There are five parts. First part is introduction, second one is literature review, third is a brief explanation of credit market and credit crunch, the fourth one is trying to discover how credit market contribute to credit crunch, and the fifth one is conclusion.
- Literature review
From the former study, almost all the studies and commentaries on the financial crisis deal primarily with factors believed to have encouraged excessive household debt. For example, according to Pattanaik (2009) and Posner (2008), the movement to deregulate the financial services industry went too far by exaggerating the resilience of the free market economic model. And Taylor (2008) blames the abundance of credit as the chief cause of the crisis. Dell’Aricia et al. (2008a) also think the sharp increase in delinquency rates should take responsibility for the credit boom for. They prove that it is especially easy credit surrounding periods the most major banking crises occurred. In this period, loan delinquency rates tend to rise with the volume of loan origination. So can come to the conclusion that economic booms associated with fast rising real estate prices were more likely to end up in a financial crisis.
Barajas et al. (2007) discuss the effects of monetary excesses but find that while most major banking crises in the U.S. occurred in periods of credit boom, not all credit booms are followed by banking crises. Dell’Aricia et al. (2008b) also conclude that larger and longer-lasting booms, which coincidingly with higher inflation and lower growth, were more likely to result in a crisis. Rogers (2008) also blames the rapid development of credit market globalization for the eventual economic recession that followed the financial crisis. The deepening wealth-poverty gap that globalization caused makes government encourages subprime credit, which resulted in the transnational banking and economic crisis directly.
- Credit market and credit crisis
To discover the relationship between credit market and credit crisis, we should define them first. Credit Market is a broad market for companies looking to raise funds through debt issuance. The credit market encompasses both investment-grade bonds and junk bonds, as well as short-term commercial paper. And it is also a market for debt offerings as seen by investors of bonds, notes and securitized obligations such as mortgage pools and collateralized debt obligations. As the global credit market matures and profit margins shrink on standardized products, credit derivatives are increasingly seen as one of the most promising growth areas for the future and play a more and more impressive role in credit market. Interest rate and currency swaps are considered highly technical and esoteric products. And they are now viewed as standardized products by most market participants. Consequently profit margins have declined as banks and intermediaries find it increasingly difficult to justify high fees for widely available products. The underlying credit market is huge," Blythe Masters, head of credit derivatives at J.P. Morgan, said recently. "There is no real theoretical cap, any time in the near future, on how much the market can expand."
The credit crisis started in the housing sector, unlike other financial crises in recent history. Over the past five to seven years, there are big changes in the economic environment along with various industry trends, so led to a surge in delinquencies and foreclosures in the mortgage market. The first signs of trouble appeared in a relatively small portion of the mortgage industry known as subprime. From the early 1990s to 2006, US housing prices increased higher and higher at a national level. This continuous growth in prices meant that even if a subprime borrower’s personal finances were stressed, the increase in his home value often gave him the option to refinance or even sell instead of going into delinquency. Furthermore, because mortgage rates remained low for most of 2000 to 2005, one was usually able to refinance into another low-rate product. As a result, subprime mortgage originations and securitizations increased greatly between 2000 and 2006. However, interest rates started to rise in 2004, and when combined with the deceleration and eventual decline in housing prices, subprime borrowers began to have difficulty meeting their mortgage obligations, resulting in higher rates of delinquencies and foreclosures. So many banks have to go bankrupt, this trend become more and more severs, finally it influence the wall street market, and then become a worldwide credit crisis.
- How credit market contributed to credit crunch
The securitization process also led to asymmetric information, because not all information about the loans the mortgage brokers had at loan approval was transmitted to the buyers of the mortgage-backed securities (MBS), as the crisis subsequently proved. At the time, the existence of asymmetric information was difficult to demonstrate because buyers relied on prices set by credit rating agencies that were presumably fully informed about the approved loans. Once money was lost from MBS, withdrawal from the market by investors gave rise to a modern version of a‘run on the banks’ in the financial system. The failure of the market to provide credit might not have been so evident or debilitating for the economy, if the dependence on credit from the market had not been so great. When the market temporarily becomes illiquid due to uncertainty following an initial shock from unexpected news, it normally recovers quickly and trading resumes around new consensus price levels. However, in this crisis, market recovery did not occur quickly, highlighting the existence of an asymmetric information problem. After several months of the crisis, we still seem to be a long way from a solution to this problem. Many parts of the credit market have remained closed to new lending, suggesting that something still more serious has affected the market. It seems that having more information on the mortgages is insufficient to unlock the market, since we need to translate individual loan data to prices for securities with credit risk. This appears to be beyond the capabilities of the credit risk models that are currently in use. So credit market may be the root of this credit crisis. It is urgent to build a healthy credit market to help the world economy recover from the credit crisis. Meanwhile, the credit crisis exert a great influent on the credit market, makes it still in the low ebb. So we should strengthen the control of government, to help the market get better.
- Conclusion
This study began with a review of some of the factors that contributed to the global financial crisis which started in 2007 with the collapse of the U.S. housing market. The absence of a connection between market and credit risks during the pre-crisis period and their relationships with the equity market is prominent; it was found that before the crisis, the stock market showed a muted response to innovations in the credit markets. Investors are increasingly rational in factoring credit risk into the valuation of financial assets.
The financial crisis was primarily driven by two factors. First, investors and financial institutions generally did not expect that real estate prices would fall dramatically. This dramatic fall in real estate prices led to large defaults on subprime mortgages and large falls in value in securitizations of subprime mortgages. The second factor is that many financial institutions were operating with extremely high levels of leverage and held large investments in subprime securitizations, so that significant cant unexpected losses on these investments could quickly lead market participants to question their solvency. As these events unfolded, financial derivatives were associated with losses and uncertainty at some institutions. So the credit market has great relation with the credit crunch.
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