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Proceedings of ASBBS Volume 16 Number 1

THE CREDIT CRUNCH AND THE IMPACT ON THE US


ECONOMY AND GLOBAL MARKETS: HOW
DAMAGING WILL IT BE?

Ashley, Clyde Ph.D.
Florida A & M University
Clyde.ashley@famu.edu

Krystal D. Wilson
Florida A & M University
darcell2005@yahoo.com


ABSTRACT
Since the 1950s, Americans proved to be innovators of spending money. Heading into the 1980s, they
invested their savings into the booming stock market and used their earnings made from the stock market
to spend in excess of their normal income. Since then, it became a growing commonality for Americans to
borrow against their home values. The bursting of the housing market bubble, subprime loan fiasco,
costly wars in Iraq and Afghanistan, excessive tax breaks, and the $9 trillion federal debt all contributed
to the U.S. credit crunch and the impending economic recession.

This paper examines the credit crunch issue and analyzes possible implications for consumers, financial
institutions, housing market, student loans, U.S. economy, and global financial markets. Numerous
proposals and plans have been offered by Congress, the current Administration, Senator Obama, Senator
McCain, and the Federal Reserve.

Addressing the credit crunch issue in an effective way will require a comprehensive and wide ranging
strategy. The credit crunch problem impacts several industries (housing, banking, investment,
automobile, student loans) and governmental operations. This paper concludes that the correct approach
must allow the marketplace to operate independently, along with the careful use of monetary and fiscal
policy. There is a need for the government to monitor and provide oversight to make sure that market
forces are fair and efficient.


INTRODUCTION
For more than half a century, Americans have been ingenious at finding new ways to spend money. The
1950s and 1960s manifested the rising popularity of credit cards. It marked the growing commonality to
buy now and pay later. Instead of waiting for payday, many Americans began using the available credit
from credit cards to fulfill wish lists and to cover miscellaneous expenses. Leading into the 1980s,
millions of Americans entrusted their savings to the thriving stock market, and used their winnings to
spend in excess of their income. Recently, millions more borrowed against the value of their homes.
However, the United States recent economic downturn suggests that the glory days of credit and risk are
over (at least for some period of time).

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Currently, the United States is in the midst of a credit crisis and/or credit crunch. Credit crunches are
considered to be an extension of recessions. A credit crunch makes it nearly impossible for companies to
borrow, because lenders are afraid of bankruptcies and defaults that result in higher interest rates. The
consequence is a prolonged recession (or slower recovery) and it occurs as a result of the shrinking credit
supply.

The unraveling of the real-estate market appears to have left millions of American families with limited
choices and unable to take of advantage of new credit opportunities. The construction of this research
paper supports historical, present, and future analyses; proposed solutions; and a thorough identification
of the impact that the credit crunch has on the United States economy and global markets.


ANALYSES
The models below differentiate subprime lending and traditional lending. Traditional functions of
mortgage lending position banks to finance mortgage lending with deposits received from customers.
Subprime lending allows banks to sell mortgages to bond markets and creates a new way to fund
additional borrowing. It leads to banks losing the incentive to carefully monitor the mortgages they issue
(see Figure below).




The subprime mortgage market lends money to people who dont meet the credit or documentation
standards for ordinary mortgages. These borrowers are individuals with poor credit histories and weak
documentation of income, who were rejected by the "prime lenders such as Freddie Mac and Fannie
Mae. Subprime lending proved to be extremely profitable for banks. They earned a fee for each mortgage
sold and urged mortgage brokers to sell more and more of these mortgages. Currently, the mortgage bond
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Proceedings of ASBBS Volume 16 Number 1
market is worth $6 trillion and is the largest single part of the whole $27 trillion US bond market, bigger
than Treasury bonds.

Banks and lenders believed that the risks of subprime loans could be managed, a belief that was fed by
constantly rising home prices and the perceived stability of mortgage-backed securities. However, while
this logic may have held for a brief period, the gradual decline of home prices in 2006 led to the
possibility of serious losses. As home values declined, many borrowers realized that the value of their
homes exceeded the amount they owed on their mortgages. These borrowers began to default on their
loans, which drove home prices down further and ruined the value of mortgage-backed securities
(because the underlying assets behind the securities were now worth less). This downward cycle helped
to create a mortgage market meltdown.

The practice of subprime lending has widespread ramifications for many companies, with direct impact
on lenders, financial institutions, and home-builders. In the U.S. housing market, property values have
plummeted as the market is flooded with homes, but lacking buyers. The crisis has had a major impact on
the economy at large. Rather than lending money for business growth and consumer spending, it forced
lenders to hoard cash or invest in stable assets. This contributed to a number of factors that led to the
credit crunch that occurred in 2007.

