Credit crunch

Credit crunch started as a US mortgage problem and it rooted by the falling house price.

Between 1997 and 2006, American house price rose by 124%, while prices in Britain went up by 194% and in Spain is 180%. Average prices rose steadily during 5 years and peaked in mid 2006. Ignoring other risks, People had thought that housing price would increase forever. Banking was so rich and it made easier for people who did not have money to make a loan to buy houses in hand. That is the reason why Banker set up a low interest rate therefore all people, including the poor were afford to buy a house. “Lenders relaxed their standard and borrowers signed for loans that they couldn’t afford” (Zuckerman, 2007).

However, the fact is not as people expected. Sales of new homes are down 22% after 1 year. It makes the loans are more valuable rather than the property. Due to the credit crunch, market losses in 2008 more than $6 trillion, average house prices had fallen back to 170%, the Dow Johns is off by around 40% from its Oct. 8, 2007, home values continue to seek a floor (Roybal, 2008).

The overconfidence of Banking led to serious situation of credit cruch, with the huge losses of billions of Dollars in many giant organizations like Northern Rock, Bear Stearns or even the collapse of Lehman Brothers.

Lehman Brother had both residential and commercial mortgage risks, which lead to a negative performance of the firm in 2008. The firm reported a significant losses during the second quarter of 2008. Its shares fell by 45% on the 9^th September, 2008 and went bankruptcy on 15^th September.

To cope well with the crisis, the function of Central Banks is very essential to solve the mess. Two clear tasks for Central Banks are keep the financial system working smoothly by ensuring that the banking system has enough liquidity. If the system gets jammed, credit will become scarce and market interest rates will rise--and the economy may become jammed too. On the other hand, pumping in liquidity too eagerly may create moral hazard: if banks think that central banks will bail them out come what may, they will be more inclined to lend recklessly.

Central banks' second function is macroeconomic stabilization, setting interest rates to keep inflation in check without causing the economy to stop and start. Because a credit squeeze raises market interest rates, it will slow the economy down. On the other hand, if a central bank responds by cutting official interest rates too drastically, it may push up inflation, or cause expectations of future inflation to rise. The medium-term goal of price stability might be put at risk.

In seeking to resolve these dilemmas, central bankers have tried to keep their two tasks separate. That is a hard distinction to sustain. Although liquidity crises are short-term emergencies and macroeconomic stability is a medium-term goal, locked credit markets soon have wider economic effects (The Economist, 2007).