Effect of financial crisis on consumer finance - Essay Example

? Effect of financial crisis on consumer finance College Introduction The recent subprime mortgage crisis affected many facets of the global economy. Many countries recorded decline in economic growth as their access to loans declined. Since the subprime crisis affected both the economic growth and liquidity levels in financial institutions, it is then likely that it impacted adversely on the lending market, including consumer finance market. This study presents the diverse consequences of the mortgage crisis to the global consumer markets. The main aim is to prove that recent mortgage subprime crisis significantly reduced the ability of financial institutions to extend consumer credit, reducing their standard of living. Subprime mortgage crisis The recent subprime mortgage crisis was as a result of lending to people who were not qualified for such loans. Behind such crisis financial instruments and institutions are often the key drivers. The mortgage crisis was a complete loss of business by financial institutions which had enjoyed low risk lending to the mortgage sector for centuries. The complexity of financial instruments that were involved in the crisis deepened the effects of subprime mortgage crisis (Ghoshi, 2006). The subprime crisis led to a number of problems in America’s as well as the global financial system. As home owners defaulted on payment of their mortgage costs, financial institutions were drained off liquidity necessary for lending. It also led to reduction of revenues generated by many financial institutions as well as other organizations whose operations were adversely affected by the turbulence on financial markets. This led to decline in economic growth rate, forcing the United States of America and United Kingdom of Britain to record negative gross domestic product growth. Ben Bernanke, a leading economist and the Chairman of Federal Reserve in US indicated that the Federal Reserve policies are not the main cause of the crisis and its subsequent reduction in access of consumers to credit. He noted that while the US financial policies are partly to blame, other countries policies such as currency management policies in China make the global economy more prone to financial crisis (The Washington Post, 2011). In a debate moderated by the char of economics department in Harvard University, important facts about the recent global financial crisis were revealed. The people involved in the debate were economics professor Jeremy, and Professor Rogoff, both from the institution and a history professor Nial. Roggoff noted that while the lending policies were lax, the outsider attitude of customers equally catalyzed the 2007/2008 global financial crisis. This led to low cooperation between financial institutions and their mortgage customers, accelerating the rate of the 2007/2008 global financial crisis. Roggof had predicted the crisis one and half years earlier (Crimson Staff Writers, 2010). Analyses The subprime crisis significantly reduced the willingness of financial institutions to extend credit to consumers. Such institutions withheld liquidity as panic and loss of confidence spread in the financial sector. This led to fall in consumer lending since 2007 to 2008 (Bricker et al, 2012). The value of loans issued in US in 2008 last quarter of the year was almost half of the value of loans issued during the same period in the previous year. Lending declined across all credit lines, including that of short term and consumer lending. Majority of the banks that were vulnerable to bank run during the crisis cut on their spending. Banks with average level of deposits to assets cut on their loan originations by 36% between August and December in 2008 as compared to the same period in the previous year. The recent subprime mortgage crisis resulted to economic recession. During economic recession, the demand for loan able funds decline. This was evident in 2008 to 2009 when business activity declined and unemployment shot up in many countries. This reduced the confidence of consumers about their future level of income, reducing their demand for consumer financing. Decline in loan supply was evident in economies as a result of the subprime mortgage crisis. Consequently, the per capita income held by households reduced significantly. High household income levels build the confidence of financial institutions on their customers. During the subprime crisis, low house hold income thus kept such institutions of the consumer finance market or reduced their level of participation in issuance of loans to this market. One of the main sources of liquidity necessary for lending is customer savings. As income levels declined in 2007, savings equally declined. Between 2007 and 2010, the number of savers declined (Bricker et al, 2012). Although some customers who were not involved in saving started saving for precautionary measures, this did not stop the fall in saving rates in US as well as in other markets. This resulted to lower level of liquidity that was held by organizations. This reduced the supply of loans in the market, resulting to lower access to consumer finance by customers. Financial institutions often feel secure by lending to wealth people of good character. As a result of the subprime mortgage crisis and subsequent drop in business activities and household income levels, the wealth of many families declined. This reduced their attractiveness as borrowers of consumer finances. This on the other hand led to the fall of loans extended