For the first time in decades, credit is extremely tight as the bursting of the housing bubble has spread
misery over Americas financial system. During the Summer of 2007, these new vulnerabilities of our
financial system became evident. Looser credit standards in the housing market, combined with an end to
rapid home-price appreciation, led to a significant rise in delinquent mortgages. In turn, this has
contributed to immediate and unexpected losses for investors and a reconsideration of the risk-reward
relationship, first in housing and then in all asset classes. It drove up demand for cash and liquidity and
restrained the pace of new lending and investment, which is necessary for strong growth to continue.
Investors shaken confidence in the housing market could possibly impact global markets, both short-term
and long-term.

For many years, Cleveland, Ohio was the sub-prime capital of America. Mortgage brokers focused their
efforts by selling sub-prime mortgages in working class black areas, where many people had achieved
home ownership. They were offered cash by refinancing their homes, but brokers often neglected to
properly explain that the new sub-prime mortgages would "reset" after 2 years at double the interest rate.
The result was a wave of repossessions that blighted neighborhoods across the city and the inner suburbs.
By late 2007, one in ten homes in Cleveland had been repossessed and Deutsche Bank Trust, acting on
behalf of bondholders, was the largest property owner in the city.

In 2005, sub-prime lending had spread from inner-city areas across America. During that year, one in
five mortgages were sub-prime and they were particularly popular among recent immigrants trying to buy
homes for the first time in the "hot" housing markets of Southern California, Arizona, Nevada, the
suburbs of Washington, DC, and New York City. These mortgages had a much higher rate of
repossession than conventional mortgages, because they were adjustable rate mortgages (ARMS). The
payments were fixed for two years, and then became both higher and dependent on the level of Feds
interest rates, which also rose substantially (see Figure below).

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Consequently, a wave of repossessions is sweeping America, as many of these mortgages reset to higher
rates over a two year period. It is likely that as many as two million families will be evicted from their
homes, as their cases make their way through the courts. The Bush Administration is pushing the
industry to renegotiate, rather than repossess where possible. Mortgage companies are being
overwhelmed by a tidal wave of cases.

The wave of repossessions is having a dramatic effect on housing prices, reversing the housing boom of
the last few years and causing the first national decline in housing prices since the 1930s. There is a glut
of four million unsold homes, which is depressing housing prices. Builders have also been forced to
lower prices to get rid of unsold properties. Housing prices are declining at an annual rate of 4.5% and
are expected to decline at least 10% by next year and even more so in areas such as California and Florida
(see Figure below).

The housing market crash is also affecting the broader economy. The building industry is expected to cut
its output by half and cause a loss of one to two million jobs. Many smaller builders will go out of
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Proceedings of ASBBS Volume 16 Number 1
business and larger firms are also suffering huge losses. The building industry makes up 15% of the US
economy, but a slowdown in the property market also hits many other industries.
No one is sure how long the slowdown will last. Many U.S. consumers have spent beyond their current
income by borrowing on credit and the fall in the value of their homes may make them reluctant to
continue this pattern in the future. One reason the economic slowdown could get worse is that banks and
other lenders are cutting back on how much credit they will make available. They are rejecting more
people who apply for credit cards, insisting on bigger deposits for home purchases, and looking more
closely at applications for personal loans.
In the U.S., many undergraduates take out federal guaranteed loans and cover their financial needs with
private loans from lenders, such as Bank of America, JP Morgan Chase and Citi-Group. During the
academic year 2005-2006, $17 billion in private student loans was used to finance higher education.


Banks have become reluctant to offer private student loans, because worsening credit conditions have
meant that they cannot package up the loans and sell them. Joe Belew, President of the Consumer
Bankers Association, said: Some of the banks are getting out. Part of the reason is that Congress has
cut the fees they could charge, making some loans pretty much unprofitable. Another reason is that they
cant securitize the debt.

The problems they have had with mortgage-backed debt are some of the same in student lending. We
have talked to some of the banks about this. Its a painful decision to pull out, because of the nature of
the clientele, everyone wants to be in the business of helping people get ahead, but at the end of the day
you still have to deliver value to shareholders. At the moment, its a fine line between hanging in there
and pulling out. Its a murky situation.

In March of that year, Iowa Student Loans said that it would soon stop offering private loans altogether.
The group, which made 29,000 student loans the previous year, said: This is really a reaction to the
economys recent situation, the sub-prime market in particular.

