Impact of Credit Crisis on International Global Business
Credit crisis is a term that has been coined to describe the situation whereby accessibility of loans or credit finance becomes limited due to their unavailability. It is a trend that results to financial institutions reducing the amount of loans that they can disburse to clients irrespective of increased interest rates that they can charge on such loans. In these circumstances, prerequisite conditions that are necessary before the loan can be disbursed are therefore reviewed and made stricter in order to limit the amount of credit finances that can be disbursed (Graham 2008, p.10). Credit crisis is said to occur when the relationship between interest rates and credit loans being disbursed are heavily skewed, or when there is a general reduction of loans available in spite of increased demands. Ideally the relationship between interest rates and available financial credit is such that increased interest rate in the market means that financial institutions are willing to increase lending in order to increase profits. This paper intends to investigate in the proceeding chapters the factors that triggered the 2007-2010 financial crises and the impact of the crisis to global business, now and then.
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Credit crisis is a phenomenon that can be triggered by any of the various factors in the financial sector or combination of several such factors. There are mainly five reasons that directly affect financial institutions loans and which in extension can trigger a credit crisis. One of the reasons is anticipated fall in value of collateral assets that are used by creditors to obtain loans from banks (Graham 2008). In this case the financial institutions become reluctant and unwilling to give out loans that are secured by such assets where all indications points to their market values plummeting.
Other reasons could be sudden exogenous adjustment in regulation by central bank that touches on lending requirements by banks or which elevates reserve requirements (Graham 2008). The central bank might also trigger credit crunch through regulations that intend to tightly control financial institutions lending. In such instances the banks usually respond by enacting measures that prevent their loss or transfer their operating risks to the creditors usually through increased interest rates of loans or reduction in lending.
However these factors alone cannot by their own trigger credit crunch, more often credit crisis is caused by an array of factors that combine together over a long duration of time. The hallmarks of a credit crunch usually include extensive sustained losses by lenders caused by sloppy and hasty lending policies over given period of time. Sometimes it is due to plummeting of collateral assets that were used to secure loans which substantially lose value overnight as it happened to the United States housing industry. When this happens the bank sustains huge losses caused by loss in value of the assets. The implications that follow are two parts: the bank has no adequate loan reserve that they can continue disbursing to future consumers, and two despite the availability of loans the banks becomes timid and cautious towards future lending.
This therefore are the early stages of a credit crisis since availability of loans get scarce and associated interest rates shoots up through the roof. The next phase of credit crisis is limited lending and inaccessibility of the loans by consumers and lack of funds in general that virtually affect every other sector of the economy triggering what is then referred as economic recession (Hines 2008). However the effect of a credit crisis last for sometime only depending on the extent of loans that were disbursed by the banking industry, and the extent in which the losses can be absorbed assuming the banks affected were not much.
The global credit crisis that is just ebbing away has its roots in United States banking system, more specifically as a result of lending towards mortgage housing and credit lending in general. The credit crisis did not only result to worldwide financial crisis but also caused slowed economic growth of the world's largest and leading economy that eventually the triggered global recession that started around as early as 2006 (Hines 2008). In 2005 the United States housing industry flourished and reached its peak in terms of value and business bustle, by then the banking industry had aligned their lending funds towards this end as a result of the positive and sustained growth in the housing industry.
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By the time in what is now referred as housing bubble busted most banking institutions have invested significant amounts in the housing industry that had accumulated over time in a sort of loose credit lending. The aftermath was increased mortgage payment defaults and foreclosures on existing loan repayment that was taking place on large scale. The steps that lead to increased forfeiture of loans by lenders can be analyzed in the following steps. The first step was the induced easy loan terms and reduced interest rates by the banks tailored for housing finance (Hines 2008). These incentives nudged borrowers to take up substantial mortgages with prospects of future renegotiation on mortgage terms and rate with home of easier rates.
