Research Effects and Causes of Credit Crisis in the USA (Essay Sample)

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Finance week 7 paper
According to Mishkin, (115-130), the credit crisis is a financial period that is characterized by an abrupt decrease in availability of credit which is usually in terms of loans or similarly as an emergence of strict and undesirable regulations and conditions towards the acquisition of credit facilities by individuals and private investors. The credit crisis is in most cases referred to as a financial crisis. Credits in form of loans offered generally by commercial banks and other money lending institutions in the United States of America are described as high-risk loans which eventually leads to default. This means the borrowers who are mainly individuals and private investors fail to repay their loans to the money lending firms such as the commercial banks. Consequently, the failure of loan repayments to be made causes credit crisis or the financial crisis. The effect of the credit crisis is termed to be significant since it leads to a serious financial loss to the financial institutions and losses to private investors which in turn reflects as consequences to the national gross domestic product and the productivity of the country in the service industry sector, especially the banking sector. Charging of low-interest rates towards high-risk loans without any form of substantial collateral to mitigate the risk associated with the loans advanced to clients and incorrect and ineffective loan rating systems which do not account correctly for the risk associated with the loans are some of the crucial main causes of a credit crisis. Financial institutions at early stages of loan advancement to client charge minimum interest rates to attract loan borrowers. However, they later realize the payments being made are low and they tend to increase the rates, this becomes more of a burden to the borrowers which finally results to loan defaults. This has a serious effect of slowing down economic growth. The United States national treasury and the Federal Reserve has been largely involved in formulating mechanisms to adequately deal with the credit crisis. This essay will critically analyze the various forms in which the national treasury and Federal Reserve is involved in credit crisis situation. It will also outline the advantages and problems associated with the treasury and Federal Reserve involvement in a credit crisis. (Mishkin, 115-130).
The United States of America department of the treasury was established in 1789, it is commonly mandated to administer the collection of taxes and effective management of government resources and revenue to promote its economic growth and stability. Department of national treasury makes this possible by ensuring sound, safe and secure administration of the USA financial markets in relation to other international financial markets globally. On the other hand, the Federal Reserve serves as the United States of America central bank which was established in 1913. Its main function is to formulate and guide implementation of monetary policies to ensure healthy financial systems and maintain the economic value of the American currency. These two institutions usually interact while performing their roles. One of their main function is proper and accountable evaluation and monitoring of the credit situation. Their involvement in issues concerning credit matters is significant in ensuring that the situation is controlled and monitored sufficiently. (Meltzer, 11-17).
Firstly, the role of the Federal Reserve as the lender of last resort is very crucial in controlling financial crisis situation. Lender of last resort means that the Federal Reserve comes in to lend money to financial institutions when they are faced with credit crunch and depositors are flocking the bank to make withdrawals since they fear the bank would eventually collapse and they lose their deposits. Federal Reserve being the lender of last resort creates confidence to private depositors that even if the financial institution is facing a cash crisis, the Federal Reserve can come in and bail them out of the crisis. This prevents the depositors from flocking the institutions to withdraw their deposits which could have led to more financial crisis to the commercial lending institution. The Federal Reserve provides short-term liquidity to commercial banks and financial institutions in an event of credit crisis, this action is mainly carried out to assist banks which are illiquid but these banks shouldn't be declared solvent because the main aim of lending them the short term liquidity is to prevent them from collapsing. (Kaufman, 95-110). Short term liquidity advanced to financial institutions during credit crisis usually attract a high-interest rates towards the borrowing financial institutions, these unusual interest rates are identified as penalty rates which serve to penalize the institutions for their failure to effectively manage their credit activities. In a conceptual scenario where an economy lacks a lender of the last resort such as the federal reserves in the united states of America, cash deposited in the banks and the balance kept in their respective reserves are not usually sufficient enough to meet the prevailing demand of cash whereby depositors are rushing to convert their deposits to liquid cash during a financial crisis situation. Such a situation is undesirable since it will eventually cause the collapse of the financial institution and increase negative stress on the country's economic growth which could have been saved by the presence of a lender of last resort. The Federal Reserve ability to ensure confidence during financial crisis through acting as the lender of the last resort has been very effective in ensuring that there exists an elastic and reliable currency. The Federal Reserve can also bail out private companies which it doesn't have direct control which is facing a credit crisis. A good example of such activity is when the Federal Reserve of the USA bailed out Freddie Mac and Fannie Mae companies which were facing a critical financial crisis. The efforts of the institution ensured survival and existence of these companies which were nearing total collapse. Recently, following the financial distress which had occurred some few years back between 2001 and 2008 identified as great recession, the Federal Reserve bailed out companies such as AIG and Bear Stearns which were greatly affected by the prevailing credit crisis which could also have led to their extinction from the industry. If the federal reserved hadn't intervened to assist these financial institutions they could have definitely closed their operation which could have caused a great stress to economic growth and the collapse of global financial systems due to a global depression. (Bernanke, 2).
Secondly, the national treasury and the Federal Reserve encourages open market operations to deal with effects associated with the occurrence of a credit crisis. Simply, open market operations of the national treasury basically involve buying and selling off national securities and treasury bills as a mechanism of ensuring currency stability and effective elasticity during financial crisis situations. Open market operations are classified into two categories; permanent and temporary open market operations. Permanent open market operations usually accommodate long-term purchase and sale of securities to enlarge the federal balance sheet. On the other hand, temporary open market operations are mainly concerned with operations which are identified to be transitory, they include repurchase agreements and reverse repurchase agreements. Activities by the national treasury and Federal Reserve ensures proper and beneficial operations of the credit markets since it is capable of reducing the unnecessary pressure on interest rates as a result of the credit crisis, similarly, it enables the creation of favorable financial market conditions which are desirable and comprehensive in financial credit markets. Purchase of long-term securities to the Federal Reserve portfolio are some of the activities carried out by these institutions to create a conducive credit market environment during a financial crisis. The Federal Open Market Committee (FOMC) through the board members and Federal Reserve presidents has been recently involved in buying and selling of securities in the open air markets to regulate credit crisis. In 2012, the FOMC decided to increase the policy capacity by purchasing agency guaranteed mortgage-backed securities (MBS) at a cost of $40 billion each month so as to sustenance economic recovery after the persistent economic downfall which was as a result of the financial crisis in 2008. In January 2013, the Federal Reserve initiated the purchase of long-term treasury securities at a cost of $45 billion after every preceding month.
Lastly, the Federal Reserve provides liquidity swaps as a mechanism to control credit crisis. Central bank liquidity swaps as they are commonly known are agreements on liquidity mechanisms between the federal reserve of the United States of America and central banks of foreign countries. The central bank liquidity swaps are mainly implemented to ensure improvement in liquidity conditions of dollar funding in various institutions in other foreign countries jurisdiction at the time of financial stress. Central bank liquidity swaps are categorized into two; dollar liquidity lines and foreign liquidity lines. Liquidity swap lines are effective in ensuring financial stability in financial markets and also help in relieving stress on financial markets by providing mitigation measures against effects of the credit crisis on the country's economic situation. In 2007, the Federal Reserve announced that it had activated dollar liquidity swap lines with the Swiss National Bank and European Cent...