What is the ‘Credit Crunch’ and why did it occur? - 28/3/08

The credit crunch is basically brought on by the fear by many leading lending institutions like banks and building societies to lend each other money as they fear they may not get it back. In living memory the UK money markets have never been under so much pressure. Initially in the UK it started with the Northern Rock disaster, however, the roots of the problem stem from the sub-prime catastrophe which continues to sweep America. It’s a tale of greed and lack of discipline and one which could cause the most severe damage to financial markets since the Wall Street crash in America in the late twenties.

Traditionally, banks raised money for mortgages to lend to people from the deposits they received from their own savers. This limited the amount of mortgage lending each bank or building society could arrange. However, in recent years this model changed with mortgage companies selling on their mortgages to the bond markets to gain more capital to lend out. This made it much easier to gain mortgage funds quickly and to build a large portfolio and with interest rates fairly low, housing demand high and economies stable there was great demand from bond marketers for more mortgage lending. In a prime world there is no major problem with this, however, problems have been caused by the massive overindulgence of US sub prime lending.

In many states in America after the Millennium there was a shortage of housing. There was also a rise in foreign settlement and a desire to rehouse the poorer areas of towns and cities. However, many poorer families could not afford to buy their own properties. To make mortgages attractive mortgage products came to the market based on low introductory rates (e.g. 2 year initial low rates) but with a sting in their tale – rates often doubled at the end of the initial period. There was also a complete breakdown in normal good lending practise (much better in the UK market) with simple checks such as affordability calculations being set aside and mortgages basically being granted to everybody irrespective of income or credit history. The worse the credit rating the higher the interest rate, but with world interest rates generally low, high rate sub prime loans suddenly became very attractive to financial institutions everywhere and very quickly the industry in US grew to $6 trillion!

At the same time in America alongside a decline in manufacturing industry many poorer families were targeted to remortgage their properties to raise additional income as jobs slowed and again were attracted by how much they were allowed to borrow. However, when rates and repayments rose after the initial period it led to a huge increase in repossessions.  By the end of 2007 one in ten houses in Cleveland had been repossessed and the Deutsche Bank Trust was the biggest house owner in the city. It is predicted that there will be two million house repo’s in the US due to the sub prime mess.

In addition there is now a huge housing surplus (estimated at £4m), house prices are falling and America is entering into a depression.

In 2007 reports started circulating in financial markets of the sheer size of the problem and it is estimated that up to £400billion may end up being written off by worldwide lending institutions due to the US sub prime problem. Many national names including recently Bear Stearns have been brought to their knees virtually overnight. In the UK where the sub prime market is more controlled there are now signs of the worst banking crisis this century. Credit underwriting is becoming tougher, availability of money much less at favourable terms and there is every indication that the credit crunch will continue for the foreseeable future.

Steve Burnage, director of BFS Direct says

"my recommendation to all our customers is that we will search the marketplace to find you the best deal. With many lenders becoming much tighter it is even more vital to use companies like BFS who can search everywhere. As soon as a suitable deal is found we will endeavour to complete each case as quickly as possible to ensure that our customers receive the funding package they require. We do expect the market to settle down in the future as there is such a growing demand in the UK but the short term is rocky and it is important if you are looking to refinance to grab the best deals quickly!”

Steve Burnage 22nd March 2008