Several members of Congress have urged the Bush Administration to stabilize the market after the
National Association of Independent Colleges and Universities gave warning that student loans have
become far harder and costlier to obtain, since the credit crisis. In October 2007, as the credit crisis on
Wall Street was gathering pace, Congress introduced legislation limiting the returns that banks could
extract from student loans.

Anyone shopping for a home will feel the immediate impact of the new attitude among lenders, with no
documentation (no-doc) and low documentation (low-doc) mortgages becoming a thing of the past.
Lenders are demanding more traditional 10% to 30% down payments. It sounds extreme, but maybe not,
considering that mortgage giants Fannie Mae and Freddie Mac are hiking fees sharply for borrowers with
less-than-stellar credit scores, who put down less than 30% for a home.

Also suffering huge losses are the bondholders, such as pension funds, who bought sub-prime mortgage
bonds. These have fallen sharply in value in the last few months, and are now worth between 20% and
40% of their original value for most asset classes, including those considered safe by the ratings agencies.
If the banks are forced to reveal their losses based on current prices, they will be even bigger. It is
estimated that ultimately losses suffered by financial institutions could be between $220 billion and $450
billion, as the $1 trillion in sub-prime mortgage bonds is revalued.

The American people seem to be taking the burden of a weakening economy, a drastic credit crunch, and
a faulting housing market in stride. However, the overall impact on the U.S. economy and the global
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Proceedings of ASBBS Volume 16 Number 1
markets are yet to be determined. Economies worldwide are reporting losses caused by the drop in the
U.S. dollar. Consumers and lenders are well aware of their own financial difficulties. Yet, as credit rates
rise and with foreclosures becoming an all too common event, changes in the US economy having a
spillover effect on global markets.

The International Monetary Fund (IMF) released numbers estimating the world wide effect of the credit
crunch. The estimates show a $945 billion dollar loss on a global scale over the next two years. The IMF
predicts that the worst is not over just yet and that consumers and investors should prepare for a continual
weakening of the economy. Also, the IMF estimated that the housing market alone can see losses as high
as $565 billion. The IMF expects to see additional losses in other areas of the economy, which do not
necessarily have anything to do with the housing market. Loans that are tied in with credit cards can be
expected to see additional losses, along with the commercial real estate sector.

Two-thirds of domestic banks tightened lending terms between April and July 2008, for credit cards and
other consumer loans. That was up from roughly a third of banks tightening credit-card loans in the prior
three-month period, and almost half of banks tightening standards for other loans. Banks also are
increasingly raising minimum credit scores for consumer loans and lowering credit limits on credit-card
accounts.
The stricter terms in the sector could threaten consumer spending, which accounts for more than 70% of
U.S. economic activity, into next year. A weak labor market, high energy prices and the fading effect of
government stimulus checks are already poised to restrain consumers in the coming months.

The Fed survey, conducted in July and released in early August, found 60% of domestic banks expected
to tighten standards on credit-card loans in the second half of the year, and more than a third expected to
tighten those standards in the first half of next year.
While the latest tightening was sharpest in credit-card and other consumer loans, it also showed more
banks growing restrictive in their lending for mortgages and business loans. Banks had already
significantly tightened terms for those loans.
The credit tightening is likely to hit the battered housing sector further, weighing on home sales and
prices. About three out of four banks -- up from 60% in April -- said they tightened lending standards for
prime mortgages. Almost half said they would tighten further in the second half of this year, and a third
said they would tighten standards in the first half of 2009. About 85% of banks that originated
nontraditional residential mortgage loans tightened standards on those loans. Two-thirds of banks
originating nonprime loans expected to tighten further in the second half of this year (see Figure below).
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Proceedings of ASBBS Volume 16 Number 1

About 60% of banks reported stricter lending standards for medium and large size firms in the prior three
months. Roughly two-thirds of these firms said they were doing the same for small businesses as well, up
from about half in the April 2008 survey. Four out of five banks -- increasing 10% since April -- said they
increased the spreads between the loan rates and their cost of funds for large and middle-market firms,
while a slightly smaller fraction did so for smaller firms.
More than half of domestic banks said they expected to tighten lending standards to businesses in the
second half of this year, and a little less than half said they would do so in the first half of 2009. The
moves could restrain business investment even further in the coming months.


