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.