In addition due to growth boom in the housing industry borrowers easily took up mortgage loans as an investment option with intention of selling the properties at higher values at a later time (Hines 2008).
Underlying all this was the fact that more housing constructions were taking place as investments funds that financed housing sector flowed from every other sector of the economy.
By the time the housing bubble eventually busted many players had invested substantial amount of money in the industry that could not be written off easily without encountering huge losses that would lead to bankruptcy. This is because the housing value plummeted at a rate that had not been foreseen. The bank reacted immediately by increasing mortgage interest rates and phasing of earlier easy mortgage packages, additional lending on mortgage was tightened and all lending in general.
The borrowers on the other end moved to dispose off housing properties and salvage finances that could still be obtained from the mortgages, thereby triggering drop in house values. In the resulting scenario many borrowers choose to forfeit their mortgage to the banks rather than sell the houses in a collapsed market since it would eventually cost them additional funds to settle the difference (Hines 2008). The other option of financing the full cost of the mortgage was now complicated by increased interest rates.
But housing industry is not the only sector that hoodwinked consumers to apply for large chunks of loans; it was the same case in automobile industry and in credit cards. Increased availability of liquid cash from foreign reserves had prompted the financial sector to invent financial packages such as Mortgage-backed securities (MBS) and others like Collateralized-Debt Obligations (CDO) (Hines 2008). Both are forms of funds that allowed investors to finance the housing industry and gain financial returns through banking institutions.
The consequences of housing industry collapse was therefore greatly felt by the banking institutions that had advanced loans in all the three sectors that were hardest hit, this sectors were the first to announce financial losses.
There are several main causes that systematically contributed to the subprime crisis that originated from United States which can be categorized in the following ways. One, was the housing market boom and bubble that was characterized by low mortgage interest rates, increased availability of funds that pooled borrowers to taking unnecessary and inflated mortgages (Gjerstad and Vernon 2009). Borrowers and investors in the process saved less and substantial funds were channeled to this sector, by the time the housing market was collapsing more than $10 trillion dollars was approximately held in the industry. The upshot was more than 50% of home owners that had negative equity or houses that just equaled their mortgage values which could not be sold due to house surplus in the market and cheap going prices (Gjerstad and Vernon 2009).
The other cause is the amount of mortgage that borrowers had obtained that were purely for speculative purposes and therefore for investment only. By 2006 the number of mortgage and houses that had been secured as investment options were approximately 40% of all the total houses in the market (Gjerstad and Vernon 2009). This was the main factor that greatly contributed to the housing surplus that their price falls. Another cause was the securitization, a term that is used to describe a practice where bank can transfer the value of the mortgage to their investors and therefore continue to obtain further funds for lending to borrowers (Gjerstad and Vernon 2009).
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Ideally the bank is supposed to hold on the mortgage as security until it is paid in full or forfeited, this way additional funds cannot be secured until such time when any of the two outcomes occur.
However securitization system allowed banks to continue pumping funds to an already saturated sector while hoodwinking investors to believe housing industry to be thriving by transferring mortgage agreements to them. In the process the banks were able to ease the lending terms and lower rates due to availability of funds in a bid to disperse as much funds as possible and therefore make profits. The lending conditions to borrowers were even questionable verging to illegal practices, figures released by Federal Reserve indicates that 47% of borrowers did not make any down payment of the mortgages (Gjerstad and Vernon 2009). Over time borrowers were not required to provide evidence of income nor employment as is usually the tradition instead banks focus was on credit score which depended mainly on the amount that a borrower had in the bank beside other factors.
Credit ratings calculations that were used at the time led to the credit crisis as well (Gjerstad and Vernon 2009). The inflated credit ratings that were given to Mortgage-Based Securities (MBS) by credit rating agencies are now under investigations since their high ratings allowed transfer of MBS to investors who later ended up holding less valuable MBS than they initially paid for them.
Lack of government regulations and intervention during the whole process also contributed to the financial crisis.
