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What is a credit crunch?

A credit crunch is characterized by a sudden reduction in the availability of credit (loans) together with an increase in the cost of obtaining this credit (rising interest rates). Theoretically speaking, a credit crunch could be the result of anything from an increased perception of risk, a change in monetary conditions, or an imposition of credit controls. In the real world however, it usually results from an interaction of several factors.

What caused the credit crunch?

In very simple terms, a credit crunch is the end product of a chain reaction resulting from lax and inappropriate lending. In the second half of 2007, ‘credit crunch’ as a phrase, dominated the headlines and although fueled by rising bankruptcies and mortgage defaults, it isn’t an issue restricted to mortgages and the subprime.

It’s basically a reflection of how consumers apply for, accept and use credit as well as credit policies of the various lending institutions. As a result of poor management of credit on the part of the consumer, the lenders hoard cash – reduce the availability of credit and increase interest rates. Thus, there is a reduction in the supply of credit in the face of a high demand.

How it all happened?

Experts have traced the credit crunch to the business of collateralized debt obligation (CDO). By definition, collateralized debt obligations are a type of asset-backed security and structured credit product. They gain exposure to the credit of a portfolio of fixed-income assets and divide the credit risk among different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches. Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added risk. Collateralized debt obligations serve as an important funding vehicle for portfolio investments in credit-risky fixed income assets.

Ten years after they were first issued in the 1980s, they emerged as the fastest growing sector of the asset-backed synthetic securities market. This growth reflected their appeal among insurance companies, commercial and investment banks, mutual funds, unit trusts, investment trusts, pension fund managers and on. By the end of 2006, the size of the global CDO market was put at $2,000 billion.

Types of CDOs

There are two major types of CDOs: collateralized loan obligations (CLOs) and structured finance CDOs (SFCDOs).

The former are backed primarily by leveraged bank loans while the latter are backed primarily by asset-backed securities. Other types of CDOs include commercial real estate CDOs (CRE CDOs), collateralized bond obligations (CBOs), collateralized insurance obligations (CIOs), CDO –Squared (CDOs backed primarily by the tranches issued by other CDOs) and CDO cubed.

From 2003 to 2006, new issues of CDOs backed by asset-backed and mortgage-backed securities had increasing exposure to subprime mortgage bonds. In 2006, $200 billion in mezzanine ABS CDOs (mezzanine ABS CDOs are mainly backed by the BBB or lower-rated tranches of mortgage bonds) were issued with an average exposure to subprime bonds of 70%. As delinquencies and defaults on subprime mortgages rose to record levels, CDOs backed by significant mezzanine subprime collateral continued experiencing severe losses.

As the mortgages underlying the CDO’s collateral declined in value, banks and investment funds holding CDOs faced difficulty in assigning a precise price to their CDO holdings. Many recorded their CDO assets at par due to the difficulty in pricing. The pricing challenge arose because CDOs did not actively trade and mortgage defaults took time to lead to CDO losses.

In June 2007, two hedge funds managed by Bear Stearns Asset Management Inc., an asset management company affiliated with a top U.S. investment bank, faced cash or collateral calls from lenders that had accepted CDOs backed by subprime loans as loan collateral.

Investors have criticized S&P, Fitch Ratings and Moody’s Investors Service, saying their ratings on bonds backed by U.S. mortgages to people with limited credit didn’t reflect the gaining default rate. They often gave top ratings to the securities. Some bonds had lost more than 50 cents on the dollar while their credit ratings hadn’t changed one bit.

Escalating mortgage defaults and huge losses recorded by the CDOs led to the credit crunch.

Fearing further losses, the banks have become afraid to lend money to consumers, risky or not; they’re also dreading lending other banks because no one bank really knew how exposed to the credit crunch the other was.

Credit Rating and Credit Crunch

As a result of the credit crunch, banks have been forced to put consumer applications for loan under real scrutiny before final approval. In addition to an excellent credit report, many banks are demanding income verification from employers and a higher down payment. Consumers with a high credit score may not necessarily feel the impact of the credit crunch but they story would be the opposite for those with a poor credit rating.  If you indeed get that loan, you’ll have to deal with paying higher interest rates.

Implication for the foreign exchange investor

Concerns about the credit turmoil and escalating tensions in the money market of the US economy have fueled the rise of several foreign currencies, including the yen against the dollar and higher-yielding currencies but it is unclear whether or not this rise will be short lived.