Credit Crunch!

Five years ago people were happy with a secure job and plenty of credit available to buy whatever their needs desired. Living in blissful harmony if you mentioned the word credit crunch people would have thought you were talking about some tasty new cereal.

O.K maybe the past seems a little better than what it was but compared today’s economy it was heaven!

Ahead of the budget next week Chancellor George Osborne has a difficult task coming up with a solution to end the UK’s economic plight. The UK has already been warned it could lose its AAA status within the next two years if it doesn’t sort out its public debt. There are also talks that the Chancellor may scrap the 50p tax rate. It would seem strange to give the rich a tax break when the average Joe is struggling to make ends meet. However, the argument for this is that if the rate is lowered more high earners will settle in the UK thus more tax will be raised offsetting the short term losses.

The UK economy is struggling like many of the world’s leading economies. The reason being it is still suffering the consequences of the credit crunch. The impact of the credit crunch has been so huge that in 2008 the term was accepted into the oxford English dictionary! For those of you who don’t know what is meant by a credit crunch, it is basically a severe shortage of money or credit available to lend.  

The start of the credit crunch has been pinpointed to the 9 August 2007 when BNP Paribas announced negative news causing a spike in the cost of credit. However, many people believe that the origin of the crisis which has unfolded in recent times can be traced back to the early 2000s. The dot com bubble had ended and terrorists had just attacked the twin towers, the world quite frankly was in disarray. To in store confidence back into business the US Federal Reserve slashed interest rates to just 1%. This meant credit was cheap and the economy thrived on cheap money. Banks could afford to lend cheaper and the low interest rates were carried on to the wider public through cheap mortgages. The problem was that the interest rates were held too low too long. It was not until 2004 that the US raised them unfortunately they rose too sharply and by 2006/2007 were above 5%.

This is where the problem really started and the credit crunch was about to hit home. The interest rates had been low and this meant that because more people had access to mortgages house prices began to rise due to the demand. The problem was that banks started to lend to people who they really shouldn’t have, they were undertaking subprime lending. The banks were lending to people who would have difficulty maintaining the repayment level. Due to the fact house prices were increasing, banks thought this was a safe idea. Unfortunately for them they were extremely wrong.

It was bad enough banks were lending these subprime mortgages but even worse was the fact they were trading them through collateral debt obligations (CDOs). I’ll try to explain what these are as simply as possible! Basically the mortgages the banks were lending were all bundled together. The mortgages were then given different risk classes such as AAA, BBB etc. known as tranches. The owners of the CDOs earned money from the interest mortgage owners paid each month. The riskier tranches obviously received higher interest because of the risk involved. They effectively got paid last after all the cash had been collected. The problem was that these riskier tranches were re-bundled into secondary CDOs. They were then given the same risk structure as the primary CDO. The problem being the risk structure was inaccurate. This meant investors were buying AAA tranches from the secondary CDO which should have in fact been rated as BB. When the housing market bubble burst in 2007/2008 people were unable to pay their mortgages. Therefore, owners of these CDOs at the bottom end unfortunately were not getting paid. Owners who thought they had an AAA CDO but didn’t, realised just what a mess they were about to face!

An explanation of CDOs can be better explained in the video below:

So that is how the credit crunch came about, over confidence and too much fiddling in the financial markets. Banks have gone bust, leading businesses have failed and unemployment seems to keep rising. Five years on from the credit crunch we are still living with its consequences. How long before things start to pick up again, who knows? America is showing signs of the recovery with employment improving and the dollar strengthening, however, only time will tell.

Sources Used: bbc.co.uk, youtube, FT