Author Topic: The truth about the Credit Crunch  (Read 10411 times)

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The Prophet

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The truth about the Credit Crunch
« on: December 02, 2011, 01:16:09 pm »
The credit crisis is as much about a wealth crisis as it is about a debt crisis. It was a crisis of economic theory, created in the United States and exported via selling complex financial securities throughout the developed world.

The broadening of the income distribution was the initial step that led to the current crisis.

Equity markets
Markets work by setting a price for something that is right. As the price goes up demand goes down and vice-versa. The market self-regulates the price. This is what is known as the "Efficient Market Hypothesis" After the Dot Com crash in 2000, there was a sector rotation away from equities and into property.

Everyone who owned property was advised to take out the equity they had and reinvest it into real estate "as you just cannot lose". Real estate prices were rising and soon there was a gold rush mentality, which in turn fuelled further rises creating a huge asset price bubble. A bubble is described as a speculative price increase that cannot be justified, and is contrary to the efficient market hypothesis.

The problem was that these assets, real estate properties, were financed with debt. Central banks encouraged more and more borrowing by keeping interest rates low to enable the assets to keep rising which eventually created the US real estate bubble.

Money distribution
There has been a marked shift upwards in income inequality in the US.
In 1929 the top 1% had 22% of the income. This was because those on low incomes were borrowing to buy the latest electrical consumer goods. Debt increased to 320% of US GDP. Between 1945 and 1970 incomes were closer with the top 1% averaging 9% of income. In 1950 regarded as the golden age of capitalism it was the period of the least income inequality. But by 2007, the top 1% were again accounting for 25% of the total US income.

In 2007:
The top 10% earned 50% of all US income.
The top 1% earned 24% of all US income
The top 0.1% earned 12% of all US income
The top 0.01% earned 6% of all US income 

To put this in perspective, 15,000 Americans earned $700billion between them - half of the GDP of Brazil!

US wages for the masses grew steadily until 1970, when with globalisation and industrialisation, average wages stagnated.  People looked to other ways to increase their wealth and maintain their standard of living. The obvious one was the value of their home. The top earners tend to invest in assets rather than buy manufactured goods. They ignited an asset bubble that cascaded down through the income distribution, with ordinary people paying more for their home just to keep pace.

The US the house price index shows that, when adjusted for inflation, there were no increases in house prices between 1890 and 1990. The only increase was the huge bubble that began in 2000 and led to a 100% increase in house prices.

In the 80's and 90's a lot of money was made. It needed to go somewhere and it was invested in mortgages. The income inequality provided a ready supply of capital to be invested in the increasingly easier to get mortgages.  The top earning 1% were not prepared to pay the bottom earners reasonable wages, but were happy to lend them money. As long as the worker earns enough to make the payments on his debt, the cycle is maintained.

What went wrong was that people were borrowing a large fraction of the value of the house and re financing after 3 to 5 years taking out equity to pay down debt. Incomes were falling in real terms for most people at the same time as house prices were rising, so people borrowed money on their homes to make up the shortfall in their wages to support their living standards with more debt.

As credit increases, corporate profits also rise with increasing dividends favouring the equity-owning rich 1%. Most of the profit from debt is made by the banks through fees and interest, boosting financial profitability more than the rest of the economy. In 1983, financial profitability was 15% of US GDP - by 2003 it was 40% of US GDP.

Around $1.5 trillion was transferred each year from the bottom 99% to the top 1% creating a massive redistribution of wealth. This took place in a stable democracy, with successive elected governments promoting this upward wealth redistribution. The consumer and mortgage debt paying the rich higher returns than if they invested in US companies.

Mortgage financing
As soon as the loans had gone through lenders would off-load them to the market freeing up their capital to make further loans. The majority of loans were sold to borrowers refinancing their mortgages to release equity generated by the rising real estate prices. These loans added nothing to the housing market - they diluted it as equity was withdrawn. Around 77% of the sub-prime loans sold at the time were re financing. Fewer checks were made as the loan was soon sold on. The banks wanted fees and commissions, both of which stripping more out equity from the housing market.

