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CREDIT CRUNCH

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TECHNICAL RELEASE
FEB 2008

CREDIT CRUNCH


A credit crunch is a sudden reduction in the availability of loans (or "credit") or a sudden increase in the cost of
obtaining a loan from the banks. There are a number of reasons why banks may suddenly increase the costs of
borrowing or make borrowing more difficult. This may be due to an anticipated decline in value of the collateral
used by the banks when issuing loans, or even an increased perception of risk regarding the solvency of other banks
within the banking system. It may be due to a change in monetary conditions (for example, where the central bank
suddenly and unexpectedly raises interest rates) or even may be due to the central government imposing direct credit
controls or instructing the banks not to engage in further lending activity.

A credit crunch is often caused by a sustained period of lax and inappropriate lending, which results in losses for
lending institutions and investors in debt when the loans turn sour and the full extent of bad debts becomes known.
These institutions may then reduce the availability of credit, and increase the cost of accessing credit by raising
interest rates. In some cases lenders may be unable to lend further, even if they wish, as a result of earlier losses
restraining their ability to lend.

Credit Crunch – 2007

US Sub Prime Market

The 2007/2008 credit crunch has followed the problems in the US sub-prime mortgage sector, which specialised in
loans to people with poor credit.

Traditionally, banks have financed their mortgage lending through the deposits they received from their customers,
which in effect limited the amount of mortgage lending they could do. In recent years, however, banks have moved
to the securitisation model whereby they sell on the mortgages to the bond markets, earning a fee / premium in the
process. This has made it much easier for the banks to fund additional borrowing, and has also meant that banks
have been able to shift mortgage assets off their balance sheet into special purpose vehicles, thus also improving
their regulatory capital position.

As a result of the risk transfer to the bond market, the banking sector has dramatically expanded its role in the
mortgage bond market, and have specialised in new types of mortgage products aimed at sub-prime borrowers with
poor credit histories and weak documentation of income.

This business has proved extremely profitable for the banks, and has been aided by the continual price growth in the
property market, and a stable interest rate over recent years.

Subprime mortgages have a much higher rate of repossession than conventional mortgages because they are based
on adjustable rate mortgages – i.e. the payment terms are fixed for two years, and then became both higher and
dependent on the level of government or bank lending rates. Loan incentives and a long-term trend of rising housing
prices has encouraged borrowers to assume mortgages, believing they would be able to refinance at more favorable
terms later when the mortgage rate reset after the fixed term. However, once housing prices started to drop
moderately in 2006-2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure
activity increased dramatically as the interest on the adjustable rate mortgages reset higher. During 2007, nearly 1.3
million U.S. housing properties were subject to foreclosure activity, up 79% from 2006. As of 22 December 22 2007,
The Economist estimated subprime defaults would reach a level between U.S. $200-300 billion.

The mortgage lenders that retained credit risk (the risk of payment default) were the first to be affected, as borrowers
became unable or unwilling to make payments. Major banks and other financial institutions around the world have
reported losses of approximately U.S. $200 billion as of 1April 2008. As a result of the increased use of the
securitisation model to finance lending, many mortgage lenders had passed the rights to the mortgage payments and
related credit/default risk to third-party investors via mortgage-backed securities (MBS) and collateralised debt
obligations (CDO). Corporate, individual and institutional investors holding MBS or CDO faced significant losses,
as the value of the underlying mortgage assets declined. Stock markets in many countries declined significantly.

The widespread dispersion of credit risk and the unclear effect on financial institutions caused lenders to reduce
lending activity or to make loans at higher interest rates. Similarly, the ability of corporations to obtain funds
through the issuance of commercial paper was affected. This aspect of the crisis is consistent with a credit crunch.
The liquidity concerns drove central banks around the world to take action to provide funds to member banks to
encourage the lending of funds to worthy borrowers and to re-invigorate the commercial paper markets.

The subprime crisis has placed downward pressure on economic growth, because fewer or more expensive loans
decrease investment by businesses and consumer spending, which drive the economy. A separate but related
dynamic is the downturn in the housing market, where a surplus inventory of homes has resulted in a significant
decline in new home construction and housing prices in many areas. This also places downward pressure on growth.
With interest rates on a large number of subprime and other adjusted rate mortgages due to adjust upward during the
2008 period, U.S. legislators and the U.S. Treasury Department are taking action. A systematic program to limit or
defer interest rate adjustments was implemented to reduce the effect. In addition, lenders and borrowers facing
defaults have been encouraged to cooperate to enable borrowers to stay in their homes. The risks to the broader
economy created by the financial market crisis and housing market downturn were primary factors in several
decisions by the U.S. Federal reserve to cut interest rates and the economic stimulus package signed by President
Bush on February 13, 2008. Both actions are designed to stimulate economic growth and inspire confidence in the
financial markets.

Impact on the UK mortgage market

Inevitably the collapse of the sub prime market in the US has had a knock-on affect in Britain. Not only are UK sub
prime lenders facing liquidity issues, but UK companies with investments in the US have felt the squeeze. Many of
the large financial institutions have announced that employees will lose their jobs in an attempt to trim expenses, and
other global banks are following suit in order to increase liquidity.

There have been widespread losses amongst investors, which has caused banks to rapidly rise the rates which they
charge each other, illustrating the panic and uncertainty over the questionable creditworthiness of even the largest
financial institutions.

Many lenders in the UK have already tightened their loan conditions in response to the US financial slump,
particularly in the sub prime market, due to fears that the same thing is going to happen in this country.

The threat that this situation could present to UK borrowers is real. Mortgage deals are becoming increasingly more
expensive for people with bad credit histories, for whom a sub-prime home loan was the only option, but who could
now find themselves refused a mortgage altogether.

								
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