to such families by financial institutions (Bricker et al, 2012). It is also worth noting that bonds are a major source of liquidity to financial institutions. Between 2007 and 2010, bond ownership by consumers declined in United States of America. Reduction in consumer savings in bonds reduced the level of liquidity held by financial institutions. This consequently led to decline in their ability to issue consumer loans. This led to decline in consumer loans extended to consumers over the same period of time. Bricker et al (2012) indicates presents a survey of financial market results presented in Federal Reserve Journal. They carried out research the credit experiences of small business owners. From their interview, they found that 25.1% of the loan applicants, who were habitual borrowers in the period preceding the crisis, had been turned off as they applied for loans, or had their loans reduced below their intended figures. On the other hand, 7.5% of those who were interviewed indicated that they were not applying for loans in fear that their application would be turned down. Those whose applications were rejected as well as those who received reduced amount of credit, two of the reasons that they offered in an explanation of the same was business or personal issues (Bricker et al, 2012). This indicates the way in which the subprime crisis reduced access to consumer finance in US as well as in other countries that were hard hit by the effects of the subprime mortgage crisis. Various scholars have attributed individuals’ bankruptcies to the recent subprime financial crisis. Such bankruptcies emanated from pressures such as unemployment, layoffs and pay cuts. Edmonds, Leo and Judith (2010) noted that a rise in the level of unemployment by 1% results 320 bankruptcies per state’s quarter year. Taking the month of December, the Bureau of Labor Statistics indicates that US unemployment levels shot up from 5.0 in 2007 to 9.9 in 2009. This implies a significant rise in bankruptcies of individuals. Bankrupt individuals would hardly access credit from financial institutions. Evidence also shows that drop in per capita income by $1000 would result to rise in the level of individuals bankruptcy to 133 people per state in every quarter of the year in the United States of America. Reduction in per capita income as a result of the recent global financial crisis thus led to reduction in the level of consumer lending in US as well as in other countries that were hard hit by the crisis. As a result of the subprime mortgage crisis, the level of revolving credit declined significantly. Between august and October in 2008, revolving credit level in US declined by 39%. Revolving credit facilities offers individuals as well as firms an opportunity to borrow money to a certain level and interest (Ivashina, and Scharfstein, 2008). Reduction of revolving credit whose maturity dates were over one year surpassed the decline on less than one year revolving credit. As financial institutions tried to recover much of their liquidity tied up in loans as fast as possible, they ended up causing a decline in long term revolving facilities (Ivashina, and Scharfstein, 2008). Lending of new loans in 2007 exceeded new loans developed in 2008. This was as a result of the increase in risk associated with such loans as the repayment ability of many consumers dropped. The crisis further led to decline in demand for syndicated loans. By May 2008, the lending level had declined sharply by 38% as compared to the earlier credit boom peak that triggered the subprime mortgage crisis. This significantly lend to reduction in spending and increased credit constraints (William, Liran, & Levin, 2009) The subprime mortgage crisis resulted to high level of losses in consumer banking. It is worth noting that majority of banks engaging in consumer finance are also involved in other forms of lending. Consequently, decline in liquidity due to the failure of home owners to pay their loans led to loss of high level of liquidity in various banks. This reduced their ability to extend loans to consumers. For instance, West LB bank, in Germany, had bad assets amounting to 23 billion deutschmarks by the close of 2008. The bank had no option but to absorb the losses and pass it to shareholders. Nevertheless, during the subprime mortgage crisis, bigger banks were more willing to extend loans to consumers than smaller banks. This was as a result of the fact that small banks were harder hit by the effects of global financial crisis as compared to bigger banks. Bigger banks equally tended to have more cash assets as compared to small banks. During this period, banks reduced their lending with diverse reasons. Such reasons include their desire to enhance their liquidity as well as their desire to reduce the portfolio at risk. Smaller banks tended to be more inclined towards liquidity preservation rather than reduction of risk in their portfolios. While the above presentation has focused on the supply side of consumer finances, the subprime mortgage crisis equally affected the demand for consumer finance. Consumers who were borrowers of banks that were hit by the crisis as well as those who that were hardly affected by the crisis recorded decline in the number of loan applications (Puri, Rocholl, and Steffen, 2010). Loan applications declined in financial institutions after August 2007. Even in countries that were less affected by the crisis, there was a general decline in the number of loan applications in such countries. There was a general decline in the number of loan