Credit Crunch Activity

What was the Credit Crunch?

Defined as "a severe shortage of money or credit"
On 9 August 2007, central bankers became so alarmed by banks' reluctance to lend to each
other that they took emergency action. The European Central Bank and the US Federal
Reserve injected a combined $90bn into financial markets.
For the ECB, it was its first intervention since the 9/11 terrorist attacks six years earlier.
The central bank called it a piece of "fine tuning", but investors knew it was far more
serious. The FTSE lost 121 points that day, and in the US the Dow Jones average fell by 387.
A squall that had appeared at two French investment funds exposed to US sub-prime loans
was about to develop into a hurricane. Adam Applegarth, boss of Northern Rock, where
queues would form the next month, later called 9 August "the day the world changed".

What were the causes of the credit crunch?

Steps to 2007 / 08 Credit Crunch
US mortgage lenders sell many inappropriate mortgages to customers with low income and
poor credit. It is hoped with a booming housing market, the mortgages will remain
affordable.
Often there were lax controls in the sale of mortgage products. Mortgage brokers got paid
for selling a mortgage, so there was an incentive to sell mortgages even if they were too
expensive and high chance of default.
To sell more profitable subprime mortgages, mortgage companies bundled the debt into
consolidation packages and sold the debt on to other finance companies. In other words,
mortgage companies borrowed to be able to lend mortgages. The lending was not financed
out of saving accounts, for example.
These mortgage debts were bought by financial intermediaries. The idea was to spread the
risk, but, actually it just spread the problem.
Usually subprime mortgages would have a high risk assessment rating. But, when the
mortgage bundles got passed onto other lenders, rating agencies gave these risky subprime
mortgages a low risk rating. Therefore, the financial system denied the extent of risk in
their balance sheets.
Many of these mortgages had an introductory period of 1-2 years of very low interest rates.
At the end of this period, interest rates increased.
In 2007, the US had to increase interest rates because of inflation. This made mortgage
payments more expensive. Furthermore, many homeowners who had taken out mortgages 2
years earlier now faced ballooning mortgage payments as their introductory period ended.
Homeowners also faced lower disposable income because of rising health care costs, rising
petrol prices and rising food prices.
This caused a rise in mortgage defaults, as many new homeowners could not afford
mortgage payments. These defaults also signalled the end of the US housing boom. US
house prices started to fall and this caused more mortgage problems. For example, people
with 100% mortgages now faced negative equity. It also meant that the loans were no
longer secured. If people did default, the bank couldnt guarantee to recoup the initial
loan.
The number of defaults caused many medium sized US mortgage companies to go bankrupt.
However, the losses werent confined to mortgage lenders, many banks also lost billions of
pounds in the bad mortgage debt they had bought off US mortgage companies. Banks had to
write off large losses and this made them reluctant to make any further lending, especially
in the now dangerous subprime sector.
The result was that all around the world, it became very difficult to raise funds and borrow
money. The cost of interbank lending has increased significantly. Often it was very difficult
to borrow any money at all. The markets dried up.
This affected many firms who had been exposed to the subprime lending. It also affected a
wide variety of firms who now have difficulty borrowing money. For example, biotech
companies rely on high risk investment and are now struggling to get enough funds.
The slow down in borrowing has contributed to a slowing economy with the possibility of
recession in the US a real problem.
Credit Crunch in the UK
UK mortgage lenders did not lend so many bad mortgages. Although mortgage lending
became more relaxed in the past few years, it still had more controls in place than the US.

Credit Crunch Activity

However, it caused very serious problems for Northern Rock. Northern rock had a high % of
risky loans, but, also had the highest % of loans financed through reselling in the capital
markets. When the subprime crisis hit, Northern Rock could no longer raise enough funds in
the usual capital market. It was left with a shortfall and eventually had to make the
humiliating step to asking the Bank of England for emergency funds. Because the Bank
asked for emergency funds, this caused its customers to worry and start to withdraw
savings (even though savings werent directly affected)
As a result of the credit crunch, the UK has seen a change in the mortgage market.
Mortgages have become more expensive. Risky mortgage products like 125% mortgages have
been removed from the market.
UK Banks continue to face problems. HBOS (Owner of Halifax) struggled to finance its
balance sheet. Like Northern Rock, it financed an expansion of lending by borrowing. Now
money markets have frozen up, they couldnt raise enough money to maintain liquidity.
Falling House prices. Now that mortgages are difficult to get, demand for houses has
slumped. Therefore, house prices have fallen. Lower house prices mean many face negative
equity. Therefore, mortgage defaults now cost banks even more (because they cant get
back the initial loan.
Bradford & Bingley was nationalised because it couldnt raise enough finance. The B&B had
specialised in buy to let loans, which are particularly susceptible to falling house prices.

How did the UK government try and deal with the crisis?
In an effort to kick-start the UK housing market the Treasury announces a one year rise in
stamp duty exemption, from 125,000 to 175,000.
The mortgage lender Bradford & Bingley is nationalised. The British government takes
control of the bank's 50bn mortgages and loans, while its savings operations and branches
are sold to Spain's Santander.
8 October - The UK government announces details of a rescue package for the banking
system worth at least 50bn ($88bn).
13 October -The UK government announces plans to pump billions of pounds of taxpayers'
money into three UK banks in one of the UK's biggest nationalisations. Royal Bank of
Scotland (RBS), Lloyds TSB and HBOS will have a total of 37bn injected into them.
6 November - The Bank of England slashes interest rates from 4.5% to 3% - the lowest level
since 1955.
24 November - The UK government announces a temporary cut in the level of VAT - to 15%
from 17.5% - in its pre-Budget report . Chancellor Alistair Darling also says government
borrowing will rise to record levels, but defends the move as essential to save the UK from
a deep and long-lasting recession.
8 January - The Bank of England cuts interest rates to 1.5%, the lowest level in its 315-year
history, as it continues efforts to aid an economic recovery in the UK.
14 January - The UK government unveils a plan to guarantee up to 20bn of loans to small
and medium-sized firms, to help them survive the downturn.