As we know, the USA tends to let Adam Smith’s invisible hand do the job in the economy, whereas in Europe, it’s the national governments who tend to be more involved. However, at the beginning of the crisis back in the summer 2007, it was pretty much the other way around.

Indeed, while the Fed started to make its move, the ECB decided not to act yet, as first of all any economic impact only hits Europe between 8 and 12 months later. Second of all, the ECB’s main goal is to keep inflation under control, which is why they did not decide to inject any money in the economy yet.
However, this situation shifted when the illiquidity started to hit Europe and started to become unbearable. At the beginning of 2008, Bear Stearns was in severe trouble, affecting its surroundings and a huge amount of write-downs started to occur around the European Banks.
So, this led to a lack of liquity, up to a point where national governments requested an action to be taken by the ECB, despite inflation risks.
The ECB basically poured several billion Euros into the economy in order to increase the money supply and thus the liquidity in the economy. The ECB, a very generous bank one could say, even provided liquidity to American and Bristish banks, if they have branches or subsidiaries in the euro area.
Basically, the world’s largest banks now launched their latest co-ordinated action in order to appease the credit market. The Fed, the ECB and central banks in the UK, Canada and Switzerland will inject billions more into the market. This collaboration shows how global and severe the crisis has become, up to a point where banks have to support eachother, across boundaries.
However, it is not sure whether these actions would help bring back confidence into these nervous credit markets in the longer term. Indeed, the bank could solve the liquidity problem in the short term, but could do little to ease worries about long-term solvency at some financial institutions. In addition to this uncertainty, the LIBOR has now further increased, while banks are reluctant to lend to eachother out of fear that the banks they lend to will not be able to repay their loans.
We have in other words, a crisis of confidence in bank solvency. It’s not that they do not have the cash to lend anymore, but a more deeper reason.....they do not trust eachother to have sufficient assets. As we all know, it’s all about trust between lenders and borrowers, for an economy to work well, which does not look too good right now.
Another important point to mention is that the ECB started to inject money and decrease interest rates in order to devalue the strong Euro. Indeed, by doing so, the ECB allows the Eurozone to become more competitive again in overseas markets, which was not the case anymore due to the strong exchange rate. This would certainly help against a threat of recession, such as the one faced by the USA right now.
Finally, as opposed to the Fed, the ECB did not accept the security backed mortgages in exchange for loans, as this is an issue dealt by the national governments. What the European governments did instead, was to use the tax payers’ money in order to stuff the holes and repay those defaulting mortgages.

Basically, the ECB was faced with a very rough decision, because by increasing the money supply there will be an eventual increase in prices and therefore inflation, the ECB’s biggest enemy, as it affects basically the entire economy. However, in the end, in a moment of crisis, what is more important? Financial and market stability or inflation targets....

The credit crisis has spread out to the entire US economy, as seen in the previous blog, and has caused more than enough damage. So what did the US government and the Fed do in order to improve and try to rescue the situation?

Well first of all, the Federal Reserve Bank has taken several steps to work on the crisis, along with central banks around the world. Their main actions are, as Ben Bernanke said, „efforts to support market liquidity and functioning and the pursuit of our ecnomic ojectives through monetary policy.“
Between September 2007 and March 2008 , the Fed decreased the interest rates from 5.25% down to 2.25%, one of the open market operations used by the Fed to regulate the supply of money in the US economy. By doing so, they allow people and companies to borrow more in order to keep invesment active, one of the main components for economic growth, and as well stimulate consumption in this close-to recession situation.
Secondly, the Fed and other central banks have increased their loans to member banks to make sure they have sufficient liquidity. These are basically short-term loans collaterised by government securities. These mortgage backed securities are the CDO’s that were the main problem of the crisis and as a result, these securities were seen as illiquid assets. So, by accepting the securities (by the government) in exchange for loans, the banks benefit by being liquid again and regain trust from borrowers and investors, which in the end helps stimulate the economy again.
Furthermore, on March the 4th, Bernanke delivered a speech called „Reducing Preventable Mortgage Foreclosures“. He proposed some solutions about the trouble with foreclosures. These keep increasing, meaning that people lose their collateral (house) and thus spending power. As a result, a negative cycle develops in which there is less purchasing power, leading to less consumption, leading to decreased company revenues and thus decreased investment and salaries and so on and so forth. In order to avoid this, Bernanke proposed a reduction in loan principal amounts. Compared to interest only loans and standard loans, fixed principal loans generate the lowest total interest charge over the term of the loan, meaning that it’d be easier for people to repay their loans and thus have a greater chance to keep their houses as collateral.

