What Is The Credit Crunch?

Posted on: 07 April 2009 by Gareth Hargreaves

Independent financial advisor Peter McGahan explains the credit crunch and looks at how we moved into a recession.

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Ah there is a question. Well in political terms, the credit crunch is a damn good opportunity to dump everything that’s gone wrong on an inanimate object that no-one can blame.

In reality the credit crunch is simply about an over expanded, mismanaged economy, with financial excesses that need to be re-addressed.

It’s not tricky to see how the financial excesses and resulting credit crunch occurred and indeed this column warned of a housing bubble as far back as 2003. That bubble created false wealth, which in turn was borrowed, and created record debt of over £1trillion.

This was out of hand as far back as 2004. The Bank of England raised rates in 2005 to slow the economy down, then bottled it, a decision they may regret for a very long time.

And so once again we were faced with the inevitable ‘it's different this time’ as consumers borrowed with the view that the only way was up. And it was, without a paddle though.

But people kept borrowing more and more on the grounds that paddles are old fashioned and no longer needed, and the Bank of England did nothing about it. Where was this extra money coming from? Why had banks so much money to invest for borrowers?

And that’s where the hilarious bit arrives - i.e. the excuse used as to why we are in the mire now – the credit crunch.

I spent all of summer 2007 in the west of the U.S. It was clear its economy and housing market were in trouble. It is typically 18 months ahead of the UK. In the U.S. (and UK) people with poor credit ratings were given loans that in normal situations they would not. As a consequence the housing market boomed because more people could buy homes. Demand exceeded supply and off you go.

At this point you could believe the numbers were out of synch i.e. soaring house prices, or you could believe all was well and a new world would ensue. Which was the better thought?
These mortgages would be called ‘sub prime’. Clearly these lenders giving money to the sub prime borrowers needed to raise the money from somewhere. So some bright spark had the idea of bundling all the mortgages together and selling them off as an investment – today called a collaterised debt obligation (CDO).

Good thinking. So you have dumped your debt and grabbed the cash, and now you can lend more if you need. To me that’s a win all the way round unless of course if you have bought the debt – there can’t be two winners can there, or am I being too educated about this. The new bank who had bought the debt was now paid interest by the borrowers.

In the meantime the bright sparks decided to trade these CDOs with each other – a bit like drinking out of the same pint at a pub with a gang of lads with the Flu.

Better still, someone thought, ‘lets use the value of these CDOs to borrow against them to raise cash’. Better still someone actually lent the money.

And so like every bubble, the U.S. housing market collapsed. That’s what bubbles do. Borrowers defaulted, houses where repossessed and of course a debt with no-one paying it back, secured against a house that’s worth less than the debt, is basically, well a very bad day at the races.

If you have then used that debt to borrow more, you have a house built with wet cards. And so the CDOs plummeted in value as no-one knew what was inside the CDO. Did it contain good debt or a bad debt?

During this period of absolutely shocking decision making, these ‘managers’ were getting paid fortunes in bonuses, and their future pensions would be based on these incomes.
In the dictionary the meaning of  ‘bonus’ is ‘something given or paid over and above what is due’ - You aren’t kidding, so pay it back.

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