The Credit Crunch Explained

Early in 2008, JPMorgan conducted a joint research with Fujitsu Consulting on the effects of the global credit crunch on Australian households.

They concluded that as the pressure for a rise in Australian interest rates increase, approximately 300,000 families ran the risk of losing their homes. In addition, close to 750,000 Australian homeowners would likely be buffeted by “mortgage stress.”

This is not even the worst part. The chief executive of Commonwealth Bank told a Mastercard conference in Sydney last June 26, 2008 that the effects of the credit crunch may last well into mid-2010.

The Origins of the Credit Crunch

After the 9/11 catastrophe and the dotcom crash, the world’s central banks reduced interest rates to support recovery of the global economy. For many years, financial markets enjoyed cheap debt.

There was so much capital sloshing around the financial markets. Firms borrowed cheaply and used the money for all sorts of investments — some wise, some otherwise.

Particularly in the United States, home mortgages originated in banks were “securitised” and sold as mortgage-backed securities (MBS) in the secondary market. This passed the risk of default on to other investors. Because the originating banks had now freed up more cash, they wrote more loans and securitised them, and so on. In the process, loans were extended to increasingly marginal borrowers. Lenders made more money selling the mortgages; hedge fund managers collected hefty fees for arranging the purchases of the MBS; and the investors who bought them were left holding all the paper and facing all the risk.

When the original mortgages began to go sour, so did prices for securities. Since the securities were collateral for margin loans by hedge funds, brokers and investors demanded more dependable collateral when the prices declined. If the hedge fund could not fulfil the margin call, the securities were sold, driving prices even lower and creating a more vicious cycle of margin calls across the industry. Disaster struck lender Countrywide Financial and hedge fund firm Bear Stearns. The cycle tightened, credit dried up, and borrowers now had to contend with the credit crunch.

The Impact of the Credit Crunch

The slump in the property market and the increase in loan defaults caused interest rates to rise. The Reserve Bank of Australia (RBA) has increased the official cash rate by 1% (or 100 basis points) since November 2007, and banks have pegged home loans at 40 basis points above the official Australian interest rates.

But Australian banks are weathering the crisis better than other countries. The reasons for this include:

Australian households and businesses have reduced their demand for additional credit. For instance, growth in credit card balances has slowed as consumers cut back on discretionary spending and tighten budgets.

To soften the impact on customers, banks have partially absorbed the interest rises imposed by RBA. For instance, although RBA increased official Australian interest rates by 25 basis points in January-February, bank home loan rates rose by only 15 basis points, on average. Since November, RBA has increased its official cash rate by 100 basis points and home loan rates hover at 40 basis points above that.

Banks are drawing more customers away from non-bank lenders. There is some pressure to raise short-term money to meet credit demands. International markets can no longer be relied upon to provide these funds, so banks have to turn to domestic savings.

As customers have more confidence in the stability of banks than non-banks, there has been an increase in people putting their money into banks for more reliable safekeeping. The market share of non-bank lenders in housing finance has shrunk by 40%, while bank’s market share has increased.

There are still some rough bumps down the road. The drying up of credit is bound to create short-term difficulties. But the market is correcting. And while households tighten their spending, it pays to look around for savings opportunities, as banks continue trying to attract savers.

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