The Credit Crunch

LAMA MUNAJJED
What is the Credit Crunch?

A credit crunch is a period in the economy, distinct from a recession or depression, but
potentially heralding one or the other.

‘The credit crunch’ is widely used to explain the financial services catastrophes created by
the collapse of the sub-prime mortgage lending market in America in 2007, but a credit
crunch can apply to any period in which credit is squeezed.

Credit, including mortgage loans, personal loans, car finance, credit cards and any other type
of lending become much harder to obtain in a credit crunch.

This can be due to fears or actual restrictions on wholesale funding – the money used by
banks when providing loans. Tighter credit can be caused by much higher than expected
interest rates.

Furthermore, governments may impose stern credit controls or prevent mortgage lenders
from engaging in their business. All of the above constitutes a credit crunch.

During a credit crunch, consumers may find it increasingly difficult to get any kind of loan,
and they may also find that their debt becomes increasingly more expensive and hard to
manage. The credit crunch affects consumers and financial services businesses, making
mortgage lending less profitable and harder to access.

The 2007/2008 credit crunch has completely changed the face of the global economy, with
hundreds of business (including some of the foremost financial services companies in the
world) on the brink of collapse.

Companies such as Lehman Brothers, once considered one of the most powerful investment
banks in the world, have filed for bankruptcy. Countless other companies have been
nationalized.

Governments, including the UK government, have had to expend billions to restore liquidity
to troubled economies.

The causes of the Credit Crunch

We have had many bizarre analyses of the credit crunch in recent days, as remote from an
understanding of the economic theory as they have been from knowledge of the facts. I
want to sketch for you my current interpretation of events. I will inevitably over-simplify a
number of issues and miss out a discussion of others, but the core of my tale will, I hope, be
clear and intelligible to lay readers. You will also, I hope, see the political significance. For in
my view a deeply flawed analysis of these events is emerging, and risks reaching at-least-
temporary consensus, with profoundly negative implications for future policy and future
political philosophy.
Here are the factors I currently consider most important in explaining these events:

Genuinely valuable financial innovation: Over the past decade there have been genuine
financial innovations that really did increase the extent to which it was possible to diversify
away risk. For example, if I own one millionth of one million mortgages, I am less exposed to
the risk of individual people defaulting on their mortgages than if I own just one mortgage.
But how much less exposed am I? I have not eliminated all uncertainty, all volatility in the
stream of payments I will receive from mortgage holders, for what if if there is some event
that affects the whole mortgage market, so that many more people than is normal default at
the same time? Perhaps even the risk of that is reduced - perhaps financial innovation
means that the economy as a whole will be less volatile in the future. But how much less? It
is often the case with innovations, of all sorts (not just financial), that when they first arrive
people aren't sure how best to use them, and sometimes over-estimate how much
difference they will make in the short term (even if they indeed will eventually make a huge
difference). It appears that in this case, people in financial markets over-estimated how
much risk had been reduced by these new products, and consequently paid too much for
them. This necessitated a market correction.

Over-confidence in regulatory budging: The problem of mis-pricing of risk was made worse
as a consequence of hubristic regulation. Regulators in many key authorities only permit
institutions to function and certain individuals to sell financial products if they are
appropriately authorized. This authorization serves to provide consumers with confidence
as to the competence and informedness of those offering them products. I suspect that in
this case that confidence was mis-placed. Regulatory authorities did not have a good basis
for gainsaying financial institutions in their selling and pricing of these products or in the
purchasing of these products by institutions under regulatory oversight - their very novelty
prevented that. Why would regulatory authorities have a better view than market
participants about these matters? And ordinary consumers and shareholders trusted that
the banks in which they deposited funds or held shares, and the financial companies from
which they bought products, must be behaving themselves properly - otherwise the
regulatory authorities would be complaining, wouldn't they? The consequence of all this
was that if the regulatory authorities said things were okay, then no-one else was going to
check. They just bought what was before them, pensions, deposits, shares, and more
complicated products, assuming it couldn't be that bad and that the underlying behavior of
the institutions backing these products must be okay. Market monitoring was crowded out
by state monitoring, but this was hubris on the part of regulators for they were not well
placed to monitor these matters.

