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.