Credit Crisis: Causes & Effects Essay

Credit Crisis: Causes & Effects

Introduction

            Nassim Taleb the author of “The Black Swan” rightly points out “black swan is an event which is prospectively unpredictable but retrospectively predictable” i.e. people don’t see the event before it occurs, but after the event everybody claims that they saw it coming.[1] His words truly describe the current Global Financial Crisis which started out as a liquidity crunch triggered by the US Sub-prime mortgage market collapse and has brought a sea-change of unprecedented magnitude in global markets, with no country or market immune to the shock waves that have rippled around the world. At this onset of recession, as Wall Street giants crumble like a pack of cards and many more expected to suffer billions of dollars in losses in the coming quarters, the imminent question that strikes the mind: Are bailouts the appropriate radical solution?

            From the advent of the economic crisis the write-offs of about $1 trillion have been taken by various institutions. A Mckinsey study shows that the final tally of losses could be as high $2.2 trillion in United States (about 10-15% of GDP). Apart from that the combined loss of United Kingdom and European Union could be as high as $1.4 trillion.[2]

            From a company point of view, this crisis has led to severe credit crunch leading to bankruptcy, takeovers, shattered investor confidence and decrease in the consumer spending. It started with Federal bail out of two US GSEs (Government sponsored enterprises) Fannie Mae & Freddie Mac, followed by the fall of the investment giant Lehman Brothers and the sale of Merrill Lynch to Bank of America on the same day in a $50 billion all-stock transaction. After this AIG (American International Group) got a bailout of $85 billion from Federal Reserve in an exchange of 79.9% equity interest. It further resulted into the conversion of Goldman Sachs & Morgan Stanley to bank holding companies. Equity markets are the worst sufferers of the crisis. S&P 500 index has fallen by more than 50%. By November 2008 the US markets were at the same levels as they were in 2001-02 after the Dotcom bubble burst. Even the global markets both (Asian & European) have fallen down significantly from their peak levels.

            Several rescue attempts like $700 billion bailout plan, a cut in the interest rates, termination of short selling etc. were made by the US government as the trickle down effect of the crisis reached Europe in the month of October. The Icelandic currency Krona dropped 30% against the Euro resulting in suspension of trading activities. After this several European governments announced bailout plans for their financial institutions. Among them Britain (25 billion pounds), Norway (US $57.4 billion) & Sweden (1.5 trillion Kronor) were the initiators.

            Amongst this crisis, the new quarterly report by UCLA Anderson Forecast which states that US will face four quarters of recession adds to the further woes. An estimate shows that the GDP would decline by 4.1% in the current quarter and the unemployment rate would increase from 6.5% to 8.5% by early 2010. [3]

Causes of the Credit Crisis

The root cause of the Credit Crisis was “The Excess Credit Creation” over these many years which triggered a chain reaction causing the eventual Global Economic crisis. From 2005-07 the property rates were very high and they kept on increasing leading to a sense of complacency in the real estate market. Due to this billions of dollars of subprime loans were given to borrowers with high default risk and bad credit history. But contrary to the speculation, the property bubble finally burst in 2007 leading to high depreciation in the property rates. As most of the borrowers were unable to pay, the mortgage repayment defaults started to increase leading to a liquidity crunch.

Figure:  Percentage Decline in the US house Prices[4]

The following figure shows the S&P/Case-Shiller Home Price Indices, the leading measure of U.S. home prices. It shows a continues decline in the single family US homes from 2006.

Figure: S&P/ Case-Shiller Home Price Indices[5]

The July data reported annual declines of 17.5% and 16.3%.

Figure: US Foreclosure Activity[6]

The above figure shows that there was an increase of 121% year over year and 14% per quarter in the number of homes facing foreclosures.

The Decline of the Wall Street Giants

This affected the Wall Street institutions in the following manner as the forayed into the unknown risk offered by the mortgage loans[7] –

Thus, from the above flow chart we see that the chain reaction mainly affected 5 categories[8] –

Home owner who took a loan to buy a house
Mortgage lender like banks, private financial lenders who sold off his loans as income generator
Investment banks like Lehman Brothers who bought the loans and developed instruments
An insurer like AIG who through credit default swaps insured these high risk debt instruments
A bond holder who invested in these highly rated securities

The Effects of the Crisis

            The Impact of the crisis can be viewed in 4 perspectives-

1) Business Community

2) Stock Markets – Implying Investor Confidence

3) US GDP

4) Consumer Spending

            The financial institutions have been worst sufferers starting with Bear Sterns Co. take over by JP Morgan Chase in March 2008, which was more of a rescue backed by the Federal Reserve who underwrote $30 billion of Bear Sterns Subprime-backed mortgage bonds. The financial firm crisis was further fueled by bail of Fannie Mae & Freddie Mac, the bankruptcy filing by Lehman Brothers, take over or Merrill Lynch, bail of AIG and conversion of Goldman Sachs & Morgan Stanley into bank holding companies. Recently Citi Bank had an agreement with US treasury, Federal Reserve and the Federal Deposit Insurance Corp (FDIC) for a bail out package worth $306 billion. Citi Bank ended the first six months at a loss of $7.6 billion which is expected to increase in the next half.