This was because of the government policies that had been put in place which had the vision of promoting home ownership among Americans across the boards through legislations such as Alternative Mortgage Transaction Parity Act (Hines 2008). By 1995 the government also issued tax rebate to all persons with mortgage. This and other failures by the government such as to control use of adjustable-rate mortgages which do not favor borrower in the long run resulted in fueling a housing boom that was already getting out of control.
Let us now briefly examine how the subprime crisis which was the epicenter of the financial crisis spread out to the rest of the industries to cause the ultimate global recession. After the housing bubble many financial institutions were faced with losses that could not be underwritten, thereby resulting to their closure. Dozens of mortgage companies closed doors while others sought mergers in order to remain operational. The following events caused investors to scramble towards dumping associated stock bonds out of panic, a situation that further aggravated the scenario.
Most of the mortgage bonds that were now being dumped were invested in agriculture sector and in oil industry due to speculations of high returns in these industries at the time. Deprived of financial funds to sustain the production, Agriculture and oil industry come tumbling as well causing oil price crisis and world food price crisis. By 2008 the financial institutions worldwide had so far written off $5001 billion from subprime holdings and United States financial institutions could no longer keep up with investors who were still withdrawing huge amounts from the money funds (Gjerstad and Vernon 2009).
While the US was dishing out numerous and unsecured mortgage loans to its citizens, Britain was also experiencing increased lending of loans to finance home but not at the unprecedented rates as witnessed in United States. For the rest of the world the global recession was hardly caused by mortgages but by collapse of industries that relied on investor funds that had now been retracted by timid investors and by international companies that were affiliated to US companies that had collapsed in the process.
For many businesses the problem was the lack of funds to sustain daily business operations due to the credit crunch emanating from United States. Most third world countries financial institutions are tied up with foreign international financial firms though they always function independently. These local financial institutions therefore adopted strict loan disbursement policies in the wake of the subprime crisis. Without access to regular funds that medium and small businesses have always relied on, most of the businesses had to close down thereby causing unemployment.
But employment was not only as a result of lack of funds to run existing business, credit crunch meant that consumers reduced their expenditure in a bid to regain finances lost through risky investments that were done at the time (Seabury 2009). This meant the challenges that were facing most businesses were not only inaccessibility to liquid funds but also loss of business as well: many businesses corrected this by retrenching and workers layoffs further deepening the unemployment crisis (Seabury 2009).
But the most affected businesses in developing countries were the ones exporting goods to developed countries in America and Europe.
Most of the businesses exporting commodities were the agriculture sectors, mining, and oil industry. Countries that predominantly relied on agriculture earnings through exports were required to export less due to fall in demand or suspended their exports all together. In the tourism sector the trend was the same with less people unwilling to spend in holidays. Overall the foreign reserves of many countries which is almost always the dollar shrunk affecting virtually every other sector of the economy. The result was world economies hampered by lack of products market and liquidity funds to sustain growth (Saltmarsh 2008).
As the financial crisis reached its peak in 2009 many countries sprung to action with measures to halt and reverse the economic recession phenomenon by injecting billions of funds. The United Stated was the first to undertake an assortment of measures contained in the economic stimulus package that was signed into law by President Obama (Grabel and Weaver 2009). The stimulus plan included $787 billion that aimed at reinstating and creating more jobs that were lost during the recession in addition to stimulating the economic activity and consumers spending (Grabel & Weaver 2009).
The measures contained in the economic stimulus plan mainly involved tax reductions across the board. Other measures that United States implemented to address the crisis were through Federal Reserve's funds that were injected to the economy to increase liquidity levels. Emergency Economic Stabilization Act of 2008 was enacted into law which provided a further $700 billion towards banks and other lenders through Troubled Assets Relief Program (Grabel & Weaver 2009).
The legislation also enabled banks to transfer certain amount of toxic assets in their possession to the government or other actors in the market such as private investors thereby increasing their liquidity.
