About the Credit Crunch

 

The Credit Crunch

 

What is the Credit Crunch?

 

The Credit Crunch is the term used to describe an economic situation where there is reduced availability of credit from financial institutions predominantly in the form of home loans and mortgages. There are also knock on affects for other forms of credit such as credit cards. Financial institutions lend based upon their view to risk and if there is a loss of confidence by the institutions caused by losses resulting from credit lending then they will limit the amount of credit they will provide causing a squeeze or ‘crunch’ on availability which is termed as a credit crunch. At the same time they increase the cost of providing credit by lifting interest rates which compounds the problem further. We then enter a spiral where the lenders are unwilling to provide more credit due the losses already experienced.

 

 

What caused the Credit Crunch?

 

The Credit Crunch is not just a UK condition, its global and the origins of the credit crunch came from the US where financial institutions had over exposed itself to the sub-prime market. This is the financial term used to describe the less credit worthy individuals - in the UK these would be individuals with County Court Judgements or Payment Arrears on loan/mortgage repayments. One part of the problem in the US was that interest rates rose to a level that were unaffordable to sub-prime mortgage holders which caused them to default and have their home repossessed. The financial institutions then sell the house to recover the value of credit that they have provided. Unfortunately when the number of defaulting mortgages is high and the housing market has slowed due to high interest rates then the prices of house prices crash which then means houses are worth less then the credit secured on them and the banks lose money. This is just part of the credit crunch story

 

The second part which has amplified the credit crunch is the secondary mortgage market where US lenders have securitised their lending by ‘selling’ their loan packages to investors which frees up the lenders on money and allows them to provide more and more credit . As a result the owners of these packages are one step removed from the customer and rely upon ratings which have turned out to very poor in determining the risk of the credit lending. The US lending institutions carried on providing credit to individuals who represented high risk believing that the secondary market would continue to buy their loan packages at high rates. As soon as these packages start to lose their value due to defaults then the investors began to move out their investments out of mortgage packages and the financial institutions are left with packages they cant sell on and their own capital dramatically reduced as they have used it all to provide lending in the belief that they could sell on those credit packages. The result is the banks stop lending at affordable rates and all available credit is crunched. This makes the whole problem much, much worse as the financial institutions begin to struggle, customers get worried and make the situation worse by withdrawing savings deposits and therefore the available credit to lend reduces further and we enter a credit crunch spiral. 

 

The third part of this credit crunch will be the affect of Credit default Swaps which have grown massively in the last 10 years where speculators have taken out ‘insurance’ on mortgage related securities to hedge, or insure against credit events such as a defaulting occurrences on the credit repayment obligation. Bizarrely there is no requirement to actually possess the asset or indeed experience loss. The payments required by the sellers of the ‘insurance’ could bring down some very big institutions and could amplify the crunch yet further. This is the next part of the credit crunch yet to unravel.

 

 

What will be the affect of the credit crunch on me?

 

The obvious affect is that it will be difficult to obtain credit as lenders stop lending to riskier individuals and attempt to improve their profitability by increasing mortgage arrangement fees and the interest rates they charge. This causes monthly payments to increase on tracker or variable mortgages causing a crunch in own disposable incomes. At the same time it results in a big difference between the monthly repayments for people coming of fixed mortgage deals as those low monthly repayment  levels will no longer be available and consumers receive a sharp shock. This credit crunch also affects 0% rate period offers on credit cards as providers begin to reduce their risk in this crunch period. Credit card declines have increased and default levels are beginning to rise.

 

The affect of the credit crunch on the housing market has been astonishingly quick as the mortgages become unaffordable then consumers are unable to move or get on the housing ladder. This compounded further by the restriction of mortgage lending which mean that consumers with riskier profiles are unable to find a mortgage. Those with a mortgages already start to buckle under higher interest rates which causes higher monthly repayments and then they default and repossessions start to rise. Very little is moving in the housing market so people who need to move because they are emigrating, cant afford their mortgage payments anymore or are moving for their job get desperate so they drop the price. This causes others to do drop their price also and so it spirals and we have a price crash on our hands. This has been precipitated by the credit crunch.

 

There was always going to be correction in house price after the huge rises in recent years that have outstripped wage increases  but the credit crunch has accelerated this rebalance at a rate that is too fast for consumer to cope with and as the economy approached and enters a recession the credit crunch is amplified. The economy and the affects on our day to day living will not recede until credit liquidity improves and the confidence levels of banks increases so it could take time for the economy to recover from the affects of this crunch.

 

 

The opinions expressed are those of the author only. The material is for general information only and does not constitute legal, financial or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation by an FSA authorised company where the market is FSA regulated.