Idiot's Guide to the Credit Crunch

It all started with loans to people in the USA to buy homes that they couldn't afford. Or that is the common belief that history may rewrite in the coming years.

Low interest rates and a growing economy led to the confidence and belief of both bankers and consumers in the US (and the UK and many other countries) to borrow for house purchase or to release equity to spend on other goods and services. All was well whilst the rates remained low and the economy grew, but increasing inflationary pressures due to rises in commodity prices (e.g. oil, metals) meant that Central Bankers around the world raised interest rates to try and quell demand and control inflation.

Historically, most US mortgages are fixed rate and long repayment term (20 -30 years). More recently, many had taken mortgages on terms where the interest rate was variable and changed annually or every couple of years. As mortgage payments increased, so did defaults.

Many small and regional banks do not keep large mortgage books. Instead, they package up a number of loans and then sold them as a package to other banks and financial institutions. These Collateralised Debt Obligations (CDO's) were traded around the world and bought by many of the world's financial institutions.

It became clear that the underlying creditworthiness of the customers was poor - many had been sold loans in excess of the value of the property and beyond their ability to pay. As defaults grew, repossessions increased and property prices tumbled. The spiral of decline continued and picked up pace as the economy slowed so job losses increased.

Similar issues were also true of the UK market. The belief that property would only increase in value and growth would continue, led to enormous lending for all reasons. As rates increased and the economy slowed, problems started to emerge.

As the size of the problem became apparent (though unquantifiable), banks started to write down the value of their investments and pulling back on their lending to conserve capital. The problems deepened and the asset write downs became so material for some financial institutions that they risked becoming insolvent. Banks got nervous of lending to each other (since they had no way of knowing whether they would be able to get their money back) so liquidity (cash available in the system) dried up. Rates increased to compensate for the risk and governments had to step in to rescue banks and other financial institutions to prevent meltdown and a complete collapse of the world's financial systems.

As banks further wrote down the value of their "toxic debt", their balance sheets became weaker, capital reduced and their ability to lend diminished. Huge governmental and shareholder recapitalisation programmes were launched so as to bolster the financial strength of the banks. Consolidations took place and some went into administration causing governments to announce wide scale depositor protection schemes to safeguard confidence.

The massive intervention by governments to stabilise the banking systems appear to have worked. Whilst fragile, it appears that the deepest of the challenges is over though it will take many years to recover to a position of 'normality'.