Friday, 12 April 2013

The 5 Minute Guide to the "Credit Crunch"

So, "credit crunch" is a phrase that has been tossed around way too much in the last few years. I find it tremendously cheesy and I'm not ashamed to say that it makes me cringe a bit when I read it. But, it seems to have reached that stage where it is now a socially acceptable term (ugh!) and therefore we have to roll with it. I'm taking a wild stab in the dark here assuming that a lot of people know what the "credit crunch" is but don't know how it came about, or how we ended up slap bang in the middle of it! Fear not, I am here to talk you through it in 5 minutes (don't hold me to that).

So, we roll back the clock to the early to mid 2000's. We are in America and looking at the US mortgage market. Around this time most things economical are going well, generally the world is in a stable position and growing well - meaning confidence is high. What is important to note is that, due to this, property prices in the USA were on the rise. High confidence and rising house prices put the mortgage lenders in a fairly arrogant position. We saw an expansion of what is known as the 'sub prime' mortgage market. These are essentially risky mortgages - mortgages given out to people who may have trouble meeting the repayment schedule. Why do this? Well, the banks felt safe because the rising house prices meant if the recipient of the mortgage couldn't make the payment then the bank would inherit an asset that was rising in value - increasing their profit.

Everything was all well and good until we reach 2007. Towards the end of the year inflation in the USA rises and this forces interest rates up (higher interest rates are a method of bringing prices/inflation down). The mortgage default rate begins to rise now because the low introductory interest rate of the mortgages start to come to an end. The mortgage recipients now have to pay the higher national interest rate on their repayments and many could not do this and were forced to default.

Coinciding with this, the housing boom collapses and house prices plummet. Now the banks are left with a defaulted mortgage and a worthless house - they have entered a very sticky situation and their balance sheets are severely hit. A key part of the finance sector is banks lending to each other when needed, they do this at special rates and it is the cheapest way of generating short term funds. This stops. Banks stop lending to one another because their balance sheets were hit by the defaulting mortgages and worthless properties.

This essentially is the problem. Some banks cannot afford to keep going due to the losses they've made and with no access to short term funding from other banks they have no option but to declare bankruptcy - Lehman Bros for example. It becomes a global crisis because of the integration of the world economy. Countries are so intertwined now due to trading, international agreements that something like this can spread around the world in a matter of months. It took roughly 3 months from when the USA entered recession for the UK to enter recession. In the space of a few months a crisis in one country has become a global financial crisis.

That's it. Sub-prime mortgages increase -> inflation causes interest rates to rise -> housing market collapses -> default rates increases -> banks stop lending to one another -> recession -> spreads around the world.
This is a very simple look at the credit crunch, of course there is a lot more to it. For the normal person, this is as much detail as you need to understand, essentially, what went on and why we are where we are now.
Cheers guys,

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