Magazine article New Zealand Management

Consultation : Credit Crunches and Good Faith

Magazine article New Zealand Management

Consultation : Credit Crunches and Good Faith

Article excerpt

Byline: Kevin Gaunt

My timing might be a bit slow and you might think this question a bit late but can you explain in simple terms what has happened to cause the C[pounds sterling]credit crunchC[yen] and what is likely to happen in the future?

Well basically what happened was that banks became nervous about lending to their customers and to each other. This resulted in higher interest rates across the board which then led to the prospect of an economic slowdown.

The cause is fairly straightforward. Basic economics covers the law of supply and demand. If there is too much of something its price falls. If there is too little its price rises.

The world has experienced huge economic growth over the last decade or so and banks have been very keen to lend cheaply on the back of this. The result is that many people who canCOt really afford it have been able to take out large loans and mortgages, particularly in America.

The basis for this over-lending was that as house prices were rising so quickly, banks felt they could afford to lend to risky borrowers with the increasing house value providing equity that would cover risk. Yeah right! This was a real Cysmoke and mirrorsCO strategy as the easy money created the spiralling house price increases which in turn motivated the banks to lend more.

Finally, it got to a point where the bubble burst. The riskiest borrowers started to get too stretched and defaulted which then started a decline in house prices. Once this spiral got going, interest rates started to rise as banks became more risk averse and more and more people defaulted on their loans which continued the decline. At this point banks started to lose confidence in being able to lend to their borrowers and also to each other. This meant that some of the more stretched banks went out of business, which then reduced confidence further.

However, the story gets worse as the banks had packaged up these sub-prime loans and had on-sold them worldwide as investment securities to hedge funds and investment banks. This enabled these organisations to offer high-yield but risky investments. However, the investors tended to accept the risk due to the apparent strength of the worldCOs overall economic growth.

Once the bubble burst these fund providers and investment banks were on very shaky ground and started to go out of business themselves. Therefore an issue primarily starting in America became a worldwide problem as these people bought into these high-yield securities. …

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