The Credit Crunch Explained

TEP - 6 October 2008

IT was once an arcane term only known to economists, but the phrase "credit crunch" has been so widely used over the past year that it has been added to the latest edition of the Oxford English Dictionary.

What is a credit crunch?

In simple terms, a crisis caused by banks being too nervous to lend money to us or each other. Where they will lend, they charge higher rates of interest to cover their risk.

In the real world, that means more expensive mortgages, dearer credit cards, pain for pension savers and other investors as stock markets fluctuate wildly, and in the worst cases repossession and bankruptcy.

Is it the same as a recession?

There is often confusion between the two but they are not the same. A recession is usually taken to mean two successive quarters of negative economic growth. A credit crunch can be separate to or part of a recession.

Who invented the term credit crunch?

It is unclear, but it was used in a study by America's Federal Reserve bank as far back as 1967.

What sparked the current crisis?

Years of lax lending inflated a huge debt bubble as people borrowed cheap money and ploughed it into property.

Lenders were free with their funds, especially in the US, where billions of dollars of so-called Ninja mortgages - no income, no job or assets - were sold to people with weak credit ratings (called sub-prime borrowers).

The barmy notion was that if they ran into trouble with their repayments rising house prices would allow them to remortgage their property. It seemed a good idea when Central Bank interest rates were low; the trouble was it could not last.

Interest rates hit rock bottom in America in 2004 at just 1 per cent, but in June that year they began to rise. As interest rates jumped, US house prices started to fall and borrowers began to default on their mortgage payments sparking trouble for us all.

How did it turn into a global crunch?

The way the debt was sold on to investors gave the crisis global significance. The US banking sector package sub-prime home loans into mortgage-backed securities known as CDOs (collateralised debt obligations).

These were sold on to hedge funds and investment banks who decided they were a great way to generate high returns (and big bonuses for the oh-so-clever bankers that bought them). When borrowers started to default on their loans, the value of these investments plummeted resulting in huge losses for banks globally.

How did this affect the financial market?

Banks had invested large sums in sub-prime backed investments and have had write off billions of dollars in losses.

But it got worse. Investors became nervous about buying any investment linked to mortgages, no matter how high their quality.

Banks had been using the investment markets to fund large chunks of their mortgage business (a process known as securitisation).

As fear spread it became impossible to sell these investments leaving a black hole in many banks and mortgage companies. The result: a credit crunch as lending dried up.