Impact of Credit Crisis on Financial Market: Assignment

Added on - Sep 2019

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Running Head: IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITYAssignment TitleStudent NameCourse NameInstructor NameDate1
IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITYCredit CrisisThe credit crisis is a major threat to the economy. It is a situation where theavailability of lending gets tightened due to the various activities. It will have an impact onthe short-term debt, long-term debt and the day to day operations of the bank. These creditcrises are popularly known as the credit crunch, in this case, the amount that is available forcompanies to obtain a loan for the commercial purposes gets tightened, and there will be lesssupply of funds (FRBSF, 2012). On the other hand, there will be a reduction in the amount ofcredit available for the retail customers, and it creates more crunch to the money supply.The credit crisis is mainly used for referring the crisis that took place during 2007 and2008 in the United States. The main reason for terming the great recession as credit crisis isthat it has created a catastrophic effect on the entire economy of the country and the rest ofthe world. Having an understanding of the reasons for such crisis is essential. The credit crisisis triggered when the event of non-repayment of loan is increasing in the market. In otherwords, when the default rate of the borrowers is increasing it is the initiation phase of thecredit crisis, and it is the primary reason for the 2007-08 crisis (FRBSF, 2012).In the US, due to the housing bubble, many sub-prime loans were disbursed at thehigher rate of interest on the mortgage-backed securities and asset-backed securities vehicles.These instruments were more famous and highly demanded in the market by the investors asthey were providing a higher rate of interest to the people. Many investors invested in varioustranches of these instruments (FRBSF, 2012). These instruments had various tranches witheach tranche having their identifying characteristics like the rate of interest, level of risk,repayment method, etc. Based on the requirement and as per the risk tolerance level andamount of investment that can be made by the institutions and individual investorsinvestment were made on these instruments.2
IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITYThese instruments were not transparent in disclosing the information about theirinvestment portfolio to the investors and provided a loan to subprime customers with poorcredit rating and repayment ability. These borrowers were unable to repay the borrowedamount resulting in huge amount of default. It resulted in the loss of investment by theinvestors who invested in the MBS and ABS. It resulted in fall of huge institutions and thecreated great recession.The consequences of the credit crisis are negative yields in Treasury bill trade. Riskpremium soars in corporate bonds, the worst performance of the stock market, increase inilliquidity and increase in unemployment, etc. The credit crisis will have a direct impact onboth the bond market and stock market. The credit crisis will result in lack of liquidity in thedebt market that further adds more trouble to the entire economic system.Lack of Liquidity in Debt Market and Credit CrisisLack of liquidity takes place when the amount of transaction taking place is lower thatis there is a lower level of purchase and sales of bonds or lower level of trading activitiestaking place in the bond market (Adrian, Fleming, Shachar, & Vogt, 2016). Debt marketconsists of both Treasury bonds and corporate bonds. During the good economic time, morepeople have a better inflow of money, and they make more focus on generating a better returnon investment. The MBS and ABS were at a peak during this period.More investors began to invest in all these assets and various other mutual funds withan intention to generate a higher return on investment when compared to the bond market(Adrian, Fleming, Shachar, & Vogt, 2016). It is the time when the emerging economies wereproviding attractive bond interest rate to sell their bonds and raise more capital whencompared to the advanced economies. It resulted in more focus on the bond market that wasproviding lower yield on the investment due to the best available alternatives.3
IMPACT OF CREDIT CRISIS ON FINANCIAL MARKET LIQUIDITYEventually, when the credit crisis hit the market, it created more shock to the entireeconomy, and it affected the bond markets too (Adrian, Fleming, Shachar, & Vogt, 2016).More investors faced huge loss due to their investment decision of investing in more riskyassets and began to focus on making more investment in the risk-free asset. It resulted inmore switch to the treasury bond investment. When the level of investment on the treasuryinstruments was increasing, it was creating more pressure on the US economy, and it requiresthem to reduce the interest rates.On the other hand, many companies in the US were adversely affected by therecession and investors were reluctant to invest in the corporate bonds even though they wereproviding higher risk premium due to the risk associated with them (Adrian, Fleming,Shachar, & Vogt, 2016). When the amount of investment in the government securities wasincreasing, it caused more pressure on the debt management of the country as they areresponsible for repaying the amount to the investors as per the maturity.It resulted in negative yield and lowering of the transaction in the debt market bylowering the interest rate to nearly zero making the investment avenue more unattractive.When the rate of return on the investment is nil, and they are expected to provide negativeyield it reduces the investor attraction over the bonds, and it resulted in lower level of trade inthe bond market and it resulted in lack of liquidity in the market (Adrian, Fleming, Shachar,& Vogt, 2016). People were not ready to buy the bonds, and at the same time, people werefocusing on squaring off their position to guard themselves against the adversities.It resulted in increasing more volatility in the market without any considerablechanges in the prices that caused more pressure to the liquidity in the bond market (Adrian,Fleming, Shachar, & Vogt, 2016). The bond market is not the best destination for protectingthe people from the recession. They are not the destination for protecting the people from thestock market crash. There is a detailed way of looking at them is essential to understand the4
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