Regulatory Review After the Credit Term Paper

  • Length: 15 pages
  • Subject: Economics
  • Type: Term Paper
  • Paper: #67604601

Excerpt from Term Paper :

292).

The Depression of 1893

Following hard on the heels of the depression that had taken place just two decades previously, the precise causes for this economic downturn remain unclear. In this regard, Steeples and Whitten (1998) advise, "There is no adequate account of the causes of the depression of 1893 -- 1897 or, by implication, of the crisis itself" (p. 6). These authors, though, cite fundamental shifts in demographics in the U.S., as well as innovations in technology and manufacturing that caused a reevaluation of traditional institutions and the role that the U.S. was going to play in the economic affairs of the world in the 20th century as contributing to this depression (Steeples & Whitten, 1998).

The "Great Depression" of 1929-1939

The stock market crash in 1929 is frequently cited as the precipitating factor for the Great Depression, but Rothermund (1996) emphasizes that there were other economic forces at play that fueled the fires as well. According to Rothermund, "This depression upset many assumptions concerning the working of market forces in the 'real economy.' Credit was suddenly contracted, prices fell to such an extent that the law of supply and demand seemed to be irrelevant the international exchange of goods dwindled and many nations returned to the policy prescriptions of the mercantilists who had interpreted trade as a zero sum game in which gains in one place must invariably lead to losses elsewhere" (p. 2). Citing the global implications of the Great Depression, Rothermund nevertheless places the blame for this economic downturn squarely on the United States: "All major factors contributing to the depression can be traced back to the United States of America: the handling of war debts, the sterilisation of gold, a deflationary monetary policy after an expansionist period, protectionism and the overproduction of wheat. All these factors were due to long-term developments, but they were accentuated by the sudden crash of the stock market in October 1929 which undermined the world credit system and thus was the proximate cause of the depression" (p. 48). The external causes of the Great Depression were amplified by various internal factors as well, including an economic situation that was marked by a highly disparate distribution of income, a concentration of capital and a paucity of further prospects for productive investments; in their place, there was an increase in speculation in the stock market that placed enormous strains on the system of financial intermediation that remained relatively disorganised and unregulated (Rothermund, 1996).

Sources: As indicated.

How Credit Crisis Began in Third Quarter 2007 and Precipitating Factors

According to an analysis by Pomerantz (2008), the credit crisis that has rocked the world's financial markets in recent months as a result of the subprime credit crisis in the U.S. banking industry began during the third quarter of 2007. The credit crisis that resulted was due, at least in some part, to the failure of governmental regulators to monitor the situation and take action to avoid the eventuality. In this regard, Thomas (2009) reports that, "Typically central banks regulate the availability of credit by raising or lowering interest rates and reserve requirements. The Federal Fund Rate is the rate that is mandated for short-term loans between banks to cover their minimum reserve requirements (or the amount of money they are required to have on hand)" (p. 2).

In those situations where the Federal Reserve ("the Fed) tightens credit, the effect on the economy would be to intended to increase interest rates as well as reserve requirements in some cases, thereby increasing the amount of money a bank is required to keep on hand and as well as the costs associated with borrowing money in order to satisfy that objective; these requirements combine to minimize the total amount of money the bank is able to loan (Thomas, 2008). According to Thomas, though, the Fed failed to act in a meaningful fashion in the months leading up to the credit crisis and by the time it realized what was happening, it was too late for it traditional credit management approaches to positively affect the situation. In this regard, Thomas emphasizes, "To loosen credit, [the Fed] would do the reverse. In a credit crisis, however, the connection between interest rates and the availability of credit is weakened or broken by other factors, curtailing the ability of a central bank to intervene" (Thomas, 2009, p. 3).

As noted in the background and overview above, credit crises are typically the result of combination of factors, but in some cases, such as the Great Depression of 1929 (see further discussion below in Table 1), the crisis may be primarily caused by a single event. In still other cases, a credit crisis can result when a national government seeks to tighten credit by a small amount, but based on the exigencies that exist at the time, this may be sufficient to cause a larger financial crisis. In this regard, Thomas advises, a small increase in interest rates may "precipitate one through an overzealous hike in interest rates and reserve requirements. However, the main culprits are usually either a steep decline in the value of assets used by banks to secure collateral, an increased perception on the part of the financial system as a whole that particular banks or banks in general are at risk of insolvency, or both" (Thomas, 2009, p. 3).

In the most recent instance, a common theme that quickly emerges from the literature and analyses is greed on the part of lenders and mortgage companies seeking to maximize their profits while the getting was good. These factors are frequently the end result of a long-term period of speculative and ill-conceived lending practices and financial institutions and their stakeholders experience the brunt when the subprime or speculative loans are not repaid (Thomas, 2009). Moreover, the same type of panic that causes runs on banks can cause multiple financial institutions to experience these adverse effects, even those that may have practiced more stringent loan requirements. In this regard, Thomas notes that, "As the extent of the bad loans become known, a crisis of confidence in one or more bank arises. Banks in general will then reduce the availability of credit. They will stop loaning each other money to meet reserve requirements or for other purposes, because no one really knows how bad a bank's balance sheet will be six months from now" (2009, p. 4). In addition, many financial institutions may adopt a "wait and see" attitude to see which way the economic wind is blowing before the return to business as usual. As Thomas emphasize, "Banks will also restrict loans to the public and to commercial enterprises in order to retain capital and shore up their balance sheets, and also because of an irrational 'snapback' response, from reckless lending to overly conservative lending" (2009, p. 5).

The basis for current credit crisis can be directly traced to the 2006 subprime mortgage crisis that rocked the U.S. And then the rest of the world. The years prior to the current economic fiasco were marked by greedy mortgage companies seeking to capitalize on the explosion in the U.S. housing industry, and real estate values skyrocketed in a number of regions of the country to levels that were unrealistically high (Thomas, 2009). Mortgage companies ruthlessly competed with each other to make as much money as possible while the getting was good and these practices, combined with the unsustainably high levels in the real estate market finally broke the camel's back. In this regard, Thomas emphasizes that:

Reckless lending to prospective home buyers grew to a widespread practice, injecting more capital into the real estate bubble and driving home values ever higher. In the meantime, a booming business in mortgage-backed securities had grown up. These securities were based on the payments from a package of mortgages bundled together, and traded around the world as foreigners invested in the U.S. housing market. (2009, p. 6)

The resulting downturn in the housing industry, together with interest rates that continued to creep upward, resulted in the death-knell of the real estate boom. Many Americans found themselves holding mortgages for homes that were not worth nearly as much as what they owed on them, and foreclosures also skyrocketed as mortgage holders were unable to meet their obligations and the banks were left holding the empty bag. This trend ultimately affected the value of the mortgage holders and a domino effect resulted that has since extended around the world. The current credit crisis defined above has all of the hallmarks needed to satisfy this operationalization. According to Thomas, "As things became worse, banks became increasingly suspicious of each other, as no one could be sure what they value of these mortgage-backed securities were, or just how many of these 'toxic' securities were held by their colleagues" (2009, p. 5). As noted above, many credit crises are the result of a combination of both internal and external factors, but in the instant case, there…

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