First Global Financial Crisis of the 21st Century, 2008

Robert, C.T. and Tucker, P.  (1993) “Six Causes of the Credit Crunch (Or, Why Is It So Hard to Get a Loan?),” Federal Reserve Bank of Dallas Economic Review, Third Quarter 1993, pp. 1-19

Giovanni, D., Deniz, I.  and  Laeven, L.(2008) “Credit Booms and Lending Standards: Evidence from the Subprime Mortgage Market” CEPR Discussion Paper No. 6683, Centre for Economic Policy Research, 2008.

Hull, J.C. and Rotman, J. L. (2008) The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can Be Learned?

Mizen, P. (2008) ‘The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses’, Federal Reserve Bank of St. Louis Review, 90(5), pp. 531-567.