What caused the Credit Crunch? A brief Overview

On hindsight, the credit crunch may have seemed as inevitable as the ground appearing beneath a sky diver. The events surrounding the credit crunch appear constantly on our television screens and in our newspapers and one can never go too far without hearing some mention of the latest buzz word. To those people who do not work in the financial sector, or those who are somewhat alien to the business world, it is easy to find yourself caught up in the never ending theme of reported doom and gloom, without actually any idea of how the credit crunch actually started. This article will helpfully allow you a shallow insight into what actually caused the credit crunch in the first place.

Prime Markets
The traditional approach of the Mortgage providers in the USA was to lend to those who were a good risk. The institutions would lend to persons who had a steady and secure income, a good credit rating and good job prospects. This portion of the market was termed the ‘prime market’, in other words, the best part of the market to lend to. Borrowers in a prime market could haggle amongst different mortgage providers in order to get the best deal and the best rates.

Sub- Prime Markets
The major institutions in the USA found a gap in the market, those people who needed to borrow a very large sum, and those who normally could not afford to borrow at all. They decided to exploit this gap, offering jumbo loans (loans which were extremely disproportionate to the incomes of the person borrowing), teasers (consisting of very low rates for the first two years, before almost doubling), and what are often termed ‘liar loans’(money lent without the correct checks and no assessment of credit history). These loans allowed first time buyers, family starters and those in very poor communities to afford houses and move into cleaner and safer neighbourhoods, the institutions made money and everyone was happy. This market is often referred to as the ‘sub- prime’ market, in other words, not as good or as ‘safe’ as the ‘prime’ market referred to above.

So what went wrong?
As the mortgage rates began to increase after the initial two years and borrowers could not afford to meet the payments, more and more people began to default on their mortgages. The housing market started to collapse and the situation went downhill. The Financial Institutions needed money, this money could come from investments and so the Institutions decided that they could package up the mortgages and sell them to investors and other institutions. However, when people started to default on their mortgages, and were unable to meet the payments, these mortgages became ‘bad’ or ‘toxic’, who would want to invest in bad mortgages that were not being repaid? No- one would. So the financial institutions packaged the good mortgages, those where the borrowers were meeting the payments, with the bad mortgages and sold them on as a whole. As the situation became clearer and the effects of lending to the sub- prime market became evident, the Credit ratings agencies who had previously valued the bundles of mortgages far higher than they were actually worth, stopped and started to value them at the correct figure. For example, instead of rating the bundles at a AAA rating, the highest possible rating, they were now being valued at BBB or CCC. As the Banks and Financial Institutions became increasingly aware that themselves and their rivals were holding billions of pounds worth of bad debt they stopped lending to eachother. With the Institutions no longer lending money to eachother, a lack of investment and cashflow caused some of the major players to go bust. It is when this happens that the Government sometimes step in, in order to provide cash.