What on Earth is the credit crunch?

Posted on: 26 January 2009 by Gareth Hargreaves

Independent financial advisor Peter McGahan analyses the full fall-out from the credit crunch.

Somehow, somewhere, someone has managed to swing paying the price of poor lending processes and swashbuckling investment decisions by banks, over to  poor mortgage payers in the good old USA. That’s a bit like trying to glue jelly to a tree.

We will learn one thing from this recession - or we will not, and that’s common sense in lending and investment policies from the banking sector.

Let's remember that banks have individually bought investments in assets they will never be able to understand, and did not understand when they bought them. To blame the U.S. is just priceless.

I studied the U.S. as an economy in 2007 for five weeks and wrote about its poor state and in particular the state of the housing. Remember we all know they are around a year or so ahead of us in terms of their fiscal policy.

From one side to the other everyone believed the housing market was doomed, and you could already get property at sizeable discounts.

New developments lay empty. Excess supply coupled with dwindling demand. This was not an area I wanted exposure to. As a consequence we invested a sum total of 0% in the U.S.

Somehow, our banks thought it was a great idea to see beyond that and buy investments in worthless collaterised debt obligations in the U.S.

Hadn't they learned that when you move down credit curve risk to chase reward your potential for loss soars. I have no sympathy, and am stunned by how banks appear to have escaped the wrath of the public.

Instead we are asked to bail them out with our 'taxpayers' money and the joy of higher taxation in the next few years. Wonderful.

This is only part of the story. Because of this and the threat of lending to a financial institution that could go bust, banks have stopped lending to each other.

Eighteen months ago I said the whole problem would go away if banks disclosed their bad debt. I added they wouldn’t, as they probably didn’t know, and they probably still don’t. The fact they didn’t, meant we were clearly in a very difficult scenario as they knew they had plenty to hide.

As a consequence, liquidity has completely dried up, and banks are holding on to what they have got. Whilst our government is hell bent on telling banks to lend to each other and open up the doors, banks are clearly aware that’s like catching falling knives. No-one seems to really want to trust each other, and any measures the government take have to deal with that first.

The solutions are simple. Just as Bush did in the U.S. with companies with accounting irregularities, we should declare an amnesty and insist that every bank discloses its toxic or bad debt. At that point every bank will know what they are dealing with and can make a decision to lend to each other.

From that floor you have the ability for companies to refinance. If they refinance, they can stay in business and keep people employed. If people are employed, they are not costing money to tax payers and are also contributing via spending on the high street – a double whammy.

According to JP Morgan Fleming, 67% of the UK's GDP - its economy - relates to the high street. You can see why they want you to spend our way out of the recession. Moreover if you have full employment you have demand for property.

If banks believe house prices will fall, why would they want to lend? With a typical loan to value at around 75% for the better deals you can easily see what banks believe the housing market will do.

For the first six months of this year I expect the consumer to use the saving to repay debt, and they will then spend. That’s the floor to your recession as consumers delight in cheaper living and lower house prices.

As you can see banks hold quite a key so its easy to see why they are under so much pressure from the government, however cynically, its interesting that all this bad news arrived one day after the shorting ban.

If you require investment advice or have another financial query call Peter on 0845 230 9876 or email info@wwfp.net

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