Calculators

The Credit Crunch Explained

August 2008

In a nutshell, credit crunch describes a situation where businesses and consumers find it difficult to obtain loans because lenders are concerned about the risk of defaults. The current, prolonged credit crunch has arisen from the fallout of rising defaults in the US sub-prime mortgage market.

In the low interest rate environment, lenders made it easy for those with lower credit scores to obtain credit. These ‘sub-prime’ loans were then sold on to financial institutions and hedge funds through securitised products on the secondary market. However, as interest rates began to rise and market conditions worsened, these debt packages lost value – meaning banks were left holding assets worth much less than they initially paid. As a result, they became difficult to sell on and some banks had no other option but to write off some of the debts and close investment funds with exposure to them.

The ability of buyers and sellers to trade on the financial markets is known as liquidity. When credit becomes expensive in this way, the liquidity in debt markets becomes restricted - and because it cannot be sold easily, institutions become less willing to lend in the first place. For anyone trying to borrow, this is bad news.

As a result, you would expect to see an increased pressure on company performance. A lack of borrowing means corporate management can't easily turn to the market for financing. Private investors buying and selling shares might see losses from companies whose business plans depend on credit. The market in general could be affected as the share prices of some UK stocks were being supported by share buy-back activity - often funded by borrowing. In the personal market, it is becoming more difficult for those wishing to arrange mortgages – particularly those who might be classed as 'sub-prime'.

It's clear that tighter global credit conditions are predicted to slow economic growth and we are seeing illustrations of the impact as high street retailers report tough conditions. Despite positive words on the US economy from Federal Chairman Ben Bernanke, it is still unclear how long this situation will continue.

Shirebrook Financial Services Ltd is authorised and regulated by the Financial Services Authority. The contents of this article do not constitute advice and should not be taken as a recommendation to purchase or invest in any of the products mentioned. Before taking any decisions, we suggest you seek advice from a professional financial adviser. All figures and data contained within this document were correct at time of writing.

The Credit Crunch Explained

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