Credit Crunch And Its Effects On The Economy

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The world’s economy has been changing enormously in the past 10 years due to the different reasons and causes. Credit crunch in 2007 was one of the unforgettable situations which has been considerably affecting the global economy until now. Great recession started from the US and hit many countries around the world as it is the biggest financial market. Credit crunch refers to a sudden shortage of funds for lending, leading to a resulting decline in loans available (Pettingger, 2011). Credit crunch was one of the ‘cruel’ outcomes from the 2007 subprime crisis in the United States, when most of subprime borrowers defaulted and many commercial and investment banks in the United States have gone bankrupted as they failed to receive the loan…show more content…
On the other hand, when a bank lends out to a person with credit deficiency or a person below a certain amount of income, ‘credit risk’ then appears in this situation. Credit risk would appear when banks lend to unqualified borrowers who have low potential and possibility to pay back loan. Credit risk arises from the potential that a borrower or counter-party will fail to perform on an obligation. For most banks, loans are the largest and most obvious source of credit risk (Federal Reserve n.d.). As a result, the higher the interest rate banks will demand as a cost of debt when banks perceive the higher credit risk. Credit crunch in 2007 occurred due to the perceived ‘credit risk’ in both inter-bank lending and bank-to-customer lending as I will explain in the next part. Bank-to-customer lending was the main cause of credit crunch as the recession came from the inattentive lending from commercial banks at that time. It started years before the crisis when a stream of mortgage lending was sent the America and those loans were lent out to the “subprime” borrowers who have poor credit, low income and high risk to default. Subprime borrowers have are committed to pay back loans and interest as stated in the agreement. These mortgages has been pooled and turned into Mortgage-Backed Securities (MBS) or Collateralised Debt Obligation by
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