Credit Crunch Explained - A Guide for Beginners

Imagine going into your local Tesco one day to find that the greater part of the store had been given over to milk products such as butter, cream, yoghurt and cheese. Not only that but you also learn that the public are barred from this area as all trade is restricted to other supermarkets. Just as a large carton of assorted milk based goods exits the front door on its way to Sainsburys another one is coming in via the back, courtesy of Morrisons.

Well the world’s major banks seem to have been operating a similar business plan for the last few years. They have been buying large bundles of securities know as CDO (collateralised debt obligation), such as all of a particular credit card provider’s accounts receivable for say, Wigan, and at the same time, a matching bundle of a different kind of security such as shares in Northern Rock, These last are usually known as ABS (asset backed security) and there is a theory that says to spread the risk with a mixed portfolio of different sorts of investments like this is a good thing. If the credit card debts (CDO) hit problems then the Northern Rock shares (ABS) will shore up the gaps or vice versa. However, either this theory has been grossly misunderstood or it is just plain wrong.

The return on these bonds was supposed to be higher than the banks' usual yield, with the added advantage that they didn't have to perform any kind of service on behalf of their customers in order to earn it. How they made the money was to buy these bonds and either wait a long time for the cashflow from them to deliver the profit or take the preferred option by selling them on at a premium to other banks. For years the banks have assiduously traded these instruments between themselves as they took on a value all of their own especially if interest rates were either going down or expected to do so, thereby freeing up cash in order to buy a new lot.

The real villain of the piece though has been the MBS (mortgage backed security), which took centre stage from the early 2000s. This was at a time when the house price boom was getting underway in the US, as was ours. Everybody was invited to this particular party, including a lot of people who in the long run couldn’t actually afford to join in. Subsequently an MBS would then be concocted from differently rated mortgage debts; some good, some bad, some indifferent and some downright lousy, or sub-prime as they are now called. An ABS mix of say, shares and hire purchase debts was added as a hedge against the chance that some of the components might not perform and once one of the rating agencies had given the whole package the nod it was offered to the banks.

They all joined in and it would appear that some of them such as UBS, Morgan Stanley and Merrill Lynch couldn’t get their hands on them quickly enough. Then one day the apparently unthinkable happened; interest rates went up.

Many highly leveraged low income groups now discovered that they didn't have enough cash to service the loans that had once seemed so cheap. The result was that the wheels started to come off these trades as the realisation sank in that Wigan’s credit card debts, US sub-prime mortgages and Northern Rock's share price were actually all being produced by a solitary cash cow called the housing market, which was running out of milk.

The credit boom of the last few years was riding on the back of ever increasing house prices and it was this that was driving just about everything from consumer spending to share prices. If prices stopped going up the credit boom would stop causing everything else to stop too, which thanks to rising interest rates is exactly what happened. Sub-prime mortgages were the first to sound the retreat as defaults and repossessions in America rose sharply. In the event that was all it took for the world's banks to take a closer look at their balance sheets than usual and realise that they had traded themselves into trouble. At this point the securities market hit a brick wall, which is pretty much where it remains at the moment. What the banks had failed to realise is that when a product passes it sell by date it goes sour and they are now discovering that when you keep it on the shelf for too long after that, it starts to stink.

14th October 2007

Click here for a short article on the Glass - Steagall act
Click here for a definition of MBS (mortgage backed security)
Click here for a 'thisismoney.co.uk 'definition of Alt-A (Alternative 'A' rated home security)
Click here for a definition of CDO (collaterised debt obligation)
Click here for a definition of ABS (asset backed security)
Click here for a Guardian article on the FBI investigation into the sub prime crisis

© Figurewizard.com ltd. This article may not be reproduced without our express permission

Your Comments

They never learn. Now that property has gone south just look at oil and gold. Trillions of dollars have emigrated there and when these turn, as they surely will we will have a brand new crisis on our hands.
Comment by Denys Humbinet

The banks deserve to suffer for this but the trouble is that it is the ordinary person who will end up paying all of the bills for it.
Comment by franklyspeaking

