Credit Crunch

Tuesday, 8 January 2008 | posted by Ben
General, Economy

Today's blog entry is about the global financial credit crunch and it implications for 2008. I believe it is a relevant topic to be on our minds as we head to London and prepare for the WEF08.

Our current world wide financial crisis started with mortgage problems in the US and thanks to global markets spread the risk very quickly. So while US housing prices were on the way up from 19996 to 2006, banks offered interest only mortgages & low initial rates to high risk borrowers, ie families with low incomes or poor credit history. People would take up these attractive offers with a view to refinancing the mortgages at a later date, essentially jumping ship to a better mortgage rate. Now, in 2006, the bubble burst and US house prices started to drop, and banks couldn't offer the same attractive rates so subprime families were stuck with mortgages they quickly couldn't afford so they started defaulting.

Now, if people are defaulting, that is judged a risk by banks, which in the old days meant the bank suffered a loss but nowadays we securitize our risk into Structured Investment Vehicles which enable investors around the world to put money in and receive profit back. Investors could be other banks, corporations, hedge funds or other large pools of money. So many of these SIV's had large amounts of US subprime mortgage securities which were defaulting but there was uncertainty as to the size of the risk of default and where it would affect the payment to investors. Investors wanted out and they wanted out quickly resulting in SIV’s losing value very rapidly.

So, with this subprime risk in SIV and its unclear impact our banks started to raise the interest rate, in September, on the loans they gave to each other. Higher intra-bank interest rate equals lower liquidity which means banks can't get the money easily so in the UK that meant Northern Rock had to go to the central bank for an emergency loan, triggering a run on the Northern Bank with people concerned that Northern Rock couldn't meet its debts to retail customers. Banking is all about confidence, there is a great scene in Mary Poppins where the little boy causes a run on the bank because the bank wouldn't give him his money, people lost confidence.

So where are we now in the 2008? Well banks like Citigroup, HSBC & Deutsche Bank have lost billions on writesdown on the value of their securitized products because of subprime mortgages, and banks have high interest rates in lending to each others resulting in low liquidity and lack of money floating about. Translating the effects of this in the real world from financial world is difficult, but mortgages will be more difficult to get, companies who rely on cheap loans could be at risk and economies could slow down or even recess. I can't say it all these things are going to happen but rest assured those global leaders in corporations and government will be giving it serious thought. I have barely skimmed the surface on this whole crisis, but there are a lot of sites out there with guides to it and further reading should include www.ft.com and www.bloomberg.com.