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You are here: Home / General / Credit Crisis Explained

September 20, 2008 by John Duncan

Credit Crisis Explained

From reports on TV and in the newspapers the world’s financial house of cards is said to be falling. But we all know that the more sensational the story the more newspapers and television programs will be watched. The world economy is not in the best shape at the moment mainly due to the credit crisis. How has this happened and how will it affect you?

The basis of what’s going on in the world economy stems from the credit crisis or credit crunch in the United States.  What is a credit crunch? Credit crunch simply means that the amount of money available from savers to be lent has decreased and the lenders are also asking more interest on the money they are going to lend. Why is it that this seems to be causing so many problems?

Over the past 10 years the availability of credit has been expanding rapidly. Part of this is due to the way the banks raise the money and then on lend it. Previously banks used their deposit base (mum and dads money in bank accounts) to lend to home buyers. If home buyers defaulted on their mortgage it was the banks profits that suffered so before a loan was approved they would do as much as possible to ensure their borrower had the ability to repay the loan.

Banks still use customer’s deposits to then on lend to borrowers, but over the last decade banks decided that the way to increase profits was to increase the amount of fees they charged. They could do this by increasing the amount of loans they were managing.

For lenders to increase the amount of loans they either needed to increase the amount of deposits held or raise the funds via other means. To attract more deposits they needed to increase the interest rate but this was an expensive way to do business. Instead they found that after they had established a portfolio of loans they could sell these home loans to investors as a bundled product (mortgage-backed securities). This allowed them to continue using the same deposits to again fund more loans. They were now making further profits from managing the loans but they weren’t using their own funds.

This was risk free business for the bank as it wasn’t their money being lent and it was the investor buying the mortgage-backed securities taking the risk. So for the banks to now improve profit all they needed to do was increase the volume of loans they were completing. So here comes the problem. As good quality borrowers become scarcer the lenders to increase volume continually reduced the requirements to get a loan. At the start to get a loan you needed to prove your income for the past two years and show a strong amount of stability for the bank to give you a start.  Before the bubble burst you just needed tell them you could afford it without proof and they would lend you enough to cover the fees and purchase price. Even if you previously had very bad credit you could get a loan, all you needed was a small deposit and you knew for the next few years you would just be paying higher interest rate as a penalty. For the banks this was win-win situation. They took on no risk, increased the volume of business, their fee revenue increased and so to do their profits. Shareholders were happy and so too were the CEO’s of the banks now receiving huge bonuses.

So what happened next?

Next the bankers started to believe their own story on the mortgage backed securities – that they were secure investments with 100% capital backing.  So they started buying higher and higher interest rate residential mortgage-backed securities. However in the US, a lot of people got discounted interest rates the first couple of years of their mortgage. After which they would revert to a higher interest rate. But as the loans started to revert to the higher interest rate many borrowers simply stopped paying their loans due to affordability and waited for the banks to send the eviction notice. In the United States the lender does not have the ability to bankrupt a borrower as the loans are non-recourse. That is they can only take the asset securing the loan. Now with so many borrowers defaulting more and more properties are entering the market with mortgagee sales signs. Eventually the amount of properties on the market forces down the price of property and these mortgage-backed securities were no longer looking very secure.

Billions has now been written off by many investors and there were a lot of banks exposed, even those with stringent lending guidelines has come under the spotlight as the homes that they lent against are now also in negative equity. Many lenders are reluctant to lend to each other as it is difficult to tell the viability of any one lender. So they have put up their rates to compensate them with the higher risk they are now taking on lending their money.

This is where you come in: most lenders if not all in Australia get at least some of their money from overseas lenders to fund their own mortgages in Australia. Most banks borrow this short term on a variable rate. As each agreement expires they have to go back to overseas banks that have money to lend and make another agreement to continue holding their funds. But now the interest rates have gone up and they are passing the interest rate increase onto you.

So can we expect more interest rate increases?

There is no simple answer to this question – it is yes and no. If the uncertainty continues, the interbank rate (the interest rates that lenders use to lend to each other) may continue to rise. If the rise in the interbank rate was persistently higher the increase would be passed onto the end borrower you. However as the economy slows the Australian Reserve Bank, keen to ensure Australia doesn’t follow the rest of the world into a possible global recession will cut interest rates in an attempt to stimulate the economy. The market expectation is that even if the interbank rates are increased the reserve bank will reduce rates in Australia which should more than offset any increase in the interbank rate, so over time we should be seeing lower interest rates. But as a proponent of the efficient market it is impossible to tell the next move in interest rates and if you are close to borderline with un-affordability the best thing to do is get some advice before you’re a statistic.

Article date – 30/9/2008

Filed Under: General Tagged With: credit crisis, gfc, global credit crisis

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Director for True Financial - John Duncan - Fee Only financial planner To receive the best financial planning advice you need the best financial planner. John Duncan is certainly in that category. John is a financial planner who is unique in not only his high level of knowledge and experience in financial planning but also in the amount of areas that John advises in. A Financial Planner with a strong Education background John is a Certified … Read More

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