It is the ordinary person who has created this mess by driving up property prices, and the poor banks are paying for it.
Comment by Adam

It takes two to tango Adam. The banks were positively encouraged to fuel the house price boom by the government. Even when prices began to stabilise back in July of 2003, the base rate was cut to 3.5% and it was duly kick started. Forget the 'independence' of the Bank of England by the way - you only have to look at who appoints half of the MPC. Gordon Brown knew better than anybody that a slowing of house prices would lead to a fall in the amount of cash being borrowed by householders to fund increased consumption while his drip feed taxes were poured into the abyss that is the UK public sector today. The housing bubble was the only thing funding his economic boom and he did everything possible to keep it going, including nationalising Northern Rock at the time.
Comment by Figurewizard

Can somebody please ease my confusion.. As far as i am aware the central banks have inflated the economy beyond the point of reason. They have not let the market allocate credit as it needs but insisted that everyone gets free money. As far as i am aware the paper that we call money(around 95% of it at least) is created when by a borrower's pledge to repay a debt. This currency is then conjured by banks and created with interest already attached to it, hense money=debt. The central banks seem to me to be winning by the this credit crunch. They have further sunk us into a system of perpetual debt, a system they control. "Permit me to issue and control the money of a nation, and I care not who makes its laws" Mayer Anslem Rothschild. Can someone please explain what I am missing?
Comment by Jordan

Jordan makes a good point. Suppose a business borrows short term cash from the bank by way of an overdraft and then assumes that the bank won't actually ever want it back. It then goes on to invest the cash in something long term such as property development. This would be considered to be nothing short of criminal recklessness by the bank and the inevitable result would be bankruptcy for the business. This however is what the banks have been up to themselves for generations but never more so than over the last seven years. Long before the crisis erupted in the US we provided the outstanding example of this here in the UK - Northern Rock. The irony is that we the taxpayers were then told that it was our duty to save them.
Comment by redboam

It's good to see that while Northern Rock is pretty much gone, it's not forgotten. What we should all be asking ourselves now though is if a £100 million commitment to a relatively small provincial mortgage company was crucial to 'financial stability' as Gordon Brown told us at the time, why wasn't this also true for HBOS? The answer is twofold. Firstly Northern Rock was located in Newcastle; the hinterland of which contained some twenty three safe Labour seats that could have been put at risk if thousands of jobs had been lost there and secondly unlike HBOS, it was completely bust. Not only had it run out of cash, the value of its assets were worth far less than its debts. We are all going to be paying a long and heavy price for a decision that Gordon Brown forced on us all purely on behalf of the Labour party in general and what he saw at the time as the long term security of his position as Prime Minister in particular.
Comment by Figurewizard

In answer to Adam's comment.. It is not a case of the banks suffering due to rabble's driving up of house prices. The housing market would not have suffered so much if the banking systems were not completly saturated with other bad debts; to the point that the banks started to refuse to lend to eachother. Credit has been given to people who had no chance of repaying, why? Are the ecomonmic elite that clumsy and short-sighted to make such a titanic mistake, or are we roughly where they expected us to be? I fear the attraction of conspiracy theories is upon me, can someone please tell me if any of my basic assumptions are totally wrong..
1. the banks create fiat currency with debt attached to it
2. the banks inflated the economy with this debt money over years, knowing (unless you beleive they are completly stupid) that the bubble would burst.
3. having put the markets and public into a huge debt and an untenable position, corporations start to collapse and then the government buys them with taxpayers money that is printed by the very banks and central bank that caused the problem.
Figurewizard please explain in order of preference that
a)i am disinformed,
b)that the bankers have been innocently and absurdly stupid,
c)my assumptions are crudely accurate, yet commiting to a theory of conspiracy requires a leap of faith..
Comment by Jordan

