The credit squeeze explained

30 Nov -0001, 12:00 am   -   Source: SBS
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Divorce is causing young people to sell their properties (AAP)

Divorce is causing young people to sell their properties (AAP)

What's a sub prime loan? Is the economy in recession? If so, what does it all mean for me? Find out that and a whole lot more here.

What is the US credit crisis?

The US credit squeeze has been an ongoing economic problem which surfaced in mid to late 2007. A combination of a downturn in the American housing market, risky lending by the banks, borrowing practises by consumers and corporate debt levels have all contributed to the issue.

VIDEO: The credit crisis explained

Banks are now left with debt from those people unable to repay their loans. With a shortage of money, banks are reluctant to lend to big companies or even individuals. This in turn means a down turn in productivity for major banks and companies which means havoc on their stock prices.

Bad debt has already rocked the foundation of investment giant Lehman brothers, which collapsed recently, and rival Merril Lynch, which got rescued by the Bank of America.

What's a recession?

Economists define recession as two straight quarters of economic decline. Like a business, economies like to have successful growth after each quarter.

What's all this talk about Sub Prime lending?

Sub Prime loans in particular have contributed in a huge way to the overall credit squeeze. Lenders in the US have issued sub prime loans (or B paper, near prime, non prime or second chance lending) loans to people who may not have initially qualified for standard bank loans. These people are often turned away because of their financial standings or poor credit history.

With consumers in the US defaulting on their loans, they file for bankruptcy therefore legally are unable to pay back the bank. This leaves the big banks in an unfortunate position as they're now left with the debt and have no way of chasing up the lost money. The lenders have now ended up becoming the borrowers with an increased debt.

Why is it a credit 'squeeze'?

With so many people defaulting on their loans, banks are now reluctant to issue more loans, not only to individuals but also businesses. Like any young family or individual, getting into debt to purchase a property is an important way of economically moving forward in life. Similarly, businesses take out loans to expand and increase production.

Who's at fault?

While it's easy to point the finger at the big banks and sub prime lenders, the average consumer is also to blame for taking out a loan, which in theory was a risky one in the first place. Some consumers took advantage of low interest rates years ago, under the assumption that their repayments would always stay the same.

How is the rest of the world involved?

Mortgage companies can have up to hundreds of billions of dollars in loans on their books at any given time. These debts can be packaged up and sold to financial institutions around the world, who then can sell it on to pension funds and hedge funds. British bank Northern rock was one of the first victims of the credit crisis. In 2007 the bank asked the Bank of England for a leg up, due to problems in raising funds in the money market to replace maturing money market borrowings. The bank's assets were always sufficient to cover its liabilities, but it had a liquidity problem because institutional lenders became nervous about lending to mortgage banks following the US sub-prime crisis.

Is the crisis over?

Not quite. Some analysts say the worst is yet to come. In the last financial quarter, Britain's edged towards recession after economic figures revealed the nation halted with a growth of 0%. The New Zealand statistics agency says its nation has gone into recession for the first time since 1998. Gross domestic product shrank 0.3% in the first quarter, and 0.2% in the second quarter this year. But annual growth until June remained positive.

What about Australia?

While Australia is definitely involved in the fallout in the US credit market, tough economic action by the former Howard government has some what insulated the Australian economy.

Recently the Federal Government lanched a $4 billion rescue plan of the country's struggling non bank lenders. The Treasurer, Wayne Swan, announced the move in a bid to bolster competition in the home lending market, which has collapsed in recent months as funding for non-bank lenders dried up amid the credit crunch.

Under the scheme, the Government will buy $4-billion worth of AAA-rated mortgage-backed securities from small to mid-sized bank and non-bank lenders.

Will my bank – or me – be affected?

Analysts recommend you to contact your bank or read its financial statement to see whether or not your bank's money is involved in the US market.

Where's the sunshine?

While we may not like the idea of a recession, economists say a down turn is an opportunity for rebalancing the economy. Currently booming nations have become overly dependent on consumer spending fancied by cheap credit cards and government borrowing.

This way, households can now channel their money into more secure – yet low risk channels such as bank savings.
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