Ever since US subprime mortgage companies had to write off bad mortgage debts, there has been a shortage of liquidity in the banking system causing mortgages to be more expensive and difficult to get.
A few US mortgage companies lost substantially because many of their mortgage advances were inappropriate. People couldn’t afford to pay them back so they defaulted on the mortgage, leaving the bank with losses.
As people defaulted on mortgages, house prices (which had been booming) started to fall. Falling house prices compounded the bank’s losses because the resell value of the house was much less than the initial mortgage.
The subprime mortgage companies had sold part of the loans onto other financial companies. The idea was to spread the risk. Therefore, even reputable banks became involved in the subprime mess (even though it was hard to know) Therefore, many banks such as Lehman Brothers had to write off bad debts (loans they had given to other mortgage companies, especially the US subprime companies.)
Because of the bad experience with mortgage companies going bankrupt, financial institutions became much more cautious about lending money for mortgages. Also, because they had lost money, they couldn’t afford to lend more. Therefore, mortgage finance was in short supply causing banks to ration mortgages by requiring large deposits and increasing the interest rates.
The problem is that many big banks like Northern Rock, and HBOS, relied on financing a high % of their mortgage products through borrowing from intermediaries like Lehman Brothers. They were not financing mortgages from savings, but from interbank lending. This is what precipitated the crisis in Northern Rock, one day, they simply couldn’t raise enough finance on the money markets to keep their existing business going.
The crisis continues because the losses are multiplying throughout the banking system. Now that Lehman Brothers has filed for bankruptcy, there will be an even greater shortage of mortgage funds, making it more difficult to get a mortgage (yesterday the interbank lending rate increased - the rank which banks charge each other to borrow. The Libor interbank lending rate rose to 5.89% yesterday)
Falling House prices exacerbate the credit crunch. Although defaults are currently low, falling house prices magnify the problem because it leaves homeonwers with negative equity. Therefore, if a homeonwer defaults, it multiplies the losses of banks such as Halifax.
It is a vicious cycle because the shortage of mortgage funds is causing a fall in demand for houses and therefore, house prices will fall further; this makes the mortgage industry more nervous. This is why the Bank of England has extended its emergency lending to the banking system.
Confidence. The other problem is that people’s decision to buy a house is based on confidence. Given the unrelenting bad news, most homeowners will defer the decision to buy causing further falls in demand.
4 comments ↓
[...] Effect of Credit Crunch on Housing Market [...]
This is the best explanation of the Credit Crunch in laymans terms I’ve came across on the net…………. but how would you suggest bringing it to an end?
One of the most important spanish banks is under fire in its own market. A massive scandal that could sum up to €3Bn is going to damage the image around the globe of Santander Bank. Contrary of what appear in the international press “Spain’s insurers, funds unaffected by Lehman -govt” the total amount of impact could be well above the €3Bn line
Millions of structured bonds were sold by the Santader Bank and its Private Bank branch “Banif” during last years under the name “Fondos 100% garantizados”, translated: “100% guaranteed funds”. There was not a single mention on the comercial brochures of “Lehman Brothers” nor anything else. Now suddlenly and with surprise the spanish icon, a potential €3Bn write-off could appear in its balance sheet.
http://afectadosporbanif.ning.com/group/pressrelations
[...] Effect of Credit Crunch on Housing Markets [...]
Leave a Comment