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The Credit Crisis: Economic Downturn by Credit Squeeze, Provision of Doubtful Debt and Bankrupcies

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The credit crisis is referred to as economic downturn by credit squeeze, provision of doubtful debt and bankruptcies among others. (IMF, 1998) Credit crisis is known as a credit crunch, it is an extension of recession. According to the Ocaya (2012), Credit crisis is a sudden shortage of loan and tightened the requirement of economy and society needs of getting loan from financial institutions. In such situation, lender started keeps the cash and stop lending money because they are worry about a large of debtor bankrupt and mortgage defaults. Lender had adjusted the interest rate of borrowing to unaffordable rate. Credit crisis decrease the total demand and fall in supply, therefore, it constrains the growth of the economy. The credit crisis is begun in the early 2006 when several events relating the financial system went wrong in the United States of America. The factors leads to credit crises are complex with varying weight.
Diamond and Rajan (2009) found that investment misallocation is the proximate cause of the credit crisis. In response to the crisis, corporations, governments, and households reduced on investment and decreased consumption. Federal Reserve provides an adaptable monetary policy to guarantee that the world did not suffer in deep recession. The low interest rates increase a large of demand of housing. House pricing become more value for sale and rent in many countries. Credit crisis is initially occurred in U.S because the financial invocation of U.S. Hence, there is more marginal-credit-quality buyer into the market.
The international investor is found it difficult to hold the house mortgage directly because the uncertain credits qualify has a higher rate of default than arm’s-length conservative investo...

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...nt interest. The company wanted to invest extra mortgage-backed securities with $100 million and get 7 percent interest. Then the company borrows a short term loan for $100 million at 4 percent interest. The leverage of company is $10 in a debt for every $1 of equity. The return on equity would be 3.7million on equity of $10million. Hence, investor was willing to obtain short term loan in the bank while they would be given a higher premium. Diamond and Rajan (2009) suggest that the short term debt is seemed like cheaper compared to the future illiquidity’s cost and the long term capital. Therefore, heavy short term leverage market becomes more common in the market of bank capital structure. While the risk-averse banker is unlikely bear the excessive risk, the illiquidity’s costs would be more salient. This had enforced the market into a heavy capital structure.
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