Monday, September 22, 2008
So what exactly is the Credit Crunch?
So what exactly is the Credit Crunch? Simply put, a large number of Global Banks slowly realised that they were all fighting over the prime mortgage markets, which was capital intensive and low margin due to market competition.
Some bright spark then noticed that there was a whole spectrum of customers who were not prime, they were near prime, sub prime and deep sub prime, and lo! The Banks spotted a golden chance to make a pile.
It was decreed that a non prime customer was inherently a higher risk than a prime one, and therefore the rate that they would be charged for their money to buy their home would be higher than that given to prime customers. Bear in mind at this point that the money is costing the Banks exactly the same, irrespective of who they lend it to.
So in a nutshell, those that could afford to borrow, or those who just said they could, but hadn’t been great at making payments in the past were offered mortgages to buy property, the loans were priced higher, and the yield for the Banks went through the roof. Happy Days !
Soon, every global Bank wanted a slice of this ‘lucrative’ market, where high profits could be made easily and quickly. But just as quickly came the defaults and late payments, so some of the early players who had been in at the start of the sub prime debacle decided to package up these higher risk loans and sell them on to other banks, and so the merry-go-round of Banks buying each others high risk debts began.
All of a sudden, the UK Banks realised that these high profit bundles came with a serious risk of non-payment, and to protect their ‘investments’ began slowing the amount of money they were prepared to gamble on the LIBOR exchange. This is a mechanism whereby the Banks set the amount and the rate at which they lend currency to each other.
The key thing to bear in mind throughout all of this, is that whilst all these global players are writing down assets, (which attract massive tax allowances and reliefs by the way), each and every one of these high risk home loans have a property attached to them, which has an inherent value typically the same or greater than the exposure of the loan on it.
The Big Banks in the UK, Europe and North America have panicked; they want liquid cash flowing through their veins, not tied up in buildings. Lenders in the UK and Europe find themselves owning bundles of debts that may or may not be paid, but are tied to various properties in North America and elsewhere – not a great position to be in, but a position of their own making, tempted by the promise of high profits.
The UK Banks decided that, as they 'may' get stung by toxic debts that they accepted because they were incredibly profitable*, they would all slowly reduce the amount they put into the LIBOR market, and as a reducing supply of anything drives the price up, the LIBOR rate went up. The Banks, realising they had painted themselves into a corner, were granted a lifeline by the Bank of England, of emergency liquidity finance at special rates.
As Banks recoil from these toxic debts, they over-react by hoarding the liquidity cash granted to them by the Old Lady, and begin reducing their potential liability to debts by reducing credit lines, credit card limits ( often referred to as the credit card target by my wife...) overdrafts and other credit facilities. SME businesses are usually the first to feel the pinch, followed by industries with seasonal fluctuations, like Motor Dealers in March and, oh, September. Perhaps you understand why I feel this economic phenomena should be referred to as the Credit Choke, or the Credit Strangle.
*Anyone remember the white flagger, those customers that (pre-FSA of course...) would nod politely and take everything, Creditor, Gap, MBi, and all at - ahem - a healthy rate ? As a BM I often found that the more profitable the deal was, the harder it was to get it bought by a funder, typically because of the lenders view of the risk, not to the deal per se, but to the client. I would venture that the Banks, tempted by high profits in a lean market, have ignored their gut instinct and approved debts that now carry too high a risk, and all the "profit" has vanished.
Some bright spark then noticed that there was a whole spectrum of customers who were not prime, they were near prime, sub prime and deep sub prime, and lo! The Banks spotted a golden chance to make a pile.
It was decreed that a non prime customer was inherently a higher risk than a prime one, and therefore the rate that they would be charged for their money to buy their home would be higher than that given to prime customers. Bear in mind at this point that the money is costing the Banks exactly the same, irrespective of who they lend it to.
So in a nutshell, those that could afford to borrow, or those who just said they could, but hadn’t been great at making payments in the past were offered mortgages to buy property, the loans were priced higher, and the yield for the Banks went through the roof. Happy Days !
Soon, every global Bank wanted a slice of this ‘lucrative’ market, where high profits could be made easily and quickly. But just as quickly came the defaults and late payments, so some of the early players who had been in at the start of the sub prime debacle decided to package up these higher risk loans and sell them on to other banks, and so the merry-go-round of Banks buying each others high risk debts began.
All of a sudden, the UK Banks realised that these high profit bundles came with a serious risk of non-payment, and to protect their ‘investments’ began slowing the amount of money they were prepared to gamble on the LIBOR exchange. This is a mechanism whereby the Banks set the amount and the rate at which they lend currency to each other.
The key thing to bear in mind throughout all of this, is that whilst all these global players are writing down assets, (which attract massive tax allowances and reliefs by the way), each and every one of these high risk home loans have a property attached to them, which has an inherent value typically the same or greater than the exposure of the loan on it.
The Big Banks in the UK, Europe and North America have panicked; they want liquid cash flowing through their veins, not tied up in buildings. Lenders in the UK and Europe find themselves owning bundles of debts that may or may not be paid, but are tied to various properties in North America and elsewhere – not a great position to be in, but a position of their own making, tempted by the promise of high profits.
The UK Banks decided that, as they 'may' get stung by toxic debts that they accepted because they were incredibly profitable*, they would all slowly reduce the amount they put into the LIBOR market, and as a reducing supply of anything drives the price up, the LIBOR rate went up. The Banks, realising they had painted themselves into a corner, were granted a lifeline by the Bank of England, of emergency liquidity finance at special rates.
As Banks recoil from these toxic debts, they over-react by hoarding the liquidity cash granted to them by the Old Lady, and begin reducing their potential liability to debts by reducing credit lines, credit card limits ( often referred to as the credit card target by my wife...) overdrafts and other credit facilities. SME businesses are usually the first to feel the pinch, followed by industries with seasonal fluctuations, like Motor Dealers in March and, oh, September. Perhaps you understand why I feel this economic phenomena should be referred to as the Credit Choke, or the Credit Strangle.
*Anyone remember the white flagger, those customers that (pre-FSA of course...) would nod politely and take everything, Creditor, Gap, MBi, and all at - ahem - a healthy rate ? As a BM I often found that the more profitable the deal was, the harder it was to get it bought by a funder, typically because of the lenders view of the risk, not to the deal per se, but to the client. I would venture that the Banks, tempted by high profits in a lean market, have ignored their gut instinct and approved debts that now carry too high a risk, and all the "profit" has vanished.
