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The Credit Crisis (Credit Crunch)

How the Subprime Mortgage Crisis turned into the Credit Crisis

Right after the bursting of the US housing bubble, when people started to default on their subprime and adjustable rate mortgages in large numbers, the press talked about a "subprime mortgage crisis". You may have noticed that this term is no longer used. At some point it got replaced by the term "credit crisis" (also known as "credit crunch" or "credit squeeze").

When did the subprime mortgage crisis turned into a credit crisis and how did this happen?

The world lost a lot of money. Actually, it still doesn't have clear idea how much money it really lost. What happened is that investment managers kept investing in mortgage-backed CDO's thinking that they were as safe as government bonds, thinking that it was like putting trillions of dollars in a savings account. Yet, last time they checked this "account" half of the money was gone, never to come back.

And because of these tremendous losses, now investment managers have completely changed their way of thinking. In addition to the lost money, they also lost their obsession with getting bigger profit. Now they just want a safe, really safe place for their money. The return on capital is no longer a priority; it is the return of the capital itself that matters.

And all of a sudden, the US government treasury bonds, which are near their historic lows of 1 and 2% but safe, are exceptionally acceptable and even attractive.

Everyone avoids even the slightest hint of risk. Even the big financial institutions. Actually, especially the big financial institutions. Since the confidence in so many financial institutions was shaken banks avoid engaging in any interbank lending activity, mistrusting the solvency of other banks.

And that is the point where the subprime crisis crossed the border and turned into a credit crisis.

The Paralysis of the Capital and Money Market

The constantly increasing number of subprime mortgage defaults led to the reappraisal of all types of risky assets. In the mid 2007 the ratings agencies downgraded from AAA to A+ (that is four notches down) many assets that were backed by subprime residential MBS.

The effect of this act was first felt in the capital markets.

Last few years nearly half of the growth in the commercial paper market was due to the expansion of mortgage related asset-backed commercial paper (ABCP) issuance. The issuance of ABCP at short maturities was used by conduits and SIVs to fund the purchases of CDOs and other securitized assets. The ABCP needed to roll over periodically which put pressure on banks' liquidity.

However, since investors began avoiding the purchase of short-term paper in the capital markets, after the mid 2007 the ABCP issuance was sharply reduced. In September 2007, all types of asset-backed securities and CDOs suffered a sharp drop in the issuance. Investors began to realize that these assets were much riskier than what they originally thought. The insurance for covering default risk using credit default swaps (CDS) became very costly which further made asset backed securities issues more difficult to sell.

As a result, capital markets basically got closed for the risky asset backed securities.

The financial institutions, which depended on the markets for funding, were adversely affected. Commercial banks that relied on short-term commercial paper could no longer obtain the necessary funds to provide new loans. Investment banks that needed short-term paper in order to buy asset-backed securities, on the other hand, could no longer make payments when they were due.

The dislocation in the capital and money markets led to a number of sore events such as the threat of bankruptcy for Bear Stearns and its subsequent sale to JPMorgan Chase. Large investment banks, such as UBS, Merrill Lynch, and Citigroup had to pay the price as the substantial losses were revealed and their CEOs had to resign.

In September 2008 the failure of the Lehman Brothers investment bank and the threat of collapse of AIG nearly froze the market entirely, which could paralyze the financial system.

The subsequent uncertainty which banks would suffer next and what the exact scale of the losses was, affected the interbank markets. Being afraid of the scale of the counterparty risk banks stopped lending to other banks.

Consequences

The freezing of credit all around the world is something the world hasn't witnessed before, at least not on this scale.

Companies that need credit to survive are being shut down. It leaves many people without a job and unemployment keeps growing up.

The number of bankruptcies keeps rising and there are practically no new businesses or jobs opening.

It is much harder to borrow money to buy a house. It is hard to find the funding to build a factory or renovate and buy new equipment for an existing one. Even student lending suffers.

And the storm hasn't subsided yet.

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