The aim of this essay is to analyse the recent phenomenon of the "credit crunch" and its effects on businesses and ordinary people. Different theoretical perspectives will be drawn upon to investigate the current financial crisis. The American economy will be used as a framework for critically analysing the issue, as The Global Financial Crisis (GFC) sometimes referred to as the Great Depression 2.0, from its origins in the subprime loans of the United States to affecting almost every nation in the world. Finally a variety of measures that governments have taken are evaluated on combating the associated economic downturn by unveiling their fiscal strategies and stimulus packages. The issue seems to be how did we get here?
This whole financial crisis started in August 2007, when property prices in America started to fall, revealing certain uncreditworthy or so called "sub-prime" homeowners that were given mortgages on very relaxed terms by the financial companies and banks. Moreover, The Federal Reserve played a key role in encouraging this mortgage innovation (Gross 2007:139). These subprime loans were packed together as Collateralised debt obligations (CDOs). These CDOs were complex securities that provided high returns in the prevailing market conditions, and effectively hid the below par collateral that was backing the security, they were even rated 'AAA', the highest possible by credit rating agencies such as Moody's(Rose and Hudgins 2008:285). Hence, these financial instruments were deemed risk free and traded in financial markets extensively, since they were back by an assest i.e. land which traditional always had a rising value (Gower 2006). Bear Sterns and Leman Brothers, were the most heavily involved in mortgage backed securities (MBS), and as the investors extracted its money, they were essentially insolvent. The loss of just two institutions was not the issue, but the universal risk it posed; threatened to bring other firms down and the widespread use of Credit Default Swaps, ensured the consequences of a bankruptcy would be far reaching in the economy (Rose and Hudgins 2008:299). As such the Federal Reserve and the Treasury were forced to bailout firms, to avoid a systemic solvency situation.
As the financial contamination spread and the apparent counter party default risk amplified, demand for liquidity went up. This led to a situation of credit crunch i.e. reduction on availability of credit or conditions required to obtain a loan. This is evident in the dramatic increase in the corporate bonds spread over government yields, in the United States (Appendix 1.1) and a similar situation occurred in the financial markets around the globe.
The Financial crisis resulted in reduced credit flows to consumers and businesses which when combined with significant declines in major share indexes, house prices and high unemployment rates, this led to resulting net loss of wealth that reduces the appetite of consumers and businesses to consume and invest. This can be seen in drop of in consumer and business confidence in the world's major economies (appendix 1.2).
The Credit Crisis has made the situation difficult for both the lenders and borrowers. Many banks and financial institutions are reluctant to participate in intra-bank loans with each other. This means that lenders are finding it more difficult and more expensive to raise the finance that they need to fund t