The mortgages were sold on as Collateral Debt Obligations (CDOs). These are bundles of mortgage securities, graded to reflect risk with AAA being the highest. However, most were sold on as Frankenstein Securities, a mixture of good and bad risk loans. Higher risk loans were added in the pot to juice up the CDO so that it paid a higher return.

The credit crisis
As the CDOs were sold and re sold around the world to various financial institutions, it was unclear how much risk the holders were exposed to. Once the market began to fall in 2006 and borrowers fell behind with their payments some of the securities were downgraded creating a panic sell off.

The reason for the credit crunch was the way in which capital moves in the economy and the way in which income inequality causes it to move so inefficiently. Transferring money from people who would spend it, helping the economy, to people who don't need it and don't spend it. During growing income inequality, consumption goes down, but this time it was prevented by using debt.

Over the last 30 years, capitalism has decreased the standard of living for everyone except those at the very top.

The Prophet

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"Inside Job" (2010) shown on BBC2 Wednesday 7 December 2011
« Reply #1 on: December 09, 2011, 11:17:27 am »
This film documentary showed just how the global financial crisis was caused.
It transpired that many top bankers in the US knew about the impending doom as early as 2004 but nothing was done, enabling the problem to be spread around the world and, as a result, limiting US exposure.

It also showed how Goldman Sachs profited by taking out Credit Default Swaps with AIG.
CDSs are a type of financial product insurance, designed to transfer the credit exposure if CDOs go bad. 

The film also showed how many bank chiefs got rich on the proceeds of CDOs and even richer when they received tax-free windfalls and left their posts to take up senior financial government appointments under the Obama administration.

Since the crisis, no one has been held to account and as one expert put it, "the problem being that a full blown investigation would have led those culpable being identified". 
The promised banking reforms have also been minimal.


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Re: The truth about the Credit Crunch
« Reply #2 on: December 09, 2011, 11:30:56 am »
What started in the US and caused a world wide financial meltdown, is taking place in the UK.
Those at the top are getting richer, whilst the majority are seeing their standard of living falling year on year.
This great income disparity cannot be allowed to continue -  it damages society.
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The Prophet

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Credit crunch (2) - due in UK October 2016
« Reply #3 on: October 23, 2012, 09:27:16 am »
Conditions for Credit Crunch 2 have started and will hit the UK in October 2016 if the similar timescale to the 2008 crisis repeats itself.

It's all good in the USA again so are the World's financial problems soon to be over?
Well the short answer is no!

In the US consumer confidence is at a 5-year high, retail sales jumped 1.1% in September and sales of house are at their strongest for two years. Even industrial production crept up last month and payroll figures are positive too.

So why the gloomy predication you ask?
Well US banks are doing great.
The US biggest mortgage lender, Wells Fargo, made $4.7bn last quarter.
JP Morgan reported a year on year rise in profits of 36% with a quarterly record of $5.3bn.
Citigroup reported a rise in underlying profits of 27% to $3.3bn.

So how is this done? 
Well the FED has started Quantitative Easing (QE) or money printing, to buy mortgage debt, for as long as it takes, until the US economy improves.
This has driven down mortgage rates to record lows and with a slight recent rise in house prices and an easing in lending criteria, a boom in refinancing existing loans is taking place.
The average 30 year fixed-rate loan is as little as 3.5%.  Fill yer boots US home owners!

Banks are earning more fees by writing new mortgages and are also earning money from packaging them up and selling them on.
The Fed's mortgage security buying is driving up prices for these bundles.

Sound familiar?  It should.
This is exactly how the US started the first world wide credit crunch that spread throughout the world.
It took from late 2003 to 2007 before the tide turned last time.
So sensible money would be on a return to recession, hardship, job losses around October 2016.

Anyone for austerity now?