The credit crunch refers to a market environment in which borrowing costs soar due to a fall in the availability of credit. So how can it affect your business?
The credit crunch is a negative market reaction to a long-term a structural credit bubble. It has occurred during cycles of rising inflation and unemployment. The liquidity crisis is having a profound impact on small business financing and spending. Businesses already reliant on easy credit, are now struggling to raise working capital to invest in people and product development. So how has this current economic phenomenon come about.
Traditionally, high street banks and building societies encouraged savers to deposit money with them, typically in the form of instant access savings accounts. In turn, these institutions would lend this money out to borrowers as an increased interest rate. This lending takes the form of mortgages, unsecured bank loans, business finance, bridging loans or unsecured loans. The reputation and creditworthiness of these old banking institutions remained second to none. As a result, a variety of complex financial processes were created to satisfy the increased demands for borrowing by institutions. These have taken the form of asset based lending and capital market collateralization. These processes allowed institutions to lend hundreds of millions of pounds to each other, quickly, and at a push of a button.
The credit boom had begun - providing a sea of 'cheap credit' to businesses and individuals seeking quick profits. The options and futures markets has compounded the credit boom, by enticing even more credit to be invested. Complicated and fast moving electronic environments, have been deregulated by Governments. Institutions spent millions lobbying governments to provide a 'lighter touch' regulatory environment.
By the late 1990's mortgage lenders and banks did not need to grow organically. They could just borrow enormous sums of money from the international secondary capital markets, to finance loans and mortgages for its own domestic customer base. Failure to join in and compete had the effect of threatening smaller, more traditional lenders (such as mortgage brokers or building societies), who also took more risk and exposure to potential bad debt on the secondary markets. The volumes and cost of this money between institutions is determined by the future market valuation of collateral of the debt. During this period, credit rating agencies gave some institutions reselling mortgage debt a AAA credit rating. This gave the market a measure of market confidence in the value of the collateral. Shareholders were happy. Credit was cheap. Property prices soared in many economies. Eventually this house of cards began to crumble.
Foreclosures in the USA sub prime housing market helped to kick start and expose massive over leveraging across the international financial system. American mortgage brokers sold high credit risk products to groups of people with an irregular income, few savings for a deposit and poor credit histories. As interest rates rose, many homeowners could not afford to keep up repayments. By 2008 nearly 9 million mortgage holders, representing almost 20% of the total in the United States, were in negative equity. Mirroring this bubble, the housing markets of most western economies peaked, as people realised that unsustainable prices would surely come to an end. US Bank's ability to provide large volumes of cheap credit had been artificially undisguised through the process securitisation.....
Most credit risks (like sub prime mortgage debt) has historically been, 'packaged up' up in other debt. This is then sold onto the money markets (in the form of Residential Mortgage Backed Securities (RMBS) bonds and Collateralized Debt Obligations (CDO). This process is referred to as securitization, and had the effect of disguising the risks of sub prime bad debt. In simple terms, securitisation allows banks to exchange standard loans into trade securities (bonds). These bonds were purchased by other institutional investors from pension funds from all over the world. Most UK mortgage debt has had exposure to US sub prime debt. To the homeowner is financing was irrelevant and behind the scenes.
Yet to the banks securitisation meant that they could pass the risk on to bondholders, who in turn pass the risk to another institution. Bond holders credit ratings were officially calculated credit rating agencies such as standard and Poor's and Moody's and Fitch. The market looked to these credit rating agencies for guidance as to the credit worthiness of the holders. The cataclysmic misjudgement by these credit rating agencies is now leading to the potential threat of class action litigation by investors, who incorrectly believed that money was ironically "as safe as houses". The inappropriate lending culture of the past, has finally caused a situation where banks simply do not trust each other to know how much toxic debt is wrapped up in inter banking loan agreements.
