Credit Crunch in Usa-Causes and Solutions

Topics: Subprime mortgage crisis, Mortgage, Subprime lending Pages: 15 (4868 words) Published: December 5, 2010
Credit Crunch in USA2
Causes of the Credit Crunch2
Housing Bubble2
Financial Product Innovations5
Sub Prime and Alt-A Lending5
Shadow Banking System6
Other Factors7
Solutions for the Credit Crunch7
Regulation of the Shadow Banking System8
Regulations on Mortgage Lending8
Capital Reserve Requirement9
Government Initiatives10

Table of Charts
Federal Funds vs Mortgage Rates3
USA Home Price Indices4
USA Property Foreclosures 20075
USA subprime Market Share6
Mortgage Foreclosures Factors..............................................................................................................9

Credit Crunch in USA
“USA” is facing a shrinking supply of credit in the credit market which is often termed as a “Credit Crunch”. A credit crunch has made it difficult for companies to borrow because lenders are scared of bankruptcies or defaults, which results in higher rates. The credit crunch has done a lot of damage to the US economy by stifling economic growth through decreased capital liquidity and the reduced ability to borrow (Keara, 2009). This crunch coupled with the recession, has led to many corporate bankruptcies.

Causes of the Credit Crunch
Housing Bubble
The central element in the Credit Crunch was the “Housing Bubble”. The real estate prices in US were unchanged for almost a century until 1995(Baker, 2008). The period between 1995 till 2002 showed an increase of 30 % in the house prices which grew up to 124% by 2006 (The Economist, 2007). The house prices were being driven by a speculative bubble rather than the fundamentals of the housing market (Baker, 2008). Adding fuel to the fire were the lower interest rates offered by the Federal Reserve System. The country was grappling back to normalcy after the 2001 recession. To ease out the pressures on the potential home buyers, the federal fund rates were slashed drastically to 1.0 percent by the end of 2003, which was a 50 year low. The 30 year fixed rate was also reduced to 5.25 %. Chart 1 gives us the trends for the 30 Year fixed rates and the mortgage rates across 2001-2008.

Chart 1. Federal Funds vs Mortgage Rates(Freddie Mac,2008)

These extra ordinarily low interest rates accelerated the house prices. Alan Greenspan, the Federal Reserve Board chairman encouraged people to buy adjustable rate mortgages instead of fixed rate mortgages (Baker, 2008). This housing bubble also resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation. This bubble began to burst in 2007, as the construction boom led to so much over-supply that prices could no longer be supported. By the end of 2007, the housing prices had started to fall in most parts of USA. The prices had declined to almost 20 % of their peak value since mid 2006(Standard`s & Poor`s, 2008). This dramatic fall in the house prices put the borrowers in a ‘negative equity’ where the appraised value of the mortgage was far lower than the actual amount owed to the financial institution. Chart 2 shows the Home Price trend in USA until 2008.

Chart 2. USA Home Price Indices(Standard & Poor`s,2008)

The Federal fund rates were raised significantly between July 2004 and July 2006 .This contributed to an increase in 1-year and 5-year adjustable-rate mortgage (ARM) rates, making ARM interest rate resets more expensive for homeowners(Mastrobatista,2009).  People were unable to cope with the higher interest rates offered by the adjustable rate mortgages in the latter periods.  Refinancing became more difficult, once house prices began to decline. Borrowers who could not afford the higher monthly payments by refinancing began to default. During 2007, lenders started the foreclosure proceedings on nearly 1.3 million properties, a 79% increase...
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