I see you use the word 'stupid' in respect of the banks twice and this more or less says it all. The construction of the securities that were being traded daily to the tune of billions of dollars, pounds and euros was actually a mystery to them. The 'leap of faith' to which you refer was that these were regarded by them as sound investments, guaranteed to make significant returns when in fact any reasonable person could see that nothing of the kind was possible in the long term. Their bonus systems didn't help much either as they provided the incentive for their traders to take ever greater risks for ever increasing rewards. I don't see a conspiracy however between these and the central banks. After all they are the ones who have to pick up the pieces, using our cash at the end of the day; something that our political masters would have regarded as electoral suicide if the regulators had done their job and passed their findings on. One only have to look at what has happened to this government's poll ratings since this whole business started to understand that.
Comment by Figurewizard

I applaud this article. It makes the point that other commentaries on the credit crunch seem to have missed-That without bloated house prices that bear no relation to their true value, the economy of the UK in particular is never going to go back to the la-la land of Gordon Brown's so called economic miracle. Throwing yet more billions at our banks as has been announced today is simply going to prop up the villains while the rest of us are facing the best part of a generation of real penury.
Comment by Frank Webb

Thanks for that Mr. Webb. Your point underlines the frightening truth. Even if the banks were able to lend as freely as before the asset base (housing market) that has supported the supposed economic growth from 2001 to 2007 by way of collateral is shrinking fast. Massive tax cuts, putting more of our cash into our own pockets might have been a better strategy but this government has gone too far down the road of pouring our cash into the banks instead to be able to contemplate this now. The only tax cut of any significance has been a pathetic attempt to be seen as doing something by cutting VAT by 2.5% for thirteen months; a move that the public finances cannot afford, which will fail to make much of a difference at the end of the day and for which we will all have to pay the price from 2010 onwards.
Comment by Figurewizard

Not bad I also came across a really entertaining and informative paper on the credit crunch. It's really easy to follow and yet quite academic, even amusing in places so all round great article go to www.johnabbey.co.uk

Comment by Peter Hughes

Peter Hughes: Thanks for the info on the johnabbey.co.uk article which gives a thorough explanation of the sub-prime fiasco. One point he makes re. the relaxation of regulation in the Clinton era is worth expanding on.

From 1933, in the wake of the great depression the 'Glass-Steagall' was introduced into US law. This drew a distinct line between commercial and investment banks, restricting the commercials to generating no more than 10% of their annual revenues in securities trading other than government issue bonds. Also whilst they were allowed to sell insurance products, they were not allowed to underwrite them. Would be investors, depositors and crucially other banks therefore had an informed choice between 'Commercial' - Boring but Safe and 'Investment' - Sexy but Risky. It is arguable that it was the fact of this legislation that played the key role in the relative stability of the banking business both in the US and the rest of the developed world for the next sixty six years.

In 1999, under pressure from Citibank, who wished to merge with Travellers Insurance inc thereby forming Citigroup, this act was largely repealed (Gramm - Leach- Bliley act). Banks in the US and most of the rest of the world took this as a signal first to seek such consolidations for themselves and then to to dive head first into the securities markets with precious little experience of them and next to no knowledge of the risks involved.

As this article points out the vast majority of securities trades were either directly or indirectly dependent on the uninterrupted inflation of a housing bubble. However, as John Abbey points out the bubble was ultimately pricked by the sub-prime sharks with Northern Rock being an outstanding domestic example. Now thanks to this; boring, safe and sexy have evaporated leaving taxpayers here in the UK, the US and most of the rest of the world to fund the risky. If Gordon Brown ever manages to get a grip he might consider dusting off the old Glass - Steagall act and giving it a go.
Comment by Figurewizard

I agree that Glass-Steagall ought to be making a comeback but the banks won't wear it. The only lesson the think they have learned is that mortgage backed securities are not necessarily a good thing. But heh! they will come back with something else and in the fullness of time the cash that the taxpayers have been forced to dish out will go south once more with all of us back where we started. After all if you're a bank, where's the risk these days?
Comment by Stephan

Please use this area to contribute your opinion to this article whether its to add detail, critiscise or correct we really appreciate your input

Bookmark with:

What are these?

Home Cashflow calculator How it works Register My account Articles Contact
Website development by PWDC

Terms and conditions Privacy Policy