Many companies and banks have suffered from this crisis and billions of dollars have ben lost. The Fed thus helped some of them and one of the most recent „actions“ is the Bear and Stearns case, which is one of the largest global investments banks, securities trading and brokerage firms in the world. In March 2008, the Fed provided funds to enable J.P Morgan Chase to purchase and „save“ Bear Stearns. This company had important mortgage-backed securities (MBS) investments that had recently strongly decreased in value, which could then have led to further devaluation in similar securities in the vulnerable banking system.


Then, the US government also had a say in this whole crisis. The „booster package“ mostly comprised of tax reductions, which would then leave more disposable income and thus allow more consumption as well, hopefully stimulating the economy enough to avoid a recession.
Furthermore, Bush introduced several programs, in order to ¨freeze¨ the mortgages of a certain number of mortgage debtors holding ARM´s. Bush also created a refinancing facility called FHA-Secure, which is part of a collaborative effort between the US Government and private industry to help some sub-prime borrowers called the Hope Now Alliance.

During February 2008, a program called "Project Lifeline" was also announced, whereby six of the largest U.S. lenders, in partnership with the Hope Now Alliance, agreed to defer foreclosure actions for 30 days to 90 days or more. This program was to encourage more loan adjustments, to avoid foreclosures, which are a thread to the economy right now.
The government is also considering action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling and qualifications of lenders. These regulations or guidelines could influence the nature and the transparency required for the very complex legal entities and securities involved in these transactions.

All in all, the Fed and the government basically use Keynes’ and Milton’s theories, whereby the government counteracts the economic cycle through monetary and fiscal policies. They
hope to create a positive multiplier in the Circular Flow of Income through these interventions, however, this might lead to the opposite. Indeed, by pumping more money into the economy, there will eventually be inflation, which combined with unemployment during this crisis, could lead to stagflation, one of the worst case scenarios.
So, let’s just wait and see.

The Spread of the Credit Crunch

We have seen from the previous blog that the main causes of the 2007 credit crunch in the USA were too lax sub-prime lending conditions, which led to huge amounts of borrowing from consumers who would not be able to repay in the end and led to an extremely high amount of debts defaulting at the same time. In addition to this, these loans were often tied up in „mortgage groups“ and resold to companies for example as SIV’s, which was a very tricky and unfortunate operation. Indeed, the defaulting of one debt, led to the defaulting of another and so on and so forth, up to a point where there was no liquidity left and noone could repay anyone anymore in this vicious cycle.

So, what happened next?
The months of September until the present day have been full of turmoil and we still haven’t seen the end of it.
First of all, as explained before, we experienced a snow-ball effect due to securitisation failing and all the debts and loans collapsing as they were defaulting one after the other. This led to a huge problem of liquidity in the economy, which brought all activities to a „slowdown“.
Indeed, without liquitity, not much can be done in the economy.
Both the capital markets and the banks failed because of the collateral debt obligations and structured products (eg loan obligations), which drove America towards recession.
Let’s have a closer look at this.
All these debts made, may they be student loans, mortgages or even credit card debts, can be seen as an opportunity cost. With these loans, whether corporate or for consumers, people financed their projects and the main idea behind them, according to a more Keynesian view, is that one person’s expense is another person’s income. We have a multiplier effect, but unfortunately a negative one.
Indeed, due to this whole crisis companies made big losses and are heavily indebted, which are all shown restated on the company books. Due to this, investors lost confidence in the companies and started to decrease investment, which also led to a decrease in share values on a massive scale. This caused the stockmarket to „get nervous“, although no major crash happened.
The crisis caused huge losses of income, companies had to postpone projects and had less capital in order to investment and innovate. In addition to that, there was a clear decrease in dividend payouts, which led to a slowdown in the stock market as well.
Moreover, the US economy mainly relies on consumption, about 69% of GDP, which is a major component, so when the US has the unfortunate „chance“ of experiencing a domestic consumption slowdown, this can have a very deep impact on the economy. Which is exactly what happened. People are now trapped in this vicious cycle in which they cannot repay the debts they made, they cannot resell their collateral (house) because the market is in a very bad shape and demande fell due to the same financial problems. Plus, as the economy is heading towards a recession and people know it, they get more careful and spend much less.
Another problem with the companies, is that as they are losing a lot of money and as demand fell dramatically, supply fell too and in order to reduce costs during such difficult times, many employees got fired. This is another aggravating factor enhancing the falling consumption.

Companies from mainly all sectors have been affected in the USA, as most of the companies borrowed money from these institutions and as we know, all the debts just collapsed and a real shortage in liquidity occured.
Due to globalisation and ever decreasing national barriers, this crisis has also spread and affected the rest of the world.
Nothern Rock, a British bank, over invested in the american subprime market, the CDO’s dried up and the consequent losses were so high that the bank had to be renationalised.