Flaws in the Market's and the regulatory authorities' interaction with ratings agencies:
Amongst the agents that over-estimated the reduction in risk because of financial market
innovations were ratings agencies. Markets and regulators had probably become
complacent in their reliance upon ratings - assuming that if something were AAA rated then
it must be okay. Markets will think about ratings agency ratings differently in the future -
markets will learn from their mistakes. Regulators will probably change the rules relating to
ratings agencies, and will certainly adjust their own degree of reliance upon ratings agencies.
Use of novel products to by-pass regulatory requirements: We have seen time after time that
financial markets respond to restrictions on activities that are frowned upon by devising
clever new techniques that fall outside the regulatory net. That seems to me to be perfectly
proper behavior on the part of financial firms - they only need not do what they are
forbidden from doing. New financial products of recent years have allowed institutions to
by-pass banking prudential requirements and other kinds of regulation. I do not believe that
this can be prevented without totally undermining financial innovation and the workings of
financial markets. The proper response is to be more modest in one's initial expectations of
what regulation can really achieve, and to trust in and value market mechanisms.

Extreme moral hazard in respect of housing: House prices have come to be closely associated
with political fortunes in recent decades. Governments have been seen to take political
responsibility for house prices, boasting when they rose and suffering when they fell. As a
consequence, financial markets anticipated that governments would intervene in the event
that house prices fell, to limit defaults and foreclosures. Because of this, lending associated
with housing was seen as very much lower risk than would be its natural status in a market
in which governments would not intervene. As a consequence, it was appropriate for
lenders to take far greater "market" risks in lending on housing - driving up house prices to
extreme levels until the point at which the government bailout feasibilities were tested. The
answer is not for governments to validate moral hazard expectations of the past by
intervening today. Otherwise housing will continue to be subject to wild cycles of this sort.
Instead, governments must find ways to eschew responsibility for house prices, and to give
this credibility by enacting monetary policy mechanisms that will lean against the wind of
house price effects.

A flaw in the orthodox monetary policy regimes: I have explained before my view that
monetary policy targeting short-term inflation is flawed in that when it is most credible it
automatically starts to give rise to asset price bubbles. Specifically, in response to the
dotcom crash, 9/11, the Enron affair, and then the Iraq War bear market; interest rates were
kept very low creating excess liquidity. There was an opportunity to mop up this excess
liquidity in 2004 and 2005, but because it was not issuing in inflation at that point, and
because there was understood to be a risk that aggressive tightening would threaten
already-over-inflated housing markets, the mopping up was not done (indeed, under
inflation targeting it was not strictly necessary). This exacerbated the problems above by
creating a situation in which much liquidity was available seeking return to be paired with
novel products (poorly-understood, but regulatorily-badged and associated with
government-back housing) offering decent returns. This drove classic Austrian mal-
investment.

Markets awaiting bailouts: Once matters were underway, market participants in many cases
preferred to try to outwait the regulatory authorities so as to secure bailouts or subsidies or
other favorable terms), rather than crystallize losses or enter into market rescues early. This
meant that the markets own stabilization mechanisms tended to be undermined by the
implicit promise of government intervention if it were needed.
I believe that other factors - e.g. the thought that there was "bad luck" because the above
was paired with rising oil prices and inflation - are rather confused. The extent of oil price
rises was another manifestation of excess liquidity, and inflation was the consequence of
excessive monetary growth.

I do not believe that there was any necessity that the UK suffer equally with the US. In the
1930s, US real GDP fell by around a third. But UK GDP fell only 5% - indeed, in growth terms
the 1930s was no worse than the recessions of the early 1980s or early 1990s. Why was
that? Well, there are a number of factors, but the single most important was probably that
the UK financial system did not suffer from anything like the same degree of crisis that there
was in the US. This was for two reasons: firstly, matters in the late 1920s did not get as out
of hand on the "boom" side in the UK as in the US. But also, on the "bust" side the UK
financial regulation framework kept matters moving.