            The collapse of these MNCs has a direct impact on employment. Most of them are on a job cutting spree and because of this the unemployment rate at present is 6.7%.

Figure: Unemployment rate from 1989 to 2008[9]

            The Dow Jones industrial average has fallen almost 50% from its peak value around 1 year ago. The investor’s confidence was shattered and they moved towards investments in U.S. treasury bonds, metals like gold and strong currencies such as the dollar and the yen.

            The US GDP has shrunk by around 0.3% (maximum since the recession in 2001) this quarter owing to the crisis. The fall has been attributed to decrease in the consumer spending, low investments in the real estate, equipments and software. The prediction for the next quarter says that the drop could be as high as 0.5%

Figure: US GDP growth rate since Jan 2001[10]

            Declining household prices have impacted the consumer spending which accounts for 2/3 of the economy in a negative way as the household wealth has been reduced. The drop in the consumer spending has been about 3.1% in the 3rd quarter – highest in about 3 decades. The Auto industry has been the worst hit as the 3 Detroit Giants Ford, Chrysler and General Motors are on the verge of big fallout. US government could take stakes in the auto makers as a rescue plan.

            A survey of US customers on spending in consumer electronics gives the following results. It shows that the emphasis is more on saving rather than spending and this has become more prominent since January 2008.

Figure: US Consumer Spending[11]

Aftermath of the financial Crisis

            The current crisis would bring significant structural, behavioral and regulatory changes. Some of them are listed below-

Huge financial Companies will grow at the expense of borrowers and investors
Risk modeling needs to be given a re-thought as it as failed miserably
US government borrowing will continue to increase
American consumers will begin to save again
Regulatory reform of financial markets will carry high stakes[12]

Other References

The Taming of the Shrew, 4Ps Business & Marketing, December Edition
Stuart Fraser, Learn from mistakes. Business World, November Edition
·         The Current Financial Crisis- Causes and Consequences
http://www.marketoracle.co.uk/Article6843.html

[1] Taking improbable events seriously: An interview with the author of The Black Swan, By Allen Webb (Dec08)
http://www.mckinseyquarterly.com/Corporate_Finance/Performance/Taking_improbable_events_seriously_An_interview_with_the_author_of_The_Black_Swan_2267

[2] David Cogman & Richard Dobbs.  Financial Crisis, past and present. http://www.mckinseyquarterly.com/Corporate_Finance/Performance/Financial_crises_past_and_present_2272
[3] US to see four quarters of nasty recession: Report http://economictimes.indiatimes.com/News/International_Business/US_to_see_four_quarters_of_nasty_recession_Report/articleshow/3824796.cms

[4]Most over/undervalued US housing Markets

                http://bigpicture.typepad.com/comments/2007/06/most_overunder_.html
[5] S&P/ Case-Shiller 20-city Home Price Index down 16.6% year-over-year

                 http://bubblemeter.blogspot.com/2008_10_01_archive.html
[6] US Quarterly Foreclosures by quarter

                http://bigpicture.typepad.com/comments/2008/07/q2-foreclosures.html
[7]What caused the financial crisis? Financial engineering article

                http://economictimes.indiatimes.com/quickiearticleshow/msid-3561902.cms
[8] The Jigsaw Puzzle

                http://economictimes.indiatimes.com/quickiearticleshow/msid-3561901.cms
[9] US unemployment rate

                 http://thinkingmeat.net/2008/05/14/busted-jim-hoft-posts-another-deliberately-misleading-chart/
[10] United States GDP Growth Rate

                 http://www.tradingeconomics.com/Economics/GDP-Growth.aspx?Symbol=USD
[11] Massive Breakdown In US Consumer Spending

                http://blog.changewave.com/2008/11/us_consumer_spending_breakdown.html
[12] Henry Kaufman,  After the Financial Crisis. Editorials & Opinions, Wall Street Journal. Dec 8, 2008.