PUBLISHED: 13:33 18 March 2011 | UPDATED: 15:11 20 February 2013
This month's article is in response to a reader's request (yes! I do have one, probably the same gentleman who listens to Wogan) asking me explain what is meant by the term credit crunch and why it is having such an impact on his investment return...
In the low interest rate environment, lenders in the US have been making it easy for those with lower credit scores to obtain credit. These 'sub-prime' loans have then been sold on to financial institutions and hedge funds through securitised products on the secondary market. However, as interest rates began to rise and market conditions worsened, these debt packages lost value - leaving banks with assets worth less than they initially paid. As a result, these have been difficult to sell on and some banks have had no other option but to write off some of the debts and close funds with exposure to them.
The ability of buyers and sellers to trade on the financial markets is known as liquidity. When credit becomes expensive, this liquidity in debt markets becomes restricted. Such restriction means institutions are less willing to lend money because they cannot sell the debt on so, for anyone trying to borrow, this is bad news.
As a result, you would expect to see an increased pressure on company performance. A lack of easy borrowing means corporate management can't easily turn to the market for financing. Private investors buying and selling shares might see losses from companies whose business plans depend on credit. The market in general could be affected as the share prices of some UK stocks have recently been supported by share buy-back activity, sometimes funded by borrowing. In the personal market, it may be more difficult for those wishing to arrange mortgages - particularly those who might be classed as sub-prime.
It's clear that tighter global credit conditions could cause economic growth to slow and that's exactly the conclusion both the Bank of England and the Chancellor of the Exchequer have reached. We have already seen two cuts in the level of interest rates, however, the full effects are far from clear and investors are waiting to see the extent of the fall-out long-term.
SO WHERE NEXT?
The Governor of the Bank of England ended the year on a gloomy note. Mervyn King said that reduced availability of credit was likely to hit consumer spending and therefore economic growth in 2008. The policy committee had already taken the decision to trim interest rates by a quarter per cent early in December and have since cut them by another quarter, early in February. Can we expect more?
Most central banks were poised to raise interest rates when the credit crunch hit. The squeeze forced banks to re-examine their risk management procedures and pushed up the inter-bank lending rate (the rate at which banks will lend to each other - an important source of funding). As credit became harder to come by, central banks shifted their focus from raising to cutting rates on the basis that it would help avoid a sharp slowdown by encouraging people to continue borrowing and spending.
Now, the majority of forecasters are predicting further cuts during 2008. However, the central banks remain wary of dropping interest rates too far or too quickly because the high prices of oil and other commodities are still pushing up inflation.
But will they work to support the economy? The Bank of England faces a number of problems. Firstly, while it can introduce liquidity in the system, it cannot directly influence the inter-bank lending rate, which has been the source of the troubles in the credit markets. Also, the crisis has made banks more risk averse. They now want to improve the margin between borrowing and lending and are therefore less likely to pass interest rates cuts onto the consumer. Finally, there is the effect of previous interest rate rises, which have yet to fully filter through the system.
These issues combined mean that interest rate cuts are unlikely to be as effective in shoring up the economy as they have been in previous cycles. Above all, confidence needs to be restored to the banking sector so that they trust their counterparties and are willing to lend at a lower rate. This will push the inter-bank lending rate down to more normal levels, in line with the Bank of England base rate. Overall, borrowers could see another cut to lower rates in 2008, but they may not see a buoyant economy to go with it.
If you require further information or wish to suggest a topic for 2008 please contact me on 01743 285777 or email firstname.lastname@example.org. Or visit www.mardons.co.uk
Simon Michael MIFP AFPC
Mardon Financial Advisers Ltd