Ausbuy

The Credit Trap

July 7th, 2008

Credit generates activity and usefully focuses saving. Remember what was said about Christopher Columbus? He didn’t know where he was going, he didn’t know where he was when he got there, and he did it on borrowed money. We must, however, remember that it is a potentially dangerous tool. Companies do not get bankrupt because they lose money. They go under because of cash flow and an inability to service or repay their debt. The world forgot this simple rule and we now have the sub-prime mortgage crisis and the credit crunch.

The idea behind sub-prime mortgages being parcelled up by third party lenders and then being onsold to institutions was not a bad one. It allowed third party lenders to raise money and help people to enter the housing market who would not normally have been accepted by the major banks (for a variety of reasons). The theory was that only a small percentage would default and, since they were paying a higher interest rate, the institutions would make a profit. However, over the last five years lending standards were progressively dropped as the mortgage brokers chased business. The institutions made no effort to check the standard of the loan parcel they were buying.

As defaults started to increase in the USA house prices dropped and the institutions found that they did not have enough security to cover the loans. This meant that they had to write down the value of the assets in their books which in many cases put them in a loss situation. Since these parcels had been sold round the world and New York was the main wholesale credit market, the contagion also spread around the world. Lenders lost confidence and were reluctant to lend and, more seriously, to renew existing loans. House building in the USA almost came to a halt as forced sales flooded the market. The inevitable bankruptcies followed as the tight credit conditions were applied to other industries as well as the housing industry.

The banks tightened their lending criteria and economic activity slowed. The cost of funds increased as lenders tried to cover themselves against increased risk. At the same time Australia was importing inflation via the high price of oil and increasing price of imports. Instead of controlling credit the Reserve Bank used interest rate increases to fight inflation which paradoxically added to it. Australians continued to spend freely as credit was readily available despite our huge monthly trade deficit. However the commercial banks had to pay more for borrowing on the wholesale market and passed these costs on to the public. Consider that oil has increased in price, interest rates have gone up, food prices have increased and one can see that there are very strong inflationary pressures. It is inevitable that unemployment will increase and companies who borrowed too much will have to pay more on their loans and in many cases may not be able to renew their loans on due dates so that people who lose their jobs will find it difficult to find a new one.

It is not the time to owe money as these problems feed on each other. Australian which is in a mining boom can, as a country, muddle through the credit crunch better than most but there will be many distress stories on the way through. When the scale of the sub-prime problems emerged many so called experts rushed into print saying that it didn’t matter to Australia as China was our future. They are now looking silly but over time people will forget and they will be back looking into a crystal ball again. The people who believed them may not be so lucky. Certainly Ausbuy would advocate people to reduce debt to help them ride out the coming storm.

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