Credit Crunch

Since 2007 stories of the 'credit crunch' have been continually been headline news. The BBC defines the credit crunch as 'a severe shortage of money or credit' and this phenomenon has had a profound effect on the world economy. The start of the crisis has been pin pointed to the 9th August when "French bank BNP Paribas told investors they will not be able to take money out of two of its funds because it cannot value the assets in them, owing to a "complete evaporation of liquidity" in the market" (BBC). This news resulted in a sharp rise in the cost of credit. But was this the actual start of all the trouble? It is believed that the 'borrowing culture' particularly in western countries has lead to the economic downturn. In the years leading up to 2007 levels of borrowing were very high. A particular problem was the ease in which people were able to arrange mortgages, sometimes far bigger than the actual value of the property in question. Mortgage lenders were given attractive financial incentives to sell mortgages, resulting in not much consideration regarding whether or not repayments would be met. Since the crisis began mortgages have been increasingly difficult to obtain. Today's situation is very different to the years leading up to the crisis. Today banks are much less keen to lend money, causing problems particularly for first time home buyers who are finding it increasingly difficult to get on the property ladder. Following the dot.com bubble bursting and the terrorist attacks of 9/11, the US Federal reserve tried to stimulate the economy by reducing interest rates to just 1%. The cheap available credit encouraged borrowing and in many cases people were borrowing more money than they were able to pay back. As mentioned before, mortgages were offered to people who were unable to make repayments. These are known as sub prime mortgages and these were ultimately what caused the economic downturn. Banks would pool these loans together, creating collateralized debt obligations (CDOs). It soon became apparent that these CDOs were not worthy of the AAA credit rating attached to them. Once this was realised banks became unwilling to lend to each other. Subsequently many banks faced tremendous difficulties. In the UK, Northern Rock had to be bailed out by the bank of England after it became unable to pay back loans from the money market. Northern Rock's business model was heavily reliant on the inter-bank market so once other banks stopped lending money it had a dramatic effect on the fortunes of the company. Northern Rock used this short term method of finance to fund lending of mortgages. Following the announcement of the bail out, depositors withdrew £1bn in one day in what was the biggest bank run in over 100 years as they were fearful that they would lose their savings. The UK government responded by guaranteeing their savings but the damage was already done.

There was also a dramatic turn of fortunes for many other companies, particularly in the retail sector. Even today, many well known high street retailers are falling into administration. In recent news, companies such as HMV and Game have announced their problems and have been drastically reducing their operations in an attempt to survive.

It seems a stark contrast to the seemingly trouble free years the proceeded the credit crunch. It is not the first time a 'bubble' has burst and it will undoubtedly not be the last but looking back it seemed quite obvious that there would be problems associated with the heavy borrowing culture that engulfed the western world. Despite the credit crunch starting over 5 years ago, the world is still greatly affected by it and many leading economists suggest that it could be until as late as 2016 before the UK can officially say it is out of 'recession'. So the future still looks bleak and I have no doubt that we will see the demise of even more well established businesses. Hopefully a valuable lesson will be learned from all the events that have occurred and perhaps people will more cautious about borrowing money which they are unable to pay back.