The credit crunch



There is common understanding consensus that the credit crisis commenced in the summer of 2007, when it was initially referred to as the "credit crunch" or "credit crisis". The implication was the lack of availability of funds for lending in the industrialized world. When the crisis was in its early stage, the lack of liquidity was commonly viewed as the main problem however the crisis has proved to be lasting longer than expected and has escalated. During the months of September and October 2008, several US and European financial institutions collapsed and others were nationalized or merged with government support (PLC 2009). Well known financial institutions such as Fannie Mae, Freddie Mac and Lehman Brothers were perceived to be undercapitalized or viewed as having significant exposure to the subprime sector failures in 2008. Market uncertainty and stress escalated as organizations tried to limit their exposure. As fears persisted there were further failures. This prompted the UK government to inject a package of measures to tackle some of the main systemic issues.

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This report examines the aspects of the global financial crisis on the world economy and identifies possible implications development and investment in the UK in what has been a radically transformed financial landscape. It will outline the nature of measures taken by the UK government to stabilize the financial markets and provide liquidity for business. It will further assess using statistical data the impact of measures taken to date.

Section 1 of the report examines the demise of the sub-prime residential mortgage market in the US which triggered the global financial crisis and concludes with a discussion of policy implications of the crisis, and advocates a significant improvement in the regulatory structure. Section 2 of the report discusses the impact of the financial crisis on the UK economy and identifies the extent of the contraction in economic output.

Section 3 report explores and highlight events which have triggered incidents of financial stress and explores the actions that were taken to resolve and how United Kingdom progress, how they come up with strategies to survive with the financial crisis, with the help and support from the European government and Bank of England in its attempt to recover previous financial crisis and its statistical evidence to the extent which it has recover. The last section of the report brings together the highlights of the inter-connectivity across financial market functionality, the G-20 International Policy response, economic prosperity and property market performance as well as identifying the options required to stimulate interbank lending.

Sub-prime residential mortgage market in the US

The term 'Sub-prime lending' has been applied to the provision of loans and mortgages for people with poor credit histories, usually on low incomes and against the potential increase value of a property. Such individuals would not normally be granted loans from mainstream lenders because of their credit history or employment status. The impact of this type of lending is that a large number of debts were defaulted on with insufficient security fall back for the lenders. This type of lending is commonly held as the main driver to the current financial crisis, largely focused on US and UK lenders.

Following the meltdown of the sub-prime mortgage market in the US the world's financial markets have undergone a period of unprecedented turmoil. In turn, this has contributed to increased uncertainty in global economic conditions. Sub-prime lending was seen as boosting aggregate liquidity across the economy as a whole, as was available to lend to sub-prime borrowers in the run-up to 2007. However, because poor credit history is associated with substantially more delinquent payments and defaults, the interest rates for sub-prime loans are substantially higher than those for prime loans. (Chomsisengphet and Pennington-Cross, 2006). Evidence indicated that the probability of default is six times higher for Sub-prime loans than prime loans. In addition Sub-prime loans are less sensitive to interest rate changes and as a result sub-prime borrowers do not benefit from cheaper interest rates. (Pennington-Cross, 2003 and Capozza and Thompson, 2005).

In 2006 a slowdown was seen in the US housing market, coupled with rising US interest rates this led to a large volume of bad debt default and UK banking giant HSBC in 2006 had to make provisions of £5bn for bad US mortgage defaults. In 2005 it was estimated that investment bank Merrill Lynch had Sub-prime mortgages between £25bn and £30bn. Following rapid increases, followed by rapid decreases in house prices in the US. Mortgage debt begun to appear higher than the value of properties. Many economists believed that the US housing market price crash was caused in part by historically low interest rates. Between 1997 and 2006 house prices increased value by 124% in the US. This led to a US household debt percentage ratio of 130% of income (an increase of 30% over previous decades) (Bianco, 2008). With high default rate amongst Sub-prime borrowers and lenders inability to recover outstanding debts against the now deflated value of houses, a large financial gap begun to emerge where banks would not be able to recover monies lend. This is now known as the 'credit crunch'. There has been unprecedented government and central bank intervention. The transformed global financial landscape will have a major impact on economic growth, lending conditions and the operation of markets for years to come. Assessment by many banks revealed what Diamond and Dybvig, 1983 observed which is that the basic ingredient of a crises is panic, and that this runs through leveraged institutions such as banks which undertake maturity transformation, generating liquidity crises.

