Friday, September 19, 2008

The global credit crunch explained in words of one syllable

(The second in a very occasional series. Inevitably, I’ve simplified things - mainly because I don’t myself understand all the complexities of this.)

The shorter version:

No one knows how much bad debt there is or who holds it. And how can the banks trade when they need to raise cash but they don’t know who to trust?

The longer version:

Back in the old days, you used to get a loan from a bank to buy a house, and then pay the bank back for years. From the bank’s point of view, you were then a source of cash for years. And if you found that you could not pay, then they’d seize your house and sell it to make their cash back. If your house price had crashed, though, the bank would risk a loss. And if this went on a lot, the bank would be stuffed.

Now, though, what the banks have liked to do is to sell your home loan on. Huh? Yeah, me too.

So: say you get a home loan with Bank A and then pay them back each month. You’re a flow of cash to them, backed by your house if need be. But the bank can choose to shift that flow. They can say to Bank B: “Give us a wodge of cash now and we’ll give you the rights to this flow of cash. If it dries up, there’s a house you can grab.” If they both think that’s a good plan for each of them (if Bank A wants a big wodge of sure cash now, Bank B wants a flow of cash for the next few years), then they’ll do it.

Of course, they don’t just sell your loan. They bunch lots of them up – some high risks, some low – and sell them on in a block.

This, though, has made it tough to tell how much risk there is in the whole of one of the blocks. All the more so if Bank B makes a new bunch out of parts of the first, plus some more, and then sells that on to Banks C and D.

Crumbs.

This in fact worked quite well for the banks for some years. But it went too far. They lent too much. Rates were low, growth was strong, homes went up and up in price – if you found that you could not pay, then they could just take your home and they’d be fine. So they lent to quite a lot of folk who, to tell the truth, were not a great bet. They were not, as the banks say, ‘prime’. And the more the banks lent, the more loans they could sell on to make yet more cash.

Then the price of homes went up and up no more. What went up now was loan rates. And homes went down. And down. And you could not pay your loan back. And the worth of your home was not much use to the banks now.

In the past, Bank A would have been hit by your bad debt and all the rest of the banks would have laughed and then bought it up (or watched it die). But now Banks B, C and D have all got mixed up in what was, to start with, Bank A’s loan book. Some of these loans have turned out to be bad debt, but none of the banks knows how much risk each of the rest holds. Bank B, say, can’t trust A, C or D. And it needs to know this – it lends large chunks of cash to them all the time, and they to it. The rest of the banks feel the same way. They all need to raise cash in the short term – lots of it, all the time – to trade.

But now they daren’t lend, as they don’t know which of them might not have the cash to pay the loans back. So…

Crunch. No one can raise cash. And if a bank needs to do this to trade, then it’s stuffed. Oh, and of course you can’t get a loan now. They just don’t have much cash, and they won’t take much risk – not on your house, the price of which just goes down and down.

The state has tried to muck in, with its own loans for the banks, and this has helped a bit. But the mess seems to be too big for this to do much good. Thing is, this whole crunch thing has not just hit the banks. The shock means that growth has slowed all round the world, and jobs have been lost. Banks have gone bust. And those slick guys on Wall Street and in the Square Mile are on the prowl for more banks that might look a bit weak, and then they take them down.

This thing has built up size and strength and speed all of its own, and while we do need to sort out the bad loans that set it off in the first place, that on its own won’t make things all fine once more.

What next? I don’t know.

[Update: I am a complete, meat-headed, drooling moron. I was deeply anxious when I posted this that I might have let a rogue polysyllable slip through. I've just re-read it and found a 'happened' and even an 'another' (corrected now). Fool! I don't know whether this makes me illiterate or innumerate, but either way you may be assured that I'm hanging my head in shame.]

6 comments:

Cilla said...

Thank you! Very helpful.

SaltedSlug said...

That is superb, great post!

Anonymous said...

Nicely explained. Thanks

Anonymous said...

best fu*king explanation i've read.
you outta go on CNBC with it. They are saying what i call 'camoflage' words and phrases.
(Bullsh*t them if you don't know)
peace

Scooby said...

I have a staff meeting tomorrow and was wondering how I was going to explain the dynamics of the credit crunch and its effect on the economy in a way that people can understand. And then you came along, its just BRILLIANT!!! Very wel explained. Call it "Credit Crunch for Dummies!".

Joseph said...

You have really made my research easier with your simplicity and suspension of financial jagons. I am a Nigerian currently having my M.Sc Finance at the University Of Lagos, Lagos, Nigeria.
It is believed in Nigeria and Africa that for us, the global credit crunch is an imported one. I see this as a worthy topic of research as to whether or not it is imported and if so, the developing postures of some African countries, Nigeria in particular can be seen to be more imported than home grown?
Nigeria does not have a deep financial market and instruments like the US but it is yet to be seen the underground importation of this instruments.
Our banks are still declaring profits and dividends, but the extent of the liquidity risk is glaring.
Panic withdrawals are on the cards as some banks cannot make immediate payments on withdrawal instruments. Despite all these, our Government does not think a bailout is necessary.
I hope the damage and corresponding effects will not be too much to bear afterall.
There is always light at the end of the tunnel.