applications in Germany in 2008, although the country was yet to experience the effects of the crisis. This indicated that even in countries where the crisis was yet to have full effects, borrowers had anticipated the economy and their purchasing power to deteriorate. Since income levels acts as a catalyst for consumer finance, anticipation of deterioration in income levels was thus an important explanation to such behavior of borrowers in Germany (Puri, Jorg, and Steffen, 2010). The mortgage subprime crisis was attributed to poor lending practices. This led to increase in the level of scrutiny of customers’ creditworthiness in after the crisis set on. Customer relationships with banks emerged as a key determinant of whether they would be offered consumer loans or not. Nevertheless, for loans that were secured via collaterals, the focus on such relationships was low. Relationships were of low value when it comes to mortgages. Puri, Rocholl, and Steffen (2010) equally indicated that banks that were hard hit by the effects of subprime mortgage crisis cancelled loans more often than banks that were less affected. They equally indicated that relationships were of immense value even in the supply side of the loan. Due to the low liquidity in financial institutions, they increased their marketing strategies with an aim of enticing consumers to make deposits in order to enhance their liquidity. The subprime mortgage crisis had devastating effects to consumers especially those that collapsed as a result of the crisis. Loyal customers with high credit ratings in such institutions were forced to start rebuilding their ratings in other banks. This delayed their access to credit until the relationship with such firms was cemented. One such firm is the Washington Mutual Bank. The organization had acquired over a dozen bank and non-bank financial institutions between 1196 and 2002 (Levin, 2012). Nevertheless, as the crisis set on and ratings on mortgage securities got down rated, the success of the organization was curtailed, forcing it to close down by 2008. Such failure reduced access to credit by customers, before they could adjust to other financial institutions. As a result of the subprime crisis, access to liquidity through securitization of mortgages was significantly reduced (Diana, and Susan, 2009). Reduced rating on mortgage securities made them less attractive in the market as opposed to the credit boom period. This reduced the ability of banks to diversify income from securitized mortgages in consumer finance. My opinion I am convinced that the subprime mortgage crisis adversely affected the market for consumer finance. It not only led to reduction in supply of funds in the market, but also a decline in demand for consumer loans. Such a decline in demand for loans was as a result of reduced creditworthiness of individuals as their incomes reduced. Even in countries where the effects of the subprime mortgage crisis were minimal, change in consumer finance market was evident, as borrowers anticipated the crisis to spill over to such countries over time. The crisis led to reduction in deposits as well as savings, resulting to low level of liquidity in financial institutions. The crisis has increased credit constraints to consumers. This reduced the ability of such institutions to issue loans. This has forced consumers to cut on spending, reducing their standard of living. Works cited Bricker, J. et al 2012,’ Changes in US family finances from 2007 to 2010: Evidence from the survey of consumer finances,’ Federal Reserve Bulletin, Vol. 98, no. 2, pp.1-80. Diana, F., & Susan, L 2009, ‘The credit crunch and the real economy.’ McKinsey Quarterly, Vol 9, no. 1, pp. 30-31 Edmonds, T., Leo, S., & Judith, S 2010, ‘Consumer credit: The Next shoe to drop or a bullet dodged.’ Journal of Legal, Ethical and Regulatory Issues, Vol. 13, no. 2, pp. 117-128 Ghoshi, S 2006, “East Asian finance: The road to robust Markets,” Retrieved 14 April 2013, http://books.google.co.ke/books?id=NrvBmZ70Vf0C&printsec=frontcover&dq=Ghoshi,+Swati.+East+Asian+Finance:+The+Road+to+Robust+Markets.&source=bl&ots=tyGJvvfThP&sig=otBVXqrWFa1sQEjCC-lvZRTYeeQ&hl=en&sa=X&ei=p7lAUNXCGOTS0QXGw4CAAg&redir_esc=y#v=onepage&q=Ghoshi%2C%20Swati.%20East%20Asian%20Finance%3A%20The%20Road%20to%20Robust%20Markets.&f=false Ivashina, V., & Scharfstein, D 2008, Bank lending during the financial crisis of 2008. Harvard Business School, UK. Levin, C2012, “Wall Street and the financial crisis: Anatomy of a financial collapse. “ Retrieved April 14, 2013 from http://books.google.co.ke/books?id=WsAn87c05-oC&pg=PA54&lpg=PA54&dq=low+accces+to+laons+during+subprime+mortgage+crisis&source=bl&ots=f5I3mFg0T2&sig=2EipyrPyjvUejvL5mX8HE2q7LTg&hl=en&sa=X&ei=xrpAUOSqFOab1AXX54HgDA&redir_esc=y#v=onepage&q=low%20accces%20to%20laons%20during%20subprime%20mortgage%20crisis&f=false Puri, M., Rocholl, J., & Steffen, S 2010, Global Retail Lending in the aftermath of the US financial crisis: Distinguishing between supply and demand effects. Duke University, North Carolina Crimson Staff Writers 2010,” The Harvard Crimson.” Retrieved 14, 2013, http://www.thecrimson.com/article/2010/2/12/ferguson-economic-panel-rogoff/ The Washington Post 2011, “Fed chairman Ben Bernanke says US policy isn’t causing Financial Woes.” Retrieved 14, April, 2013, http://www.washingtonpost.com/wp-dyn/content/article/2011/02/18/AR2011021807046.html William, A., Liran, E., & Levin, J 2009, ‘Liquidity constraints and imperfect information in subprime lending.’ American Economic Review, Vol 99, no. 1, 49-84 Read More