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The Credit Crunch: How Did it Happen?

By: Kevin Dowling BA (IMC) - Updated: 16 Oct 2012 | comments*Discuss
The Credit Crunch: How Did It Happen?

The credit crunch began as a liquidity problem faced by homeowners in the US, and quickly spread throughout the world, prompting a stock market crash on a scale that hadn’t been experienced since the great Wall Street Crash in 1929. So what exactly went wrong within financial markets?

Even before the credit crunch took hold, economists were expecting a slowdown of growth, both in the UK and in every major economy. However, there’s little doubt that the recent crisis has helped to deepen the concerns surrounding the housing market and the wider global economy.

The Beginnings Of The Crisis

Problems first surfaced early last year, when the consequences of an over-inflated housing market, and cheap mortgage loans to high-risk (‘sub prime’) homebuyers, began to have a damaging effect on the US economy. Sharply rising interest rates meant that suddenly, millions of homeowners faced the prospect of losing their home, while some just dropped their keys in the mailbox and walked away. Yet worse was to follow. What had originally started out as an American problem was now revealed to be having a significant effect on markets worldwide. The credit crunch was starting to bite.

The lenders who approved these mortgages had been selling on large portions of their (now-defaulted) loan books to other financial institutions (in the form of secure assets). All companies left holding these secure assets were forced to announce significant write-downs in their value.

Fear Grips The Market

Because of the increasing uncertainty surrounding these so-called ‘toxic’ investments, and the fear of being left holding worthless assets, banks became increasingly unwilling to finance any loans to businesses or customers, or to even lend money to each other. The lack of lending effectively blocked up the finance system. Credit became very expensive or virtually impossible to obtain and confidence in all financial institutions rapidly disappeared. And then panic ensued.

The share prices of any companies associated with finance plummeted as investors sold their shares as quickly as they could, to claw back some of their money. Well-respected financial institutions that were once considered rock-solid now found themselves in desperate need of support that would enable them to continue trading, or face extinction. In the US, insurance giant AIG, mortgage lenders Fannie Mae and Freddie Mac, and investment banks Lehman Brothers and Merrill Lynch, faced ruin. Similarly, in the UK, Bradford & Bingley, HBOS and RBS were just some of the names facing serious difficulties. They were forced to ask their governments for help, and these governments did so, in order to prevent a total collapse of the banking system.

These government efforts have helped to stabilise markets to a degree, by agreeing to provide finance for those companies struggling to carry out their day-to-day business. They provided money to help shore up their unhealthy balance sheets, while also agreeing to take some of the ‘toxic’ debts off their hands.

While the financial sector is forced to take its medicine, the short-term pain should ultimately prove beneficial in the long run. It could be argued that a period of consolidation was necessary, and that the financial industry will steadily become healthier, and potentially more tightly regulated. Those institutions strong enough to survive the cull should be well placed in the years to come. The rebuilding phase is already starting. However, the damage has been done.

Where Next For Markets?

All over the world, many organisations have already lost huge sums of money as a result of the credit crunch, and they are looking to apportion blame. You could argue that the US government was at fault by letting house prices overheat to such an extent that mortgages were being approved that would never be repaid. You can also lay blame at the door of the major financial institutions that sold on these mortgage books as ‘assets’ without having a realistic valuation of their true worth. You can also blame consumer culture, for convincing us that property acquisition is something to be achieved at all costs. These questions are being debated all over the world, as the downturn spreads from the financial markets to the real economy, and especially in the UK, where there could be a sharp housing downturn, particularly in the buy-to-let market.

It is clear is that most of the worlds’ developed markets are either already in, or heading towards, recession. The rate of economic growth around the world is predicted to fall in just about every major region. The impact of the credit crunch could therefore be felt for many years to come.

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