Two years ago, only few people would have either used or heard the term Credit Crunch – a term which nowadays is commonly used to denote the start or the cause of the recent global recession. Credit Crunch means lack of money supply or availability of credit.

Both in business and personal life, the availability of credit (as loans and other forms of borrowings) is very important. On a personal level, buying a house without a mortgage is prohibitive for most people. In the business world, credit offers ways to mix capital investment, offers access to cash for working capital (such as paying payroll), and offers opportunities to grow faster then raising equity. Hence the ability to raise credit is important at different levels – at a personal and family level, at a business level, and also for both the economy of a particular country and the global economy as a whole.

So where is the problem?

People need credit, whilst banks need to lend money in order to make a profit – in theory the perfect match within a modern capitalist society. The more the economy grows, the biggest the aspiration and confidence of people to borrow, the more profit for the banks whose business rely on lending.

Many assumed that the market would regulate itself, and never realized that the financial system and institutions will enter into excessive risk taking which would in turn put the same institutions at risk and with them the whole global economy. Unregulated competition itself has driven many banks to take on higher levels of risks, and be able to bundle such risk so that they can pass it over between themselves at a margin.

So how did it all happen?

About two years ago, the first signs of trouble in the banking sector appeared probably with the first French bank - ABN Paribas signaling bad news to its shareholders. However, the seeds of this turmoil were planted much before.

In an effort to maximize revenue (and hence to lend more) banks started lending money to what is known as sub-prime mortgages. What is the meaning of the term “Sub-Prime”? As the term itself denotes, sub-prime is something less then being Prime. In banking it denotes the practice of lending money to people with poor credit history.

Low interest rates availability in years up to 2004, gave rise to a lot of people to borrow beyond their means, even if some of them had poor credit history. The banks were happy to lend in an effort to increase their revenues. Such mortgages, termed as sub-prime mortgages were bundled up in groups, known as Collateralized Debt Obligations (CROs) and sold on to investors globally. Thus wealth was artificially created – and banks profits ballooned. The more sub-prime mortgages created, the bigger the profit for the banks, the more money in the property markets, the higher the property prices, the richer the people who invested in property – or at least that how it appeared to function.

There was only one problem – the people who took on such debts were at the edge of being able to afford them. In the years between 2004 and 2006, interest rates in the US rose from 1% to over 5%... and that drove many of the people on the margin of affording their mortgage to actually default their payments. This caused a chain reaction – many could no longer afford to re-pay, the property market plummeted, the CRO lost their value, and banks were in trouble. Many CROs were sold internationally and therefore the effect was global – with many banks reporting loss in their investment.

The Collapse of the “Giants”

Lack of confidence in the banking system was spreading wild, with some customers pulling their savings from certain banks, causing their potential collapse. In the UK the Northern Rock, asked for emergency financial support from the Bank of England when the onslaught of the credit crunch has dried up its funds. In one day alone, the 14th of September 2007, depositors withdraw over one Billion pounds from their savings accounts, in an attempt to save guard their deposits. Merrill Lynch in the US exposed a bad debt hit of around 8Bln USD. The US Federal Reserve, followed by other central banks around the world, started pumping money into banks in an attempt to save their collapse. They also started cutting interest rates.

Leaders of the G7 suggested that global losses from the US sub-prime mortgages could add up to 400 billion US dollars. Governments around the world continued to help banks, by pouring into them tax-payers money – in Great Britain, HBOS and Northern Rock, and in the US, AIG and Fannie Mae and Freddie Mac – one of the biggest mortgage providers in the country.

That meant, that effectively the taxpayers started to own these banks (or parts of), which without their help they would have otherwise gone bankrupt. Lehman Brothers files for Bankruptcy on the 15th of September 2007 – being the first such big bank to file for bankruptcy since the credit crunch started. UK and US governments run attempts to save this giant institution but all attempts to save it fail, (including attempts by Barclays Bank to buy into Lehman fail). This leads to a controversy which is still raging on today, that if Lehman was saved, recession might have not been as bad.

Whole countries such as Iceland were in financial trouble and started to sell their foreign assets in an attempt to save their fragile and exposed banking system.

The effects of the Recession.

Property prices started to drop internationally, as loans from banks were not so easily available. Businesses had no credit available to expand and in some cases even difficulty to continue to operate. Car sales plummeted internationally by as much as 30%. Job losses increased, with many retail companies recording drops in their sale, and other laying off employees in an attempt to ride the recession.

The Road to Recovery

Hundreds of billions were pumped (and still are being pumped) to ease the crunch on credit by central banks around the world. Quantitative easing (what was traditionally known as “printing money” – but essentially increasing the supply of money in the system) started to be used in many countries to help their economies recover and for the flow of money to businesses to resume. Interest rates were also cut to record lows. In the UK, Bank of England interest rates are just 0.5%, another attempt to encourage borrowing to resume.

In both UK and US property market is now on its way to recovery. The UK government survey announced that between May and September this year, property increased in value by around 6%. Also the loss of jobs seems to be easing although it is quite a way for a full recovery to pre-recession levels.

Many analysts are not sure what 2010 will bring – some predict further declines whilst others modest increase in the global economy. New world economies such as China and Brazil seem to be pushing ahead and helping a global recovery.

The question is how long will it take for financial institutions to repair their balance sheet (clear their bad debts), and resume normal activities. Will they survive without new tax payers’ assistance? Will this be needed again?
Also, what type of financial institutions and regulations will the world have? Would it be still considered fair for the banks to undertake such high risks, and when they fail the taxpayer will be left to carry the bill?

This especially when the management of these same banks is seen internationally as awarding themselves fat bonuses, even when perhaps performance doesn’t merit this. How will the taxpayers sell their stakes in the banks which they acquired in return of assistance given in the midst of the credit crunch – will they recoup their investment? Will these banks be split in small institutions to foster competition?

Most importantly, will there be a world co-coordinated effort to regulate the banking system so that it will not over gear itself and enter into excessive risk as it did in the years pre-credit crunch. This may be a challenge, as economies want to stimulate lending and borrowing as they know that their growth and prosperity is also dependent on this. If one country over regulates, then it may loose its competitive advantage over the others, driving investment away. Hence a coherent approach is badly needed; in that no one country will act alone. That may be easier said then done…

Whilst the initial recovery seems to be gathering pace at the moment, there seems to be a long way for a full recovery, and for the future global growth to cancel the scares left by the credit crunch, not least political and social effects in some of the richest nations on earth – potentially also altering the balance between some rich nations and developing countries for years to come.