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As noted by ECB (2008), price falls affected not only the standardised instruments such as index-based collateralised debt obligations (CDOs) but also the 'bespoke' structures that are not normally traded but which are nonetheless marked to market, since implicit prices for the latter are derived from the former. It is a year since the European Central Bank was forced to inject €95bn into the euro zone banking system, bringing home what many had suspected - that the fallout from the US subprime mortgage crisis in the US was causing serious pain to global financial markets (Financial Times, 2009). Figure 3 illustrate the effects on global financial markets.

Figures compiled by the Office of National Statistics confirm that the UK fell into recession in the third quarter of 2008. The UK economy contracted 1.5% in the fourth quarter of 2008, the second successive quarterly contraction following a fall of 0.6% in the third quarter. The 2.5% contraction in the three months to the end of December 2008 is the greatest contraction over a three month period since the spring of 1982 and underlines the speed and ferocity of the downturn that had gripped the UK economy. These figures mean that national income contracted by 2.1% over the last two quarters of 2008. In the early 1990's recession the economy shrank 2.5%, peak to trough, but took six quarters to do so (Cohen, 2009). The value of the pound had dropped by more than 30% against other main currencies.

Expectations are now for GDP figures for the fourth quarter of 2009 to show growth, but the question is, what then? Some analysts have been warning that whatever the GDP outcome for 2009, the UK could be in for a very tough 2010. Even Alistair Darling is expected to admit in the 2008 Pre-Budget report that the recession is proving even deeper than feared. Treasury sources have indicated that Darling will sharply downgrade his economic predictions, forecasting a slump of 4.75% for 2009 - the steepest annual slump since modern records began. A debate continues to rage on whether the Government's borrow-and-spend solution is the right way out of recession.

Impact of Financial crisis and other Contributing factors

It can be argued that one key root cause of the crisis has been the decision in 1980's and 1990's to move away from structural regulation to an almost sole concern with the efficiency of the financial system. Both should be the concern of regulators, the costs and benefits of both should have been balanced, efficient financial markets increase welfare, and raise sustainable output. Beyond the concept of market liquidity failure, it is therefore shows that all of the theories of crisis are relevant to the understanding the events. For example, in terms of 'financial fragility' the crisis linked strongly to an asset price bubble which was fuelled by underpriced credit (see Appendix D). There came a time of realization that the situation was unsustainable, leading in turn to tightening of credit, asset price falls and bank failures.

The recession in the UK has had four key drivers. They are the housing market, the price of oil, a loss of confidence in the financial institutions and a contraction in bank lending. Other contributing factors to the financial crisis include: Ample liquidity and low interest rates -This led to a "search for yield" by investors in financial markets, which in turn drove the development of complex financial instruments using leverage to generate higher returns for investors. Decline of lending standards - The widespread securitization of loans (and other receivables Practical Law Company (2009) under an "originate to distribute" model meant originating lenders did not have to keep lending standards high as they could transfer the risk of the underlying contracts. In the US subprime sector, unsound lending practices were also possible because of a weak regulatory regime and high demand from investors. Undervaluation of risk - Competition for highly leveraged structured financial instruments led to credit risk being mispriced; the price reflected competition for the assets rather than a genuine assessment of underlying credit quality. Additionally, economic conditions were begin for an extended period which led to expectations that they would remain so. In these buoyant conditions highly leveraged instruments remained attractive. Remuneration - Bonus structures in financial institutions encouraged risk-taking; rewarding short-term gains even if these would be reduced or wiped out by losses in the longer term. Mark to market accounting - As financial institutions rushed to improve their capital position, they started to sell off assets. This forced selling caused asset prices to fall. Due to the mark to market Practical Law Company (2009) accounting rules, financial institutions had to read just asset values in their accounts to reflect the latest market prices, which further weakened their capital position. Credit rating agencies (CRA's) - Investors relied too heavily on credit ratings assigned to products by the credit rating agencies Practical Law Company (2009) (CRAs) without doing any independent risk analysis or, in fact, understanding what they were buying. Many investors misunderstood the fact that ratings only measure credit quality and do not capture the risk of a decline in market value or liquidity of an instrument. When the ratings agencies started downgrading instruments in the summer of 2007, many investors lost faith in ratings and stopped buying complex instruments altogether. It is likely that a number of these contributing factors will be addressed by regulation. The financial crisis has exposed serious weaknesses in the regulation of the financial services sector. As a result, the legislative and regulatory requirements imposed on financial institutions in the UK are likely to be strengthened, and there will be further moves away from industry self-regulation. (See Appendix B: Table 1. Evolution of Financial Crisis)

