The Credit Crunch Cascade

By   August 31, 2007

Someone put consumerism like this: Buying things you don’t need, with money you don’t have, to impress people you don’t like.

There are at least three inconsistencies in the above description.The current Credit Crunch brings one to attention: Buying with money you don’t have. If you’re buying a house, then you’re quite the exception if you can cough up the necessary money without getting a mortgage first.

This is where it all starts, at the bank (or mortgage broker). You state your income, your assets, and your credit history is investigated. In the end, you get a loan. This is all fine, if you can pay. Now consider Mrs. Sue B. Prime. The bank is unsure if her income can support the loan, but it also thinks the market value of the house she wants to buy will continue to rise. Since the loan is backed by the house, the bank decides to approve her mortgage.

Behind the scenes (at least to Mrs. Sue B. Prime), the mortgage is resold (to bigger banks, hedge funds, etc.) and the bank gets the cash it needs to keep selling mortgages.

All is well until the day Sue can’t pay anymore. If Sue can’t pay, the bank will take over the house, and sell it to cover the amount Sue owes. Problem is, the house prices where Sue lives are going down, and the bank has to sell the house at a loss. Actually, the loss is passed on to the investor who bought the mortgage from Sue’s bank. The investor is now getting nervous about his other mortgage investments, and stops buying mortgages (or demands a lower price, to cover the risk). End of story is that Sue’s original lender can’t keep lending (or even goes into bankruptcy because of the losses). Sue herself might also have to file for personal bankruptcy, since she can’t pay back the amount owed, even when the house is sold.

But it doesn’t stop here. As the number of foreclosures increases, the property prices keep sinking. There are now too many homes for sale. And because the mortgage banks can’t raise investment money for risky loans, fewer people are approved for mortgages, which means even fewer buyers. The prices continues to spiral downwards.

This not only affects new buyers and those buyers who can’t make their payments. Even rock solid home-owners who have a job, lose their equity, since their house loses market value. For instance, it used to be common to get a car-loan or boat-loan with the equity of the house as security. This may no longer work for some.

When a lot of consumers lose equity like this, it triggers lower discretionary spending. This affects the economy as a hole. Producers like GM are struggling with lower car-sales. Wal-mart sees lower consumer sales. Eventually more people in these affected businesses lose their jobs, and this lowers spending even more.

Is this bad? It is obviously bad for the people who lose their homes and have to spend years paying down debt. I don’t envy any of those, especially with the new bankruptcy laws. The lenders will also take a loss from people defaulting on their debts. These companies pushing risky loans had it coming. They knew the risk. The traders who bought these assets have also rediscovered risk, but it is part of the game. Those who lose their income because of the trickle down effects have much more reason to be mad at the banks and mortgage traders. They did nothing wrong.

The overwhelming majority of people will be affected relatively little. Sure, a lot of us must spend a tiny bit less than we’re used to from last year, but it will not affect quality of life much. It may even cause us to be a bit more conscious of what we buy (i.e less buying things you don’t need). This is certainly not a bad thing for the environment. I’m also under the impression that wealth is largely relative when all basic needs are addressed, so you might feel just as rich. Neither you nor your neighbor can afford that huge monster SUV. So less impressing people you don’t like.

Even so, it is likely that we’re in for some dark months in the stock market.

3 Comments on “The Credit Crunch Cascade

  1. Kristian

    There should be a central entity which approves all objects for sale based on their usefulness for society. That would get rid of 90% of all sales, I guess. And yes, very unrealistic, I know.

  2. Anderz

    I totally agree, and see the cleanup of the useless-stuff-market as a necessity that will happen no matter what. Really looking forward to it.

  3. Declaring Personal Bankruptcy

    You bring up a good point (many home buyers aren’t aware of): Banks often sell mortgages.

    Ours did. And, while my wife and I loved working with the bank that gave us our loan, it’s been a nightmare working with the company they sold our loan to.

    Buyer beware.

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