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The Credit Crunch

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Due to its major significance, the term was included in the latest edition of the Concise Oxford English Dictionary, meaning an economic condition in which it suddenly becomes difficult and expensive to borrow money (Oxford University Press,n.d.). A credit crunch is characterized by a shortage of funds in the credit market, resulting in decreased possibilities for credit agreements and increased levels of official interest rates. Economist John Hull (2009) argues that the origins of the credit crunch (which started in the US) can be found in the housing market. The U.S government was keen to encourage home ownership. Interest rates were low. Mortgage brokers and mortgage lenders found it attractive to do more business by relaxing their lending standards () Banks thought the good times would continue and () chose to ignore the housing bubble… Simply put, people were spending more money than they actually had – an inconsistency that grows into what economists call a bubble – the inflation of global property prices. A vicious circle is formed – prices rise, causing the number of credits to rise as well, which in turn makes prices rise even more. At some point, a large number of credits started to default. Property prices began to drop and so the bubble burst. On a related note, Mizen (2008, p. 564) points out that the most recent credit crunch was preceded by a prosperous period, which generated a certain degree of carelessness throughout the economy. Financial innovation had () introduced greater complexity, higher leverage, and weaker underlying assets based on subprime mortgages. Mizen defines a subprime mortgage as a riskier bank product – a loan given to a person with non-standard income or credit profile, which was often mispriced. They provide good returns, compared to other asset classes, and therefore receive high ratings. However, they are not as safe as they seemed because they are tied to house prices. When prices drop, foreclosures become more frequent. Losses escalated and banks took measures by lowering credit availability. White (2008, p. 2-3) states that Borrowers with inadequate income relative to their debts, many of whom had either counted on being able to borrow against a higher house value in the future in order to help them meet their monthly mortgage payments, or on being able to flip the property at a price that would more than repay their mortgage, began to default. Default rates on nonprime mortgages rose to unexpected highs. The high risk on the mortgages came back to bite mortgage holders, the financial institutions to whom the monthly payments were owed. Financial institutions that had stocked up on junk mortgages and junk-mortgage-backed securities found their stock prices dropping. The worst cases, like Countrywide Financial, the investment banks Lehman Brothers and Merrill Lynch, and the government-sponsored mortgage purchasers Fannie Mae and Freddie Mac, went broke or had to find a last-minute purchaser to avoid bankruptcy.