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There appear to be signs of improving general economic and financial conditions in UK with the services sector showing modest growth. The three-month on three-month measure, considered a better way of looking at a generally volatile indicator, showed a drop in the three months until the end of October 2009 of 0.2 per cent compared with the three months until the end of September 2009. The data are the first official signal that the services sector is stabilizing, a trend that has shown up in industry surveys but until now failed to be reflected in data from the ONS, economists said. Financial Times Limited (2009)

Figure 4 above shows that, Year on year, output of the Service sector for October 2009 fell by 3.7 per cent compared with October 2008. Four of the five components of the Service sector decreased. The largest contribution to the decrease was business services and finance which fell by 6.0 per cent. The seasonally adjusted index of services growth show a bottoming out of the decline in growth and signs of slow growth towards the end of 2009 it is uncertain whether this increase growth rates will be sustain. Several institutions and analysts have attempted to forecast GDP growth for 2010. The Treasury forecast for 2009 did indeed predict for an up-turn in GDP growth of the economy in the last quarter of 2009.

Real GDP confirmed (Figure 6) have now confirmed a slight upward/bumping along the bottom of trough in GDP growth. However for the purpose of evaluating the perceived impact of economic measures taken by the government and the dynamics of the wider global economy, the prediction is that GDP growth will be between 0.75 to 1.5% in the year 2010 (see Table 4).

UK Economic indicators

A recovery in output is likely to be driven by the considerable stimulus from the past easing in monetary and fiscal policy and the depreciation of sterling.

Figure 7 shows that the March 2008 budget was expected to confirm that the UK economy is experiencing its deepest recession in three decades. The budget was planned to focus on jobs and investment. The budget included measures to help UK businesses, savers and homeowner's. The budget aimed to significantly increase spending but would likely avoid new fiscal stimulus. The Chancellor Mr. Darling was expected to lower UK growth forecast and raise the government's unemployment estimate. UK 2009, growth was expected to contract by 3.7% and then expand by 0.3% in 2010. The November 2008 pre-budget reports forecasted that the UK economy would slowdown between 0.75% and 1.3% in 2009 and expand by 1.75% to 2.25% in 2010.

A substantial macroeconomic stimulus was put in place to help the economy through the anticipated recovery: ( See Figure 8) the Government is delivering fiscal support worth 5 percent of GDP 2009-10 from the measures announced since the 2008 Pre-Budget Report, and the operation of the automatic stabilizers; Bank Rate was reduced from 5 per cent in September 2008 to 0.5 per cent in March 2009, its lowest level in the Bank of England's history; and in March 2009, the Government authorized the Bank of England to use the Asset Purchase Facility for monetary policy purposes, to raise nominal spending and thereby support demand. As of 3 December 2009, the Banks' purchases of gilts and private sector assets amounted to £185 billion.

Response by Government and Bank of England to stabilize the UK Financial System

The following measures have taken by the UK Government to support the banks and firstly improve the resilience of the UK financial systems:-

Banking (Special Provisions) Act 2008 - These powers were used to resolve Northern Rock, Bradford and Bingley and the UK subsidiaries of two Icelandic banks. The aim of this Act is to maintain the stability of the UK financial system, to protect the public interest financial assistance had been provided by the Treasury in order to maintain the stability of the UK financial system.

Banking Act 2009 - It provides and strengthens depositor protection mechanisms in dealing with banks in financial difficulty, protecting the bridge bank and other private sector purchaser and its focus in the new liquidation rule in protecting retail depositors.

