The Credit Crunch I: How it began

4 August 2008

This week we will be running a series of longer items on the credit crunch, looking at how it affects businesses and individuals, and how businesses and individuals can best weather the economic uncertainty.

Where it all started

A sure sign that a new phenomenon has thoroughly permeated public consciousness is when the guardians of the English language feel that the term describing it has gained sufficient lexical weight and presence to warrant admission to the Concise Oxford English Dictionary. The latest edition of the Dictionary – along with ‘custard cream’, ‘drookit’ (Scots for wet) and ‘mocktail’ – has found space for ‘credit crunch’, which it defines as “an economic condition in which it suddenly becomes difficult and expensive to borrow money”. Unsurprisingly, given the frequency with which it too has been bandied about in newspapers and on television, ‘sub-prime’ has been similarly recognised for its recent disturbing ubiquity with an entry of its own.

The term ‘credit crunch’ has spread with all the relentless velocity of the events that it has ushered into our lives. One day in 2007 no credit crunch, just faraway rumours of something amiss in America; almost the next day in 2007 queues of worried savers outside branches of Northern Rock, anxious to empty the vaults of their savings lest the entire edifice collapse. Nor has there been any limit to its reach. Although its origins lie in the US housing market, the ‘credit crunch’ has echoed in households and businesses the world over, proving, if anyone doubted it, that we and our money inhabit a truly globalised economy.

The sub-prime mortgage crisis

In recent years money has been cheap. Low interest rates, easy-term borrowing. In America that cheapness encouraged competition among specialist lending companies; commission-driven sales staff offered mortgages to customers whose credit-worthiness often did not match the sums they were borrowing. Risky, sub-prime borrowers. But elastic can only stretch so far. As more and more borrowers defaulted or failed to meet rises in interest payments, so more and more of those mortgages turned into bad debt as the sub-prime risks came home to roost.

The consequences for borrowers with $200,000 loans they could ill-afford to service were catastrophic. But how did a family in Ohio, say, struggling to pay their mortgage – and many others like them – precipitate oceanic financial turmoil, the waves of which are still breaking on our shores? The lenders that provided sub-prime mortgages would package up the loans and sell them on as structured products – collaterised debt obligations (or CDOs to give them their innocuous, dusty acronym) – to financial institutions such as major banks and insurers.

Doing so allowed smaller lenders to clear their books of debt. The major banks were willing to take on the risk of sub-prime loans precisely because the risk appeared to be spread thinly, parcelled out in small amounts, bundled up with other, less precarious loans. From the banks, the loans, an economic virus waiting to find another host, were sold on to private equity funds and investment companies. In a world of inextricably interwoven financial relationships, that home in Ohio represented collateral for a sliver of debt that could be held almost anywhere on the planet.

Taking the money out of debt

Placed in the mighty scheme of things, the inability of an Ohio family to avoid defaulting on their mortgage repayments would not amount to a hill of beans (except, of course, for the family). The CDO in which their sub-prime mortgage was bundled would be able to continue to meet interest on the loans it contained. It’s just that over the last two years, the number of American families unable to pay their mortgages has risen and risen and risen. In sufficient numbers, in fact, to create a critical mass of bad debt colossal enough to hammer many CDOs into valueless pulp.

In 2007, lashed by so many empty, broken mortgages, the international debt markets suffered a storm of mind-boggling losses. Where once trillions of dollars of debt could be traded cheaply, now billions upon billions of dollars were being wiped out in a tsunami of bad credit started by a small but gathering wave of over-sold and under-funded mortgages. Bear Stearns, a leading US investment bank, watched as two major hedge funds, which had bought up a lot of debt, disappeared into a heap, $20 billion evaporating before investors’ eyes.

The ramifications, of course, could not be absorbed by the more arcane and impenetrable regions of high finance. The storm hit the real world economy too. Cheap debt had helped to bolster company share prices. It had helped private equity firms to manage leveraged buy-outs. Now market activity, drained of the flow of affordable money, stalled. Buy-outs and mergers were called off. Risk became too risky. The value of the collateral on offer in return for institutional loans came under suspicion as house prices, against which sub-prime mortgages were set, began to tumble.

Banks, in Europe as well as America, sitting on debt packages that were now worth a lot less than they had paid for them and having to dig into reserves to write off their losses, grew reluctant to lend to other banks (Northern Rock faced its difficulties because it could not raise the liquidity needed to fund its loans). Hedge funds that once invested in huge chunks of debt found themselves starved of cash, their appetite for funding corporate takeovers managed by private equity companies equally diminished.

Nor did the turning off of the money taps end there. Banks grew reluctant to lend to smaller businesses and individual customers too. And where they did lend, they raised the cost of borrowing. Mortgages have become more expensive, business loans less easy to negotiate. Money is no longer cheap and no longer plentiful.