This measures increased capital replenishment in the market and ensured bank solvency. Other strategies used were financial bailout plans of various financial institutions that were in the process of announcing bankruptcy. The financial institutions that were bailed out included prominent banks such as Goldman Sachs and Morgan Stanly; others underwent merging in order to retain their assets. The stimulus measures also include homeowners' assistance through government intervention that sought to have the lenders and banks to lower their lending rates to the minimum possible level that would ease mortgage repayments by borrowers.
The measures contained in Homeowners Affordability and Stability Plan that was funded to a tune of $273 billion was aimed at ensuring that projected 9 million homeowners did not enter foreclosure (Grabel & Weaver 2009). Finally the government moved to introduce new regulations in the banking system including regulations that would rein the shadow banking system that is not in the mainstream but which was a major financier of mortgages during the financial crisis.
The responses to financial crisis in other parts of the world were not as comprehensive as the ones implemented by the United States. This is because there was no other country besides US that had it economy affected in a major way as happened in US. China for instance, which is now the second largest economy in the world was still able to register economic growth in 2009 at the height of the global recession (Grabel & Weaver 2009).
However as the global recession recedes United States in particular continues to speculate and analyze the events that led up to financial crisis and thereafter the global crisis. What is clear though is that fall in interest rates was the main culprit that caused the financial crisis, if interest rates were increased there is no doubt that they would have discouraged Americans from purchasing mortgages en mass, but would not have prevented their investment in other questionable capital assets such as MBS's. Another trend that significantly contributed to the crisis is the American credit culture where financial institutions has traditionally leaned towards providing loose loans and the consumer culture of reliance on credit finance as opposed to saving.
As one gets to analyze the facts that caused the financial crisis the extent of the housing market speculation is notable and significant whereby all the actors in the economy from consumers to bankers continued to pump more funds in housing industry as investment options. However the causes that ultimately triggered the global recession cannot be disputed to be the result of various factors that merged to trigger the chain of reactions that we have so far analyzed
There are other measures that continue to be undertaken in order to ease the effects of the financial crisis that are still lingering and which are aimed at ensuring that the financial crisis does not occur unnoticed as it happened. Meanwhile world governments remain apprehensive as the impacts of global recession continues to recede without clear indications of what exactly needs to be done in order to insulate their economies from far off financial crisis that eventually get to impact on their economies.
- Graham, Turner., 2008. The Credit Crunch: Housing Bubbles, Globalisation and the Worldwide Economic Crisis. London, UK: Pluto Press
- Grabel, Michael., and Weaver Christopher 2009. The Stimulus Plan: A detailed List of Spending.
- [Online] (Updated 13 Feb 2009) Available at: http://www.propublica.org/special/the-stimulus-plan-a-detailed-list-of-spending.html [Accessed 8 May 2010].
- Gjerstad, Steven., and Vernon, Smith., 2009. From Bubble to Depression? Why the Housing Bubble Crashed the Financial System but the Dot-com Bubble Did Not. Wall Street Journal, [e-journal] 15 (9). Available at: http://online.wsj.com/article/SB123897612802791281.html [Accessed 8 May 2010].
- Hines, Patricia., 2008. From Crunch to Squeeze: Global Impact of the Credit Crisis on Commercial and Small Business Lending. [Online] (Updated Jan 2008) Available at: http://www-903.ibm.com/kr/financing/pdf/GFL03040USEN.pdf [Accessed 8 April 2010].
- Saltmarsh, Mathew., 2008. Impact of Global Credit Crunch Expands in Europe. New York Times, [Internet] 29 September. Available at http://www.nytimes.com/2008/09/29/business/worldbusiness/29iht-banks.html?_r=1.html [Accessed 8 May 2010].
- Seabury, Chris., 2010. The Impact of the Global Credit Crunch on Business Environments.
- [Online] (Updated 2009) Available at: http://www.ehow.com/facts_5769404_impact-credit-crunch-business-environments.html [Accessed 8 April 2010].