Bank re-capitalisation scheme - UK incorporated banks which have a substantial business in the UK. Credit guarantee scheme. The establishment of a government guarantee of a new short and medium term debt issuance to assist those financial institutions.

Guarantee scheme for asset-backed securities - A financial asset where a large number of assets are pooled together to create an asset backed by a large number of interest-yielding assets as collateral, The government will issue a full or partial liquidity or credit guarantee of eligible triple-A rated residential mortgages over properties over properties in the UK.

Asset protection scheme - This scheme offers protection to eligible institutions against exceptional future credit losses on assets where there is the greatest degree of uncertainty about future performance given the economic conditions.

Enterprise Act 2002 (Specification of Additional Section 58 Consideration) Order 2008 - The enactment of the Enterprise Act 2002 (Specification of Additional Section 58 Consideration) to add maintenance of the stability of the UK's financial system (PLC 2009).

In addition to the above measures the Bank of England have also taken the following: Special liquidity scheme.

Discount window facility - It has established a discount window facility, When the economy is in a recession monetary policy may be ineffective in increasing national spending and income. However, there may be factors which make fiscal policy ineffective aside from the usual crowding out phenomena. Future-oriented consumption theories hold that individuals undo government fiscal policy through changes in their own behavior, for example, if government spending and borrowing rises, people may expect an increase in the tax burden in future years, and therefore increase their current savings in anticipation of this. While Monetary policy in the UK is extremely flexible (rates can be change each month) whereas changes in taxation take longer to organize and implement. Thus the impact of increased government spending is felt as soon as the spending takes place and cuts is direct and indirect taxation feed through into the economy pretty quickly.

International Policy Response

Through the UK's G20 Presidency, the Government has helped facilitate vital international coordination to tackle the financial crisis and its impact on the global economy. At the G20 summit in London in April 2009, G20 Finance Ministers and Leaders agreed a series of actions to stabilise the global financial system and restore growth to the global economy. Since then: G20 countries have continued to undertake fiscal expansion, which the International Monetary Fund (IMF) estimate will, by the end of 2010, amount to $5 trillion and raise global output by four per cent. Interest rates have also remained low in most countries and central banks have used the full range of instruments.


As the consequences of the sub-prime collapse in the US transpired

The cause of the current financial crisis according to statistical data analysis seem of rooted in the artificial stimulation of US house prices because of the easing of money supply for mortgages to individuals who would not normally qualify for the traditional mortgage. The model used by the financial markets for sub-prime lending appear not to have been tested in extreme conditions that was certainly plausible and even if the model was tested, the volume of sub-prime lending amongst large banks made it impossible to recover from large scale defaults on loans.

Increases in interest rates placed considerable pressure on individuals who were already over stretched financially as a result of sub-prime lending. Adding to these effects was a loss of confidence by the financial markets in banks and the value of their stocks fell rapidly. Depositors withdrew funds rapidly (Appendix C) as was seen by Northern Rock where two billion pound was withdrawn by savers.

Important considerations need to be applied with global solutions for global problems. Financial stability that simply displaces activities outside the UK and into other countries will not reduce the threats to either UK or global markets. Those who make and influence policy should balance the risk of withdrawal of the financial support policy too soon, and balance the possibility of the economy overheating fuelling rapid inflation.

There is some evidence the UK economy contracting at a slower rate than in previous months and some sectors have seen a slight upturn in activities. Unemployment seems set to continue to rise but at a much slower rate. The financial markets remain uncertain and the values of shares remain generally down compared with values 3 years ago. Shafer stated that 'uncertainty is linked closely to confidence, and helps to explain the frequently disproportionate responses of financial markets in times of stress in response to adverse shocks' (Shafer, 1986). Consumer spending remain slow and manufacturing is down fueling unemployment. As a result UK GDP remains low.

The effects of the UK government intervention has stabilized the banks and allowed some lending to continue to businesses. Together with record breaking low interest rates and partial reform of financial regulation, the effects that is hope for (economic stimulation) is yet to be seen. There is general agreement amongst experts that the worst is over however uncertainty remains about the amount of growth (see Table 4) that would be seen in 2010 and its sustainability.