Monday, June 14, 2010

Global Economic Trends: The Credit Crunch

View from the Street: Impact of the Credit Crunch

The Recession Explained

An Australian Perspective of the Credit Crunch

What is the global credit crunch? Simply explained it emerged when brokers and banks were offering mortgages to borrowers who had little or no income.

These mortgages were called sub-prime mortgages. The mortgages were written and structured as "non-recourse loans". If a borrower defaulted on his mortgage, he could simply return the house key to the bank and walk away. These mortgages were "bundled into packages, and re-sold to investors.

When home owners with sub-prime mortgages couldn't pay their mortgages, banks foreclosed and property prices dropped, in some cases by over fifty percent.

Trying to Understand the Credit Crunch

The Credit Crunch or the Great Recession is the most profound and significant economic event to affect global markets since the Great Depression of the 1930s. While the Great Recession was not a cause for the widespread poverty that marked the Great Depression, its impact significantly affected the wealthy. Literally billions of dollars were wiped off stock exchange boards. Victims of the Credit Crunch included the rich and famous and extended to leading investment banks on Wall Street, two of which collapsed.

The main cause of the Great Recession has been attributed to the unprecedented growth of sub-prime mortgages in U.S. markets. Real estate prices across the globe were affected. A consequence of the housing bubble and its subsequent collapse has been a move by regulators to scrutinize the provision of mortgages by Mortgage Bankers. This has invited increased regulation. The approach to apply greater levels of oversight through regulation is controversial amongst proponents of free market principle, as they argue that it merely increases inefficiency within an economy. Additionally, the role that investment banks play in the economy has also been criticized. This has resulted in several changes in regulation with limitations being placed on the scope of business in which investment banks are permitted to operate.

A consequence to the credit crunch has been a drying up of available credit in financial markets. This significantly impacted money markets, the ability of businesses to meet their commitments and constrained economic growth. The manner in which the Federal Reserve has dealt with the affect of the credit crunch, is very different to the style that their European counterparts adopted. The U.S. has sought to adopt lessons that were concluded from the Great Depression and consequently used a Keynesian approach to address incongruencies within the economy. Keynes believed that the austerity measures of the Great Depression by the Federal Reserve strengthened the negative impact of the depression. The economist concluded that it was only after the government increased spending that the economy was able to revitalize and achieve positive growth. Conversely, European Central Banks have concentrated on adopting the application of stringent austerity measures, reducing government spending and budget deficits. It is unclear and still too early to establish how these two very different approaches are working. Early indications suggest that both methods have achieved some measure of success. In the United States, there has been somewhat of a recovery and Europe is also experiencing a slight resurgence. Early economic indicators reflect improving economies in both Greece and Portugal. These are two countries within the Eurozone that were severely impacted by the credit crunch.

Another question that needs to be assessed is the sustainability of the Euro currency, which is approximately ten years old. The most difficult challenge for those countries within the Eurozone is the disparity between the individual needs of a country countries and that of centralized strategy for fiscal and monetary considerations. This incongruency begs the question, as to whether the continued functionality of the Euro currency is sustainable within its current structure.

With the goal of achieving a deeper and clearer understanding of the Credit Crunch, there are several key questions that need to be addressed:
  1. How did the sub-prime industry contribute to the Credit Crunch?
  2. What were the mechanics within the economy that contributed towards the Credit Crunch and which specific factors caused the housing bubble?
  3. Could the Credit Crunch have been avoided?
  4. Do the lessons of the Credit Crunch warrant increased regulation, as is the current trend?
  5. To what extent did the Federal Reserve contribute to the recession, if at all?
  6. What steps should Central Governments play in reducing the impact of a recession?
  7. What role should derivatives be allowed to play in financial markets?
Readers are invited to comment on the points discussed in these articles, to further enhance debate and discussion.