At the sheer scale of the sub prime losses became apparent, banks around the world were naturally reluctant to lend to each other. Banks have realised that even the banks themselves are becoming a potential source of considerable bad debt. Consequently, there has been a dramatic decline in money supply. In particular, there has been a collapse in the volume of mortgage lending, an increase in repossessions and a lack of business investment as market confidence evaporates.
To make matters worse, banks have increased the bank to bank interest rates they charge each other to reflect this increased risk of bad debts. Banks have simply become risk averse in an economic climate of fear, uncertainty and doubt. Central banks were forced to provide emergency funding as well as cut interest rates to relieve the pressure on borrowers. Many banks around the world had to 'shore up' these cash reserves on their balance sheets, as opposed to redistributing this cash through the supply chain of the financial system.
It is easy to point the finger and blame it all on American mortgage lenders. Yet, the global credit crunch is particularly complicated and involves many stakeholders. In the good times, few Governments, small businesses or individuals store savings aside to prepare for 'a rainy day'. In fact, most Governments public borrowings exposure increased, average consumer savings levels fell, and mortgage and unsecured consumer debt rose dramatically. The 'moral hazard' became a commonly used phrase in the media. This describes the risk that bailing out financial institutions that have behaved recklessly, will simply encourage more reckless conduct in the future.
It is likely there will be an increase in market regulation to mitigate future taxpayer bailouts. In hindsight, Government policies should have mandated to regulatory watchdogs, to determine lending practices and threshold affordability limits. Yet in the boom times, most Governments left the market equilibrium to balance itself, using a 'light touch regulation' approach. The dilemma is immensely complicated. Is market regulation there to protect consumers against themselves? Should regulations govern how big a house or car consumers can afford? Is it the duty of regulators to let the market correct its own mistakes and simply ensure integrity, fairness and honesty in the market process? Managing any fast moving, highly complicated, automated and electronic market, remains an immense challenge for any regulator.
There are many booms and busts in financial history that can provide valuable lessons for future generations. In the 1920s, the great crash and subsequent depression that occurred, was caused by the huge surge in demand for manufactured goods such as cars, fridges and radios. More recently, the dotcom bubble refers to the explosion and subsequent collapse of Internet based share values. This provides a very recent example of short term greed and over leveraging. In this example, credit was extended to both corporate investors as well as newly empowered individuals, seeking quick returns. The common theme has been an over indulgence of credit, that has fuelled sudden and overexcited investment decisions. People collectively believe that markets will continue to rise. Everyone foolishly feels comfortable and secure in their new-found paper based wealth.
The impact on businesses large and small has been severe. An increasing number of small businesses are facing corporate insolvency, leading to company winding up petitions, personal bankruptcy or corporate insolvency. With the ability to raise additional capital reduced, cash strapped firms are cutting back on business investments. In particular large retail customers are squeezing small suppliers margins. The credit crunch has destroyed consumer confidence. Consumers have tightened their belts knowing that a recession is around the corner. So businesses are being forced to discount and cope with weak demand.
The banking crisis is causing unprecedented levels of uncertainty and volatility across all types of economic markets. Like an infectious disease, panic selling spreads between institutions and across geographic boundaries. The 'real economy' is going to be impacted for some period to come. Cut backs will see more job losses, house prices falls and reductions in business investment. The most important ingredients in any modern financial system are confidence and credit. Yet, even the drastic reduction in interest rates by central banks has done little to change this interbank interest rate. Until market complexity is unravelled and better regulated - confidence is unlikely to return.
The interventionist rescue plans by most Western governments to provide loan guarantees, preference shares and equity in fledgling financial organisations is a crucial first step on the road to recovery. Politicians are also providing reassuring public messages that the Government will do what ever all they have to maintain stability. Governments simply cannot afford to allow major banks to fail. The banks tentacles spread throughout all aspects of a country's economic prosperity - from building roads and schools and hospitals to funding small businesses and lending homeowners mortgages.
It is likely that small businesses will have to do endure a long and painful economic storm, by conserving cash and acting prudently and conservatively.