The Credit Crunch of 2007-2008 Essay Example | Topics and Well Written Essays - 1000 words

The Credit Crunch of 2007-2008 - Essay Example As shown in the diagram underneath, this led to rising housing prices since decades. In 2000, the rate of increase of house prices was rising at unsustainable levels, much faster than they had in the last decade. Sub-prime mortgages (mortgages to high risk customers) began to rise due to availability of cheap credit (Mizen). The low interest rate environment stimulated upsurges in mortgage backed financing and hence considerable increases in house prices. It encouraged investors (financial institutions, such as pension funds, hedge funds, investment banks) to design instruments that offer yield enhancement such as subprime mortgages. The bullish attitude of Wall Street led to creation of complex structured products such as collateralized debt obligations (CDOs) and a lot of repackaging of high-risk mortgage backed securities. The credit and house price bubble led to a real-estate boom and eventually to a surplus of unsold homes, which triggered U.S. housing prices to peak and before declining and bursting in mid-2006. Subprime borrowers began to default on their loans as real estate prices decreased further. The default on a significant ratio of subprime toxic assets produced cascade effects in financial markets via the securitized mortgage derivatives into which these mortgages were bundled, to the balance sheets of investment banks and hedge funds. The vagueness about the value of the securities collateralized by these mortgages spread chaos and concern over the soundness of loans for leveraged buyouts. That led to the freezing of the interbank lending market in August 2007, collapse of key financial institutions such as Lehman Brothers and triggered the credit crunch crisis. 2. Economists classify macro-economic indicators as leading, lagging, or coincident. Define each classification and give two examples of each, relating them to the recession that began in 2007 and the recovery that is now under way. ? Economic indicators are periodical statements by the government and private institutions that describe the health of a country's economy. Economist classify these indicators into lea ding, lagging or coincident kind that are described below in detail: Leading Indicators: Leading indicators are economic indicators that predict future events. They are foreign exchange indicators that change beforehand the change in the market or economy has occurred. Examples of leading indicators may include bong yields, inventory variations, stock prices and insurance claims. Economic establishments and central banks study leading indicators in expectation to fluctuations in expected interest rates. A forex-leading indicator is a pointer that advises the trader to buy or sell before a new trend in the market commences. Leading indicators, however, are difficult to recognize and could lead to misleading results or interpretations if not analyzed by an experience trader. Two examples leading indicators for the financial crisis of 2007 are stock prices (500 common stocks) that reduced by 8% in 2007 (The Conference Board) and Building permits that reduced by 16% leading to a 40% dec line in US Home Construction Index. Lagging Indicators: Lagging indicators are indicators that follow an economic event. These indicators usually exist three to twelve months after the economy. Lagging economic indicators are the confirmation to outline the peaks and troughs that