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How the Credit Crisis Spread

how credit crisis started

Readers Question: how did the recent financial crisis spread from the US and the EU to the rest of the world.

It is fair to say the crisis started in the US.

  • In the US many people took out mortgages they later couldn’t pay  back. These mortgage defaults caused many mortgage companies and banks to lose significant sums of  money and go bankrupt.
  • It was also in the US where house prices first started to fall causing a negative wealth effect and fall in consumer spending.

Why Were other Countries Effected?

1. Foreign banks bought collateralised US debt. Many of these subprime mortgage loans were rebundled into CDOs and sold onto financial institutions around the world. For example, many British and European banks had exposure to these mortgage loans. Therefore, when defaults rose, European banks lost a lot of money.

2. Global Credit Crunch. The banking system is internationally linked. When some banks started to lose money they became reluctant to lend to other. Therefore the international banking system became affected and banks stopped lending to each other

and therefore it became difficult for firms and consumers to borrow from banks. This decline in bank lending contributed to a fall in aggregate demand. Even countries which didn’t have any exposure to subprime lending were effected by the global credit crunch

3. Global Trade. With the US entering recession, their demand for exports fell. So many countries experienced a decline in exports. This decline in global trade contributed to the global recession.

4. Confidence. Problems in the financial and banking sectors adversely affected confidence of consumers and firms leading to lower growth

5. Global Stock Markets. The financial problems of US and UK banks hit stock markets around the world 2007 and 2008 saw large fall in share prices which led to lower wealth and confidence. Leading to lower growth.

Typically, there is a weak correlation between stock markets and consumer spending. Only 20% of consumers have direct exposure to stock markets, and the wealth in stocks is not directly linked to spending. But, the sheer size of the stock market falls meant it did start to effect consumer spending and business investment.

Category: Credit

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