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Impact of the Credit Crunch

Impact of the Credit Crunch

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A Credit Crunch is a recessionary period during which growth in money or credit has slowed and subsequently causes a drying up of liquidity in an economy. It is often caused by lack of or inappropriate lending, which results in losses for lending institutions and investors when the loans turn sour and the full extent of bad debt becomes known. These lending institutions may then reduce the availability and ease of obtaining credit and increase the cost of any new credit by raising interest rates.{{more}} Furthermore, a credit crunch is generally preceded by an irreversible reduction in the market prices of previously overvalued assets, and in general refers to the financial crisis that results from such a price collapse.

In the summer of 2007, reckless subprime mortgage lending to low income Americans began a ripple of financial problems around the world. It has made banks less willing to lend to each other and to consumers. That in reality was the beginning of the credit crunch. Secondly, consumers were also feeling the squeeze as commodity prices were rising fast, driven by the demand from the booming economies of China and India, which made food, petrol and other basic items more expensive. This surging inflation has been restraining central banks from cutting interest rates which in other circumstances they would have done to help ease the credit crunch.

In today’s globalized environment, if the failure of a financial institution is likely to have serious repercussions on a world wide basis, the regulatory authorities will be expected to intervene. This is what occurred in the case of American International Group (AIG), the biggest insurance company in the U.S. AIG provides insurance to large companies not only in America but across the globe, including banks, and has been under financial pressure for some time after posting three consecutive quarterly losses. The U.S. government clearly believes that unlike the investment bank Lehman Brothers which did not receive support from the regulatory authorities, AIG is too big to fail. AIG’s Insurance policies remain in force so that SVG or other CARICOM businesses insured with the company would be protected. Banks buy insurance to protect themselves against the risk that loans would go bad and that borrowers would default. Their motive for so doing is to reassure their respective regulators that these loans are of minimal risk. And the benefit of so doing is that they can then proceed to lend considerably more relative to their capital resources. But if AIG is in trouble, it becomes doubtful whether these deals are properly insured and the financial industry around the world would be in deep trouble. AIG is also known as the sponsor of Manchester United Football Club in England.

The investment and brokerage firm of Lehman Brothers had to rely on the intervention of Barclays from the private sector to buy discrete components of its business. Both Merrill Lynch and Lehman Brothers who are now in the hands of Bank of America and Barclays, respectively, may well have attracted funds from high net worth individuals and corporate entities in our islands for management. These funds should continue to be under safe management, but may have lost some value on the Stock Exchanges. The credit crunch is not yet over so there could still be an opportunity for investors in these parts to diversify their assets out of instruments or away from institutions that are perceived to be weak.

The rescue of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) is being undertaken with the use of public funds. Confidence in the two businesses which are at the heart of the multi-trillian US dollar housing market has waned as property prices have collapsed and foreclosure levels have soared. They are both shareholder-owned companies mandated by the US congress to provide mortgage financing. These two buy mortgages from approved lenders then sell them to investors, rather than lending directly to borrowers. Together they own or provide guarantees for more than half of the U.S. mortgage market, so the authorities could not allow them to fail. Almost all U.S. mortgage lenders from huge financial institutions such as Citicorp to the very small rely on Fannie Mae and Freddie Mac for Funds. The nearest equivalent in our financial system is the Eastern Caribbean Home Mortgage Bank which also provides liquidity to the financial system but does not lend directly to borrowers. It is conceivable that given similar circumstances ECCB would have intervened in the market.

In St. Vincent and the Grenadines, the Credit Crunch has been more evident on the consumer side with the squeeze being felt where commodity prices including petrol and basic food items have been rising fast. This is the inflation effect; the impact could also feed into the disposable income and reduce consumers’ ability to service mortgages. What is not yet known at this juncture is the extent to which our portfolio managers (private and corporate) have become exposed to overseas investment houses and have been caught up in the global credit crunch. We, however, trust that in the final analysis such an impact will