Bears, oil and interest rates

The effects of the credit crunch are still reverberating. The equity markets are in turmoil. The FTSE 100’s most recent high point was October 2007 when it reached 6730. By July it had fallen to 5260, the swingeing 20 per cent drop within the year qualifying it as a bear market. Banks are turning, cap in hand, to shareholders for injections of new funds in order to repair the damage done to their balance sheets.

As profit forecasts among listed companies have moved from disappointing to worrying, investors have deserted the market and sold shares. Only the performance of energy stocks, buoyed by rocketing commodity prices, have prevented further steepling declines in the value of the equity market.

On the ground, consumers, the foot soldiers of the economy, have been reining in their own investments too, preferring, where possible, to snap shut purse strings rather than spend. High Street sales have, seasonal blips aside, been showing a series of falls that, month on month, is threatening to move from a short-term switch in spending habits into a medium-term trend.

New mortgage approvals are at a historic low, and, as the mortgage market shrinks, so house prices in the UK have seen thousands of pounds wiped from their value.

Making a bad situation worse, of course, has been the soaring cost of oil, energy, raw materials and food, pumping up inflationary pressures within the economy at precisely the time it requires a reduction in the cost of borrowing and an ease in the availability of money. This has been the Bank of England’s Gordian knot: how to balance the imperative to keep the lid on prices, a move that would be compromised by making credit cheaper and easier through a cut in the base interest rate, with the equally urgent need to inject growth into the economy by encouraging consumer activity and enabling business borrowing.

In the US, the Federal Reserve went at interest rates with a sword, slashing from them percentage point after percentage point. Here, the Bank of England and the European Central Bank, caught on the horns of the inflationary/slowdown dilemma, have chosen to keep rates relatively high as a safeguard against rising prices.

Meanwhile, the CPI rate of inflation is offering signs that it will remain stubbornly above the Treasury target of 2 per cent for at least the rest of the year (it has reached as high as 4.4 per cent), just as growth predictions for the UK economy shrivel with each new forecast, dipping, some believe, to just 1.7 per cent for 2009. It is a tightrope walk for the Bank of England.

The outlook

Things may appear gloomy. But just how gloomy? Is the worst of the credit crunch over? Is it now a case waiting for the money taps to be turned back on? For mortgage lenders, battered but unbowed, to start funding house moves again? For shoppers and businesses, reassured, to resume spending and trading?

Only in July Sir James Crosby, who was commissioned by the Treasury to report on the housing market, estimated that the credit crunch would make mortgages difficult to obtain until at least 2010. Sir James’ report has prompted consideration by the government of a scheme that would allow the Treasury to underwrite mortgages by guaranteeing bonds issued by lenders. Even though it is now accepted that some form of government action may be needed to address the mortgage-funding gap, no decision is likely to be confirmed until the autumn pre-Budget report.

Hopes that ordinary savers can help bail out the banks and building societies, tempted by the generous savings account offers currently available into boosting the amounts they deposit, may be wishful thinking. Not only has the level of borrowing against mortgage-backed securities among banks and building societies, as opposed to the old habit of using customers’ deposits to fund new mortgages, never been higher (a quarter of all the money raised last year for mortgages came from the money markets), ordinary savers, foraging deep into pockets to pay for petrol and food, are having to cope with money issues of their own. How to save when disposable income is being eaten into by constant price hikes?

While the housing market labours in the doldrums, lenders unable to provide the huff and puff of finance borrowed from the money markets that would satisfy demand for new mortgages, so the rest of the economy, from major corporations to small businesses, will continue to feel the becalming effects of the lack of liquidity.

Last month, the IMF too poured more cold water on any optimism over an early end to the turbulence. “A bottom for the housing market is not visible,” its latest global financial stability report declared. Things, in other words, may get worse before they get better.

The business effect

With people, including other businesses, spending less, firms in the UK have not been firewalled against the credit crunch. Sales have dipped in many sectors and, hit by the double whammy of rising commodity costs, profit margins have been squeezed.

In response, a new report suggested, businesses are storing up surplus cash against further downturns in the economy. As part of its six-month survey of business activity, Lloyds TSB recently reported that smaller firms are depositing record sums of money into their business accounts, preparing themselves for additional falls in sales and profits.

However, the report also suggested that many firms appeared to be in a better position to handle the current downturn than in previous periods when trading conditions became difficult. Balance sheets, it concluded, are in a relatively strong condition. And while cashflows have become more problematic, the percentage of firms suffering from late payments is still less than half of the 56 per cent that reported similar difficulties in the recession of the early 1990s.

It may not be possible to pencil in a date when newsreaders finally stop referring to the ‘credit crunch’, its destabilising consequences at last exhausted. It may not be possible to say exactly when the money markets rediscover that chimerical, totemic word ‘confidence’, a word upon which many powerful financial structures rely as much as they do upon more tangible things such as hard cash. Recovery will, eventually, happen.

It is, however, possible to take practical steps, whether as businesses or as individuals, to make sure that we are in the best position to deal with the current problems: steps we will be examining in the remainder of our series of articles on the credit crunch.