Roots and Impacts of the Credit Crunch

Résumé du document

In 1970, three major events have stimulated the financial market and have lead to a necessary increase of its use and its scope. These events are:
- the adoption of a floating change system in March 1973 ;
- the increase of the American deficit ;
- the American choice of the loanback pension (The ERISA (Employment Retirement Income Security Act).

The floating rates required the creation of an exchange market rate to trade currencies. At the meantime, the American deficit increased dramatically. This growing deficit could be eventually financed by institutional and foreign investors with the creation of a fixed income market where US bonds (T-Bill, T-Note and T-Bond) were issued by the federal central bank.

The Credit Crunch began in August 2007, when interbank lending markets in the US, UK and Europe began to seize up. The topic question is about the factors which drove to the credit crunch. It means to find the root and elements linked to this root. Elements must be logically linked to the credit crunch. It's necessary to find the way which can explain the credit crunch. Separated elements without link with others elements will not be taken in consideration.

In this essay, I limit the scope of discussion with financial factors which drove to the credit crunch. Indeed the roots of this event can open onto lots of factors (socials factors, politics factors etc…)

Extraits

[...] Another root of the credit crunch was the lack of transparency in financial market. Lack of transparency Figure 13: Outstanding Value of Credit Default Swaps (in Billions of Dollars) Source: International Swaps and Derivatives Association (ISDA) Market Survey. This figure shows the market for CDs (Credit Default Swaps) during the last ten years. This market increase unregulated from almost zero to more than $44 trillion. It represents more than twice the size of the United States stock market The Credit Default Swaps market is an important market that has grown dramatically over a short period of time. [...]

[...] We know that these goals could be met also with the purchase of subprime collateralized debt obligations (CDOs), therefore such pressure found no resistance from the GSE because it's an opportunity for them: they could issue AAA-rated debt and invest in higher-yield AAA debt, gaining the spread. A lot of investors were aware of the risk of CDOs but they didn't resist with the high competition. In this table, we can see how much big company invest in CDOs. Figure 11: Investments of Some of the Largest Money Market Funds in CDO Commercial Paper. Source: Evans (2007). Money market funds have become a staple for investors. [...]

[...] Furthermore, a potential failure in the system was created by the low level of collateral posted for these contracts. For example during the hurricane season in Florida, if all homeowner lost house insurance, everybody will buy a new one. The prices will increase because of the limited capacity. Indeed the term of insurance is short. In case that the homeowner couldn't pay, his mortgage will default instantaneously. Then it created foreclosures and real estate crisis. Impacts on Microeconomic environment Incomes The credit crunch affects the microeconomic environment. Indeed a survey leads by Hewitt Company. [...]

[...] First, Basel risk based capital advocated the bin approach to risk. With this approach, banks had to invest in the highest risk security in each bin, sensibly altering the distribution of asset risk. In harmony with the current accord, loans to the public sector carry a risk weight for OCED (Organization for Economic Co-operation and Development) countries and 100% risk if the loan is to a non OCED government. The rule is that government claims from OECD countries can be considered “safe assets”. [...]

[...] This essay allows us to be aware of what happen in finance market, how investors work etc This is very important because it's not about simple companies, banks deal with our money so we are all involved. The credit crunch had major impact on micro and macro environment which cannot be ignored. It concern our life and change the way we live. It was interesting to link the credit crunch to a specific bank and see what consequence it has now. In addition, plan the future impacts oblige us to think about how the market will change taking in consideration the past events. [...]