"Trust was shaken today," said Thomas Mayer, the chief European economist at Deutsche Bank. "Credit depends on trust. If trust disappears, then credit disappears, and you have a systemic issue." This quote shows how worried Europeans are from this crisis and eventhough the ECB is taking measures, there is still a very big risk for the European companies, as they all invested in US banks.

Finally, the lack in liquidity became so severe that banks now even welcome cash flows from sovereign funds, mainly from the Middle-East and Asia. On the one hand, they do inject liquidity back into the system, but on the other hand it also poses a threat as these funds are mainly controlled by the governments, who might acquire quiet a large portion of power in US business making.

In conclusion, the crisis began in the “sub-prime” house mortgage sector in the US. It then spread to many banks in the US and Europe which had invested in financial instruments linked to the value of these sub-prime mortgages.
In addition to this, we are observing the causes or symptoms of a possible recession in the USA, which could lead to many deeper problems for the economy.
And finally, some of the world’s biggest banks, like Citigroup, Merrill Lynch, UBS, Morgan Stanley and HSBC, lost many billions of dollars and some had to restore their balance sheets through massive injections of equity, mainly by sovereign funds from the Middle-East and Asia.

Causes for the US Credit Crunch

Economics has always been a delicate subject, with many theories cancelling out eachother over the centuries. Up to today we use different theories and opinions in order to explain the economic phenomenons in our societies and still it is not always clear who is right or not, nor to whom we point our finger at. In the case of the US credit crisis, there are some noticeable events that can help us comprehend what happened.

After the Tech-bust in 2001, the country’s purchasing power significantly decreased, leading to a slow down of the economy. In order to revitalise the US economy, the Fed reduced interest rates, which led to lax lending standards, thus cheap money and therefore more borrowing and eventually more spending. Furthermore, as interest rates were lower, it was not as attractive anymore to keep the money in savings account, so the spending rate increased even more.

So, let’s relate this to the credit crisis.
The low interest rates in this case generally affected the subprime lendings (to finance mortgages principally, car loans, credit card debts etc). Banks would basically lend to anyone without strict restrictions nor criteria, even to people who wouldn’t have the ability to repay. More and more people bought houses on credit that they could not refinance, partly due to higher oil and food prices, which the led to the mortgages defaulting. These lax lending conditions then led to the creation of many hedgefunds when there was still a lot of liquidity which then led to short-term purchases and investments. However, due to the crisis already 657 out of 950 of these hedgefunds went bust in the last couple of months.

A key concept in the cause of this crisis is „securitisation“. Banks or any other company wants to make the most profit as possible and might even try to „trick“ the accounting books like the balance sheet. Indeed, loans by banks are reported in the balance sheet but what many banks did in the USA was to take them off the books by selling the loans on, so that there would be more profit left. The loans would be sold to investors as collaterals or cash and used again for long-term investments. The big problem here was that there was a huge knock-on effect. When one of the mortgages would default, then everything else would too, like the Collateral debt obligations (subprime mortgages) and Collateral loan obligations (leveraged loans). The consumer would not be able to repay the loan to the new investor and in turns the investor would not have the money to pay it back to the bank.
Securitisation was supposed to get rid of the risk, as banks thought that if they would sell on their loans, they would get cash immediatly. SIVs (structured investement vehicles) invest in those securities, like subprime mortgages, they borrow in the money market where the commercial papers are being issued in order to fund their purchases of securities. Now, the commercial paper was backed by assets such as mortgages so when the subprime mortgages defaulted everything collapsed and the economy was left with illiquidity.

In addition to this, banks played a little game that contributed to the causes of this crisis.
Indeed, there were also mortgages for companies that could actually repay without a problem. BUT, then an average Joe also needed a mortgage for his new home and the bank would then decide to put those two mortgages in one „package“ to then sell it on, as the CDO is worth more together than seperately to attract the investors. However, banks were too naive to believe that the company would immediatly be able to pay back, so that there would be funding for the average Joe loan....as one can imagine this did not happen and all went bust. This costed the banks and all the intermediaries involved more than $850bn.

Furthermore, house prices plummeted, so consumers were left with a collateral worth less than their loan to finance the collateral (house). So, many had to sell the house to repay the outstanding repayment, but would only receive a small amount back for the house and still not be able to repay. This was a start as well for this vicious cycle and contributing to the lack of liquidity in the market.

Finally, the financial models that calculate the probability of default were not programmed about the possibilty that all loans would go bust through this knock-on effect explained earlier and failed to „warn“ correctly, which gave the banks and other institutions over confidence to lend the money to basically anyone.

As a conclusion, we can see that there is not only one cause to this crisis, but that it is rather a succession of events that aggravated eachother and led towards this unstoppable crisis.