Friday, October 3, 2008

credit squeeze explained

Which comes first, the chicken or the egg? This analogy partially explains the current crisis. The increasing home prices, that exceeded the growth in inflation, and incomes, inevitably leads to a time when people are unable to afford to purchase a first home. Homebuilders who took advantage of the rise in prices, paid large amounts for their landbank leading to ever increasing prices for new homes. Homeowners, seeing the increase in the value of their homes, released equity. Firstly by borrowing more by re-mortgaging and then later by taking second mortgages at higher interest rates to fund extravagances like autos and vacations, and such like.

Many of these loans were made at teaser rates for the first couple of years, but when the higher rates kicked in many borrowers found themselves unable to pay their installments. The secondary mortgage could only be called once the first mortgage was paid off, so the non-performing loans that had been sold through investment banks backed by quasi-Federal institutions like Fannie and Freddie, became worthless. Those, holding such loans in their portfolios, went bankrupt or had to be rescued. This immediately affected the confidence of both investor and lender to the financial institutions. It worsened by the nationalization of Freddie and Fannie, and the house of cards began to unravel, as the prices of property on which much of the consumer confidence in their net worth was placed, began dropping.

The government really has no option but to steady the ship by printing and pumping credit to a market that has frozen credit out of the recoil factor of being shell shocked. The quid pro quo for such intervention should be some upside benefit when the markets settle and things gradually get back to normal after a period of recession. This could be short or long depending on how it is managed both by the private sector and government, with safeguards to re-build confidence, which has been lost.

One should not get confused with the stock market and its performance, which in theory should reflect the short and long term prospects of the companies reflected therein. The credit squeeze no doubt has an impact on company performance both financial and non-financial, but is analyzed independently of the credit squeeze itself. To the extent that each individual has a stake in the stock market through pension funds and retirement savings the fall in the latter does have a bearing, but is indirect and hopefully temporary, with upside once markets settle and volatility reduces.

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