THE CREDIT CRUNCH EXPLAINED . . .
Each day there is a story in the media about the credit crunch and its effect on jobs and the economy. In order to overcome the spin and misrepresentation, Neel Gorasia explores the issue with the aim of separating truth from myth.
STAGE 1
The entire banking system is inter-related. It is made up of retail banks (e.g.: Northern Rock), investment banks (e.g.: Lehmann Brothers), the Bank of England, consumers (you and me) and the government. You use a bank to deposit and withdraw cash. Banks make money by lending out your deposits to other people/institutions and charging them interest, e.g.: you pay interest on your credit card. This is profit the bank makes for lending you money. A healthy bank lends out £1.20 for every £1.00 deposited by you.
STAGE 2
It started in the US. US institutions like Freddie Mac lent to lots of sub prime borrowers. Credit was very easily available as it was assumed rising house prices would resolve any issues.
Investment banks bought these subprime loans. Retail banks were happy to sell as the loans were high risk. They repackaged them with other less risky products using complex financial means. These were bought by institutions around the world. The investment bank made good returns and its employees - high bonuses.
STAGE 3
The financial institutions who owned this debt saw that many sub prime consumers were defaulting. Hence the debt they owned was worthless. No one knew how widespread the bad assets were.
This resulted in a loss of confidence in the financial system. Banks did not trust each other - they did not know who could/couldn’t pay the cash back. Northern Rock had subprime assets, but many good assets, but it was the first victim of the ‘crunch’. Other banks would not lend it money to keep going, & it had to go to the Bank of England for cash. Its ratio was very bad: - it lent out £3.00 for every £1.00 deposited. This started a run on the banks.
STAGE 4
The public were very worried. The bank had a ‘run’ - everyone who had deposited money into Northern Rock tried to get it out simultaneously.The government had to intervene to save Northern Rock - they feared this would spread to other banks.
This was followed by Freddy Mac and Fannie Mac in the US, Lehmann Brothers (US and UK) and now HBOS (which also owns Halifax) is in merger talks with Lloyds TSB so it can survive.
WHO'S FAULT IS IT?
It is not easy to place blame at any one person or group. You could blame the retail banks such as Northern Rock who offered credit easily to subprime consumers. They are people who are at high risk of defaulting on their loan - due to a poor credit history or unreliable income. Northern Rock knew they would have difficulty making repayments. Conversely, the materialism of consumers - we live in a society where we want instant gratification - adults chose to take out these loans. You could blame investment banks for buying the debt from the retail banks, repackaging it and selling it on to make a profit. After this, you could blame hedge funds for exacerbating the problem by short selling (pushing the price of shares down)
An easy target is the UK and US governments; they let the expansion of credit go unchecked for many years. This created a ‘moral hazard’ problem - financial institutions knew they were not bearing all the risk - the government would bail them out and did not act as prudently as they should have.
AS A STUDENT, WHY SHOULD YOU CARE?
As banks have lost a lot of money, they are very cautious of lending and want to gather in as much cash as they can. Interest rates have risen. This is good for savers, but bad for homeowners.
Your student flat rent may have increased as landlords pass on this rise to you. Your parents may be worried about making ends meet as mortgage repayments take up the largest size of a family’s monthly income.
WHY IS THE PRICE OF FOOD RISING?
The credit crunch is incorrectly used as a catch all for recent economic woes such as rising food and fuel prices. Food prices are rising due to different disparate factors such as rising demand in emerging economies, protectionism, changes in weather patterns & tight crop yields.
