Knowledge Resource Centre

The Credit Crunch Uncovered

Over the past year, the credit crunch has been on the top of financial agendas across the world. But how did the crisis develop? This Insight Article uncovers the roots of the credit crunch.

The credit crunch, writes The Times UK, was until recently an arcane term mainly known by economists. But within the last year, the phrase has been so frequently used that it has now been added to the latest edition of the Oxford English Dictionary (1). Whilst the credit crunch continues to make headlines and has created plummeting housing markets and soaring borrowing rates, the question beckons: how did it go so wrong?

August 9th 2007 became the kick start of what the International Monetary Fund later described as ‘the largest financial shock since the Great Depression’ (2). On that day, news broke that France’s largest bank, BNP Paribas, was close to collapse because it had overloaded on securities based around American high-risk mortgages. A leading German bank, IKB, had similar difficulties.

A day later, the chief of Northern Rock, a big mortgage lender in the UK, admitted to its regulatory body, the Financial Services Authority (FSA), that it only had enough cash to last until the end of the month. This was the beginning of the credit crunch that would send equity markets around the world into freefall.

Origins of the problem

One starting point for this freefall can be found in the ripples started by the dot.com bubble bursting in the late 90’s. This was also exacerbated by the deflationary pressures in markets such as the USA, with the massive importation of goods from China and the Asia Pacific region. This pressure could have pushed the United States into recession, and so to avoid this, interest rates were cut by Alan Greenspan, the Chairman of the US Federal Reserve at the time. This caused a respite, but it also had the effect of flooding the markets with cash. Around this time, US interest rates actually reached 1%. The cost of borrowing money around the world was cheaper than it had been for many years.

This record-low interest rate was an ideal climate for banks eager to increase their profits and bonuses for top staff. Many banks began to focus on the less well off, and charged higher rates to those more vulnerable and with higher credit risks – the so-called Ninja mortgages (no income, no job or assets).
 
Investment banks then re-packaged these loans, and sold them on to other financial institutions with solid double-A and triple-A ratings. What is clear here is that due diligence and financial checking were virtually non-existent. The scale of this bad debt would eventually rise to an eye-watering £500bn. On the back of this, banks created a whole new derivatives market, which would be measured in trillions.

The new Basel II lending rules meant that banks were effectively regulating themselves and doing their own risk assessment. This made it easier for them to go on lending, unchecked. There was also a lack of consensus of opinion, which created confusion. The Financial Services Authority in the UK made the point in a 2006 report that because banks were so profitable, investors had very little to worry about. This proved to be completely unfounded.