Understanding Credit Crunches: Causes, Effects, and Historical Examples, Study notes of Financial Management

Download Understanding Credit Crunches: Causes, Effects, and Historical Examples and more Study notes Financial Management in PDF only on Docsity! CREDI T CRUNC H An economic condition in which investment capital is difficult to obtain. Banks and investors become wary of lending funds to corporations, which drives up the price of debt products for borrowers. What Does Credit Crunch Mean? 1. When lending institutions have suffered losses from previous loans, they are generally unwilling or unable to lend.  This occurs when borrowers default and the properties underlying a defaulted loan decline in value. In this situation, as borrowers default, banks foreclose on the mortgages and attempt to sell these properties to regain the funds they loaned out. Consequently, if home prices fall, the bank is left selling at a loss. Because banks are required to retain minimum levels of liquidity (capital), when they suffer losses, their capital positions are reduced, which reduces the amount they are able to lend out. Let's take a look at the anatomy of a credit crunch. 2. Credit crunches can also occur when regulatory bodies increase capital requirements for financial institutions. Banks and other lenders are required to maintain a set amount of capital liquidity based on their risk-weighted level of assets. If this requirement increases, many banks will need to increase capital reserves. To comply, banks will cut lending, reducing the availability of loans for individuals and companies 3. Also, if banks perceive a greater risk in the market, they will often raise their lending rates to offset this risk. This increases the cost of borrowing and makes it more difficult for borrowers to access financing. If borrowers aren't willing to borrow at these rates, the bank is unlikely to lend at all.  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.  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. The 1990s 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 occurred 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. However, what we can learn from history's crashes is that markets can and do recover if given enough time - even if it's only to crash again. Today Consumers Cut Spending Banks Fear Making Loans Businesses Lose Access to Capital Rising Foreclosures May Bring Property Values Down for Communities The Crisis May Force the Government to Take Emergency Measures The Downside of a Credit Crisis Corporations Clean Up Their Balance Sheets By writing off the bad debt on their balance sheets, businesses become leaner, can weather the slowdown and can expand even more when positive growth returns to the economy. Transparency and Regulation in the Financial Sector Improve Hard Times Force Consumers to Regain Control of Their Spending Declines in Stock Prices Create Great Long- Term Valuations. During the crisis, when everyone is panicking and selling both good and bad investments, many smart investors are buying those good investments and holding them long-term. Once the crisis is over and the chaos has died down, they make tremendous profits. Credit shocks have many negatives, but they also create opportunities. During times of economic crisis, it is important to keep a clear head and not get caught up in the fear. Left unchecked, large-scale fear can wreak havoc on the world economy. But over time, every crisis will end and the economy will begin to expand once again. Conclusion