Impact of Credit Crisis

Topics: Subprime mortgage crisis, Debt, Federal Reserve System Pages: 6 (2057 words) Published: February 17, 2013
A Credit Crisis is mainly caused by a continued period of mindless and reckless lending which results in losses for both lending institutions and investors when the full extent of bad debt becomes known. When it becomes known, lenders will no longer lend to borrowers because of high risk, and therefore reduce the availability of loans. Borrowers then can no longer borrow money for operating expenses and to repay debts.

What had happened to cause the Credit Crisis in 2008 was simply that the mortgage lenders were money hungry and careless and began handing out mortgages to anybody, regardless of their income and credit history. These were called the sub-prime mortgages. They gave mortgages to anybody because they expected houses to continuously rise in value, and if the people applying for mortgages defaulted, it wouldn’t matter because the lender will simply just take the home that the home owner’s had purchased. Home builders kept building more and more homes, and eventually, the supply of homes exceeded the demand. Housing prices then began to plummet and soon after, the prices of the homes were way below the value of the mortgage that the home owners had owned. Home owners then didn’t think it was worth paying off the mortgage when it was worth more than their homes, and they simply left and defaulted. Not much longer, there were hundreds of vacant houses in the market, and banks and investors who had invested in these mortgages could no longer generate income to cover their operating expenses or to repay their debts or to even profit anymore (“Crisis Explained”). This was the Credit Crisis. Within this Credit Crisis, we will go more in-depth to how commercial banks and securities firms were affected and the differences between them.

The U.S. banking industries were severely suffered by this Credit Crisis. The number of bank failures skyrocketed from the impact of the crisis and most had to be aided by the government in order for them to continue operation. Banks stock values decreased significantly (Kwan).

The Federal Reserve had reported a big contraction in short-term debts. Based on the Federal Reserve flow of funds report (“Flow of Funds”), we could see that the “open market paper,” which can be defined as short-term commercial loans, “was slashed at the annual rate of $ 682 billion” (“Commercial Banks”). We can also see that it decreased again at the rate of $ 337 billion per year in the fourth quarter.

The Office of the Comptroller of the Currency (OCC) had also reported damage and destruction in the derivatives market. Derivatives are bets and debts placed by banks and others. In recent decades, derivatives have grown far beyond any reasons from the surface. The OCC reveals that in the fourth quarter of 2007 in its latest report, the national value of derivatives held by U.S. commercial banks plunged dramatically — by $8 trillion which had never happened before. The U.S. banks had also suffered a massive overall loss on their derivatives — $9.97 billion which had also never happened before (“Commercial Banks”). But in its latest report, the OCC's chart below shows the magnitude and drama of the decline.

We can see that the U.S. commercial banks had been making consistent profits from their derivatives every year until near the end of 2007. Their total revenue had never dropped below positive and infrequent and peculiar suffered a significant decline and was even making brand new highs through the first 6 months of 2007. We experienced a landmark game-changing event: For the first time, U.S. commercial banks suffered a huge loss in the derivative market, based on the drop of the red line in the fourth quarter (“Commercial Banks”).

At the time of the Credit Crisis, the Federal Reserve had lowered the interest rate to 1% to keep the economy strong. The investors who were investing in Treasury Bills (T-bills) no longer wishes to do so anymore because a 1% return wasn’t worth it to them. However,...
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