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Credit Crisis Explained

The current credit crisis (also called the financial crisis or the credit crunch) has left many people worried that there will be a worldwide economic recession. This post will explain why the credit crisis is happening and what the expected effects are.

Causes:

There are many causes of the credit crisis, but these are the main causes.

  • Boom and then a rapid decline in housing prices in the United States. Low interests rates and huge inflows of foreign funds led to heaps of people buying their own houses. 69.2% of people owned a home in 2004. The banks were willing to loan to almost anyone, regardless of their credit history (more on that below). Unfortunately, the higher demand for houses pushed the housing prices up quickly. Overbuilding during this time caused house prices to decline in late 2006 and 2007. This led to many people having mortgages worth more than the price of their home. This led to more people foreclosing or defaulting on their loans.
  • Increased number of high-risk loans. As mentioned above, the banks had plenty of money to loan to just about anyone, even people without stable incomes. In 2006, 20% of all mortgages by banks were subprime mortgages (that is, high-risk mortgages). Obviously, increased housing prices and commodities increasing in price (eg. oil) forced many people to foreclose of default on loans, costing the banks lots of money.
  • Banks also sold securities in these high-risk loans to investors. Investors basically cover the loans and earn money on the interest that the borrowers pay back to the bank. Investors were making lots of money out of this while the housing prices were booming, but lost a lot of money when people could no longer afford to pay their loans.
  • An increase in mortgage fraud.
  • Inaccurate credit ratings. Some people claim that the rating companies are paid by the banks so they rate their subprime mortgage loans higher than they should have.
  • Private debt in America is almost three times the national GDP.
  • Excessive underwriting. Underwriting is a process where the banks determine whether the risk of lending to a certain borrower is acceptable. During the housing boom, banks rarely refused loans and this caused huge amounts of debts that cannot be paid back.

Expected Effects:

  • Continued losses on the share market due to panic selling. It is expected to take years until the market fully recovers.
  • World food prices and oil prices will continue to increase.
  • Loss of superannuation.
  • Mergers of banks and other financial institutions.
  • Continued decline in real estate prices, which will see more people foreclosing on their loans.
  • A rather strange effect is an increase in crime. FBI reports indicate that arson rates are increasing, possibly because people are looking for a way to escape from mortgages they cannot pay.
  • Loss of jobs in the financial sector.
  • More renters will be evicted as the owners foreclose on loans.
  • Possible recession and economic collapse.
  • Increased global inflation.

Source: Financial Times

Other ‘Finance’ Posts:

Top Ten Banks in America- by total assets. With the current crisis, will they remain the top ten?

Pros and Cons of Bankruptcy

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