The term ‘credit crunch’ has been thrown around for many years now, a simple definition of it is “a severe shortage of money or credit”. Since 2007, when the credit crunch went full steam ahead, whether a company was deemed successful or not they were not able to function without being able to borrow, they were either refused point blank or were tied into repayments with a high interest rate tied on to the agreement.
One cause of the credit crunch was linked to the US sub-prime mortgage market, when many America consumers usually the lower class, were sold the dream of owning their own property. The U.S FDIC office could interpret this action as “lending without regard to ability to repay”, since the sellers of the mortgages had incentives for the higher amount of people they could successfully sell a mortgage too. This was do-able since banks were lending at a cheap rate, an historic low (BBC News), which caused issues since the people taking out the mortgage generally did not understand how a mortgage works. With the lending amounts increasing, the banks leveraged the debt they had, taking the form of a CDO (Collateralised Debt Obligation), this was used as security for the high amounts the banks were lending.
The use of a CDO involves securitisation, which is the process of taking an unsalable assetsand moving it to a state that is more saleable. This is what happened with peoples mortgages, if the mortgages were pooled together it was a risky investment, however if it was the repayments pooled together it was less risky. This is effectively what happened with the lenders; they pooled these together and attached security ratings to them allowing people to invest in this market. The ‘tranches’ included; AAA, AA, A, B etc, with AAA being less risky. However, what was found is that fewer were investing in the lower tranches. Credit enhancements then appeared, which involved taking parts out of the lower levels and putting them together and starting again from using AAA to try make them seem less risky, known as a re-mixer. The same problem occurred and less were investing in these lower levels, so funnily enough they repeated it, introducing the term re-remixer. There was a big incentive to do this since the big investors like the banks and pension funds were restricted from investing in the lower grades due to the lower security of it, rather deceitful of this market don’t you think?
The problem arose when the stream of payments into the pools fell when people were struggling to pay their mortgage. If these lenders used the re-mixers (which they were unaware of) up as security against their assets, other banks/lenders would not do business with them since they were unsure whether the original or re-mixed was used, due to the lack of transparency of the market the banks were unable to know. This caused historically low levels of interbank lending, due to insecurity of it all.
People invested in the CDO market since they thought they were protected, however this was only to a certain point. Santander was one company who wanted to invest into this market, however due to Spanish law they were restricted to do so. I bet now they are thankful of this, since this allowed them to have the money available to buy out Abbey National. This is even more true when considering the mess that a similar bank, Northern Rock, got itself in to. Northern Rock’s whole business design was around the London Interbank market, which was ideally designed as ‘overnight’ lending. They borrowed cheaply from and then resold in the form of a 25 year mortgage, smart move? When interbank lending levels severally lowered, it had major issues, ones that resulted in the Bank of England bailing it out at a value of £119bn (BBC News).
It could be argued that this credit crunch was inevitable, as it was not possible that lenders could continue to provide credit at such a cheap rate and repackaging the repayments and interests in the form of CDO’s without serious repercussions, don’t you agree?
You are saying this credit crunch was inevitable, but could it not have been prevented at an early stage by, for example, simply increasing the interest rates or other ways? and when looking from an individual business perspective, are there ways of potentially avoiding/protecting themselves from the whole effects of such crises (look at Santander!) and if yes, what are they?
ReplyDeleteId say inevitable from the point of their actions and the way people were going about lending, maybe people have not really thoguht about what the repucussions of their actions were and were just attracted by their lower rates of lending. Which from a business persepctive would be very appealling due to the fact that it would decrease their cost of capital and leaving more cash retained in to the business, would it not?
ReplyDeleteIn terms of Santander it was not the company that protected them from it, it was the laws of the country that restriced them from entering in to such activity, which is guess is a blessing in disguise?
However from an individual persepctive i think the promotion of for example the 'american dream' is what sold it to them and banks taking advantage of this.