RECOMMENDED SOLUTIONS
Since the start of the mortgage meltdown, political heads and financial advisors have proposed many
solutions. These efforts are designed to address the instability of the financial market and to spur growth
in the U.S. economy. At the close of July, landmark housing legislation cleared Congress, allowing the
U.S. Treasury to gain unprecedented power over the next 17 months. The Treasury purchased majority
equity interest in mortgage giants Fannie Mae and Freddie Mac. The Federal Housing Administration
(FHA) was granted $300 billion in new loan guarantee authority. It was designed to help establish a new
limit for home prices and be a source of refinancing for households at risk of foreclosures.

Additionally, $15 billion in new housing-related tax breaks and almost $4 billion in aid was authorized to
help urban communities. These communities are often stressed by concentrated foreclosures in individual
neighborhoods. In the case of FHA, the bill has the potential to help as many as 400,000 at-risk
homeowners, but lenders must first agree to take losses on the loan principal before FHA can provide
refinancing. Only primary residences would be covered and homeowners must share any profit from the
sale of the refinanced home. Higher fees would be charged to establish a reserve fund to protect the
taxpayers in case of default.

Back in December 2007 presidential candidate Senator Barack Obama proposed tax breaks to help
millions of homeowners make their payments. This proposal was designed to provide direct relief for the
victims of mortgage fraud and counseling so homeowners could avoid foreclosure and opt to refinance.
He outlined a program to help make it easier for middle-class families, not speculators, to renegotiate or
refinance their mortgages.

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Presidential candidate Senator John McCain has rejected this aggressive government intervention in the
economic meltdown. He believes that there should be limited government assistance to the banking
system to prevent systematic risk that might endanger the entire financial system and the economy.

The credit crunch is a major issue confronting the American economy and global markets. Finding
solutions to such a major problem will require a comprehensive approach. These will include increased
roles for the Federal Reserve, Securities and Exchange Commission, the U.S. Treasury, Presidents
Administration, and Congress (House and Senate). To address the credit crunch problem, it would be
necessary to employ sound monetary and fiscal policy with monitoring and governmental oversight. For
instance, the last two investment banks left standing, Goldman Sachs and Morgan Stanley will now
become commercial banks, abandoning the investment-banking model that provided huge profits in
recent years but also brought the firms to the edge of oblivion. The legal shift puts the finishing touch on
the most powerful wave of change Wall Street has seen since the Great Depression.

Yet, there is no simple or one-size-fits-all solution. The goal should be to adopt a feasible plan of action
that will address the problem both short-term and long-term.





CONCLUSION
The U.S. credit crunch has negatively impacted the U.S. economy, U.S. financial market, and global
financial markets. If this issue is not immediately confronted, the short-term and long-term outlook will
be catastrophic. There is an urgent need to restore confidence of investors, consumers, the financial
community, and global markets.

This paper concludes that the severity of the U.S. credit crunch requires a comprehensive plan that will
reverse the current trend of skeptical lending practices. To spur the economy, lending institutions must
make funds available so businesses and consumers can increase their level of spending.


REFERENCES

All Financial Matters (2007). "Barack Obamas Answer to the Subprime Mess. Dec 9.
http://allfinancialmatters.com/2007/12/09/barack-obamas-answer-to-the- subprime-mess/


Cho, David, and Maria Glod (2008). "Credit Crisis May Make College Loans More Costly." The
Washington Post, March 3, A01.

CBS News (2008). "Congress To Grill Mortgage Executives. Feb 28.
http://www.cbsnews.com/stories/2008/02/25/business/main3871989.shtml#ccmm.

Goodman, Peter S (2008). "Credit crunch changes everyday life in U.S." International Herald
Tribunek, Feb 5.

Jagger, Suzy (2008). "US credit crunch hits education as banks abandon student loans." TimesOnline,
Mar 31.
http://business.timesonline.co.uk/tol/business/economics/article3649021.ece.

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Lerer, Lisa (2008). "McCain guru linked to subprime crisis." Politico, Mar 28.
http://www.politico.com/news/stories/0308/9246.html


McCormick, David (2008). "This Turmoil Shall Pass." Newsweek, May 12.

Rogers, David (2008). "Landmark housing bill clears Congress." Politico,
http://www.politico.com/news/stories/0708/12074.html


BBC News (2007). The US Sub-Prime Crisis in Graphics. Nov. 21.
http://news.bbc.co.uk/2/hi/business/7073131.stm


Blaine, Charley and Elizabeth Strott (2008). A new era begins for Wall Street. Market Dispatches,Sep.
22. http://articles.moneycentral.msn.com/Investing/Dispatch/market- dispatches-092208markets.aspx

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