But don't we live in a much more globalised world now? Could we really avoid suffering
almost as much as the US? UK financial services have, over the past few years, become
enormously important globally. London has at least come to challenge, if not overtake New
York in this area. It is by no means obvious why a US financial crisis should not have been to
the benefit of the UK - chasing business here - rather than the detriment. In addition to the
problems mentioned above (which were shared, largely, by the UK) I attribute the UK-
specific problem to two other key factors:

1- The foolish tripartite system of regulation. The destruction of the Bank of England's
role as overseer of financial market stability empowered with prudential oversight of
banks and the untrammeled ability to force fait accompli takeovers of failing
institutions will surely rank as one of the most misguided regulatory decisions for
decades.
2- The use of deposit insurance. Deposit insurance is a deeply flawed concept, which
encourages excessive risk-taking by depository institutions (eliminating the need for
depositors to monitor the behavior of banks) and provides political comfort to
regulatory authorities (allowing those authorities not to act early so as to restrict
excessive risk-taking by depository institutions, because if worst comes to worst the
depositors will be ensured and the political damage thereby limited). The only
insurance there should be should be for payment system volumes - so that people
have confidence to use banks rather than notes and coin to make payments. If you
deposit £50,000 you are an investor, and you should accept risk. If you want your
money safe, hire a security house to keep it in a vault. If you lend it (which is what
depositing at interest is), you risk it.

Once the crisis was underway, there may have been sharp practice by firms covering up their
risks - I shall leave that to the FBI. It is also possible that "mark-to-market" requirements
introduced in the wake of corporate finance scandals may have destabilized matters once
the crisis was in full tilt. There are also other factors that I have not mentioned. But the
above represents my current analysis.

Here are a few political implications:

  Some occasional financial instability is the inevitable flip side of the enormous
positive benefits we gain from increasing efficiency in financial markets. Regulators
must never imagine that they can eliminate all volatility without killing the goose
that lays the golden egg.
 Markets learn from their own errors without the need for additional regulation, and
would do so on this occasion also.
 Excessive and the wrong sort of regulation and government intervention have been
as much to blame as any lack of such regulation. Introducing inappropriate
additional regulation may do little more than cause the episode to be repeated in a
future generation but just in a slightly different form.
 Macroeconomic management needs to change. The inflation targeting cum fiscal
policy rules orthodoxy of the 1990s has failed, either contributing to the problems
itself or shown to be impotent in addressing them. We will need to do something
different in future.

Credit Crunch Timeline

Credit crunch timeline the 2007 - 2008 financial crises was one of the more serious credit
crunches faced by the world, and the full impact may yet be realized until late 2009.

Origins of the 2007/2008 credit crunch

The credit crunch is thought to stem from a huge and unstable sub-prime mortgage market
in America.

American mortgage lenders approved high-risk mortgage loans to people with poor credit
records. These debts were packed together into CDOs (Collateralized Debt Obligations) and
sold internationally.

This problem started with problems in the US housing market. Interest rates increased from
1 per cent to 5.35 per cent between 2004-2006, and borrowers began to get into trouble
with their mortgage loans. American mortgage lenders began to feel the pressure, and the
US sub-prime mortgage crisis becomes common knowledge.

August 2007

Early indications of credit restrictions begin to appear in America, as banks refuse to do

business with each others. The US Federal Reserve tries to intervene and issue an economic
growth warning.

UK sub-prime mortgage lenders respond by withdrawing mortgages and putting up the cost
of borrowing for sub-prime customers.

September 2007
The Libor rate, at which banks lend to each other, increases to 6.7975 per cent, meaning
that banks are finding it hard to lend to each other.

The Bank of England base interest rate stands at 5.75 per cent. Northern Rock ask for urgent
financial assistance from the Bank of England to prevent a collapse, and the credit crunch
becomes apparent to UK consumers.

Northern Rock, unable to fund their mortgage lending, are in a dangerous position, and
depositors withdraw £1 billion in savings. The Bank of England auctions £10 billion to inject
some liquidity into the market.

October 2007

UBS announce massive credit crunch losses of $3.4 billion due to sub-prime problems.
Citigroup and Merrill Lynch announce huge exposures to bad debts. House prices, previously
climbing month on month, begin to stabilize.

November 2007

The mortgage market begins to be affected by the credit crunch, and the number of
mortgage approvals slumps to a three year low. In late November the Council of Mortgage
Lenders makes it clear that the credit crunch is seriously affecting the mortgage market.

December 2007

The Bank of England drops interest rates to 5.5 per cent. American intervention temporarily
lowers the inter-bank lending rate by flooding the market with billions of dollars in loans.
More funding is made available, both by the US Federal Reserve and the European Central
Bank.

January 2008

Global stock market experience severe crashes, the largest since September 11th 2001. To
avoid a recession, America cuts interest rates by three quarters of a percentage point, the
largest cut in 25 years. Bond insurance companies experience serious losses.

February 2008

The Bank of England cuts interest rates by 0.25 per cent. Home repossessions in the UK soar,
and the mortgage market is severely restricted. G7 leaders estimate some $400 billion
fallout from the sub-prime collapse. Northern Rock is nationalized temporarily.

March 2008

The Federal Reserve offer up $200 billion of funds to banks and financial services institutions
to try and increase liquidity. US investment bank Bear Stearns collapses and is acquired by JP
Morgan Chase. Early indications that UK house prices will fall become apparent.

April 2008
The mortgage market shrinks considerably, and 100 per cent mortgage loans disappear from
the mortgage market. Credit crunch losses are estimated at $1 trillion by the International
Monetary Fund. Other sectors begin to be affected by the credit crunch.

The Bank of England cuts interest rates to 5 per cent. Consumer confidence in the housing
market slumps, although borrowers with large deposits can still get a bargain. The Bank of
England gives details of a £50 billion rescue package allowing banks to swap mortgage debt
for government bonds. Royal Bank of Scotland call a £12 billion rights issue. UK
homebuilders see major cutbacks, and blame consumer confidence and a dearth of
affordable mortgages.

New mortgage approvals fall by 44 per cent, the lowest monthly figures since records
started. House prices begin to fall.

May-June 2008

Huge volumes of companies go into administration with the credit crunch the principal
cause. UBS launch a huge rights issue following massive losses. Barclays plan a share issue
from foreign investors.

July 2008

Experts predict that the UK is facing a recession as a result of the credit crunch. The outlook
is grim and the recovery period is expected to be extensive. The US mortgage lender
IndyMac collapses, and it becomes that Fannie Mae and Freddie Mac, the two giant
American mortgage lenders are in trouble. US authorities step in to help the companies,
which cannot be allowed to fail.

House prices in the UK slump by 8.1 per cent, with the average house now costing £163,316.
HBOS revealed massive slumps.

August 2008

Major banks such as HSBC recorded falling profits. UK house price falls exceed 10 per cent in
a year. Bradford & Bingley reveal massive losses due to the credit crunch. Alistair Darling
points out that the economy has hit its worst crisis for the last 60 years, with a profound and
long-lasting downturn expected. The pound falls to record lows, as does mortgage lending.

September 2008

The treasury announces a bid to reinvigorate the housing market by exempting stamp duty
for one year for houses worth £175,000 or less.

The UK is predicted to fall into recession by the Organization for Economic Cooperation and
Development forecasts. The FTSE experiences its steepest weekly slide since July 2002.
Halifax predicts the credit crunch will last until 2010, with banks continuing to suffer. In
America, Fannie Mae and Freddie Mac are rescued by the US Government. Nationwide
merges with smaller lenders, Derbyshire and Cheshire Building Societies. House sales,
according to Royal Institute of Chartered Surveyors, hit record lows. First-time buyers also
hit record lows.

Lehman Brothers posts massive losses, and files for chapter 11 bankruptcy a few days later.
Merrill Lynch is taken over by the Bank of America for $50 billion. The largest insurance
company in America, AIG, is given a $85 billion rescue package to prevent bankruptcy.

In the UK, HBOS and Lloyds TSB merge, creating banking giant with a one-third mortgage
and savings market share. Washington Mutual is closed down and sold to JPMorgan Chase.
Fortis in Europe is partly nationalized to ensure its survival. Rescue packages are launched in
Britain and America. Bradford & Bingley is nationalized. The economy of Iceland faces tough
times. Wachovia is bought by Citigroup.

October 2008

Attempts to stabilize the market, with a $700 billion financial rescue bill passed in America.
HBOS shares climb 20 per cent following consumer confidence increases. The Financial
Services Authority rises saving guarantees from £35,000 to £50,000. Germany plans a 50
billion euro rescue plan to save their banks. The Icelandic government takes control of the
second largest bank in the country, Landsbanki, owner of Icesave.

The UK government announces a combined £500 billion rescue package. Governments

across the world cut interest rates amid widening fears of a global recession. The UK plan to
nationalize Royal Bank of Scotland, HBOS and Lloyds TSB. Unemployment figures in the UK
soar. The effects of the rescue package remain to be seen.

Surviving the Credit Crunch

Surviving the credit crunch as well as damaging the balance sheets of mortgage lenders, the
credit crunch has significant impacts on the mortgage consumer. However, there are ways to
survive the credit crunch, and small adjustments can be made that will mitigate the damage.

As banks and building societies tighten their lending criteria, mortgages become increasingly
harder to access. Furthermore, all types of unsecured personal borrowing such as credit
cards and personal loans become harder to get.

Surviving the credit crunch: mortgage borrowers

To understand how to survive the credit crunch, it’s first necessary to understand how it
affects you as an individual consumer.

For people with no or low debt and savings, the credit crunch shouldn’t be causing too many
problems, aside from those consumers with savings locked into troubled financial
institutions. However, for borrowers looking for credit, the market is now a very different
place. Consumers looking for mortgages, remortgages, credit cards and personal loans will
all be affected by the credit crunch.
Repair your credit rating

Check your credit rating for free or for a small fee, with Equifax, Experian or Call Credit. If
you have a poor credit rating, there are ways to improve it. For instance, you can remove old
defaults.

Using a single credit card and a mobile phone contract, and not missing any payments, will
prove to banks that you are a reliable borrower. Make all payments with direct debit to
make sure you do not miss one. If you apply for credit across multiple sources, lenders will
notice and this can damage your credit rating.

Deal with current debt

Dealing with outstanding debt responsibly means making repayments reliably. If you cannot
make repayments, you should contact your creditor and discuss the situation with them.
Check the Mortgages.co.uk mortgage debt help and advice section for more information
about dealing with debt.

Find the right mortgage deal

Finding the right mortgage deal for your circumstances is very important, particularly when
finances are stretched by the credit crunch. Depending on Bank of England base interest rate
cuts or increases, the cost of mortgages may go up or down. Getting a good mortgage deal
requires shopping around.

Those borrowers that took out a mortgage deal several years ago could face repayment
shock. Borrowers that are hard-hit by repayment shock may consider switching to an
interest-only mortgage, if their lender will permit this, although this should only be
considered if there is a firm plan to pay off the capital. Experts say that borrowers should
consider interest-only as a last resort.

First-time buyers should not wait

The Council of Mortgage Lenders claims that there is considerable pent-up demand amongst
first-time buyers. Many are reportedly being forced to wait to get a mortgage, whilst others
are holding on in the expectation of further falls in house prices. Some experts advise first-
time buyers with a large enough deposit to commit now, and haggle to get the best price.

Use a reputable broker

Going to a mortgage broker doesn’t guarantee a cheaper rate, but brokers do have the
ability to find the best rates on the market for each individual. The UK mortgage market
fluctuates constantly, and finding the right deals can be very time-sensitive. Consumers with
little money to spare should check what fees a borrower charges, and whether they take
money from the customer or from the lender.

Use a deposit to your advantage

Although 100 per cent mortgages are virtually a thing of the past, and even 95 per cent and
90 per cent mortgages are rarer than they have been in the past, borrowers with a good
credit record and the ability to repay a mortgage can still find loans. A 10 per cent deposit is
likely to be the minimum considered, although this is subject to change considerably if
interest rates come down and liquidity returns to the mortgage market.

Learn more about your situation

Speaking to an expert or using online tools to learn more about your mortgage situation
could help you to avoid problems relating to the credit crunch.

Make a realistic budget

Make a realistic budget of your monthly outgoings, and work out what you can afford to cut
out of your spending. Working out your monthly outgoings, including tax, debts, and
spending helps consumers to understand where they can save. If you can include savings
and investment as part of your budget, all the better.

Learn about the implications of mortgage problems

With negative equity more common as house prices fall, many borrowers are encountering
difficulty with their mortgages. Learning about arrears and repossession could help
consumers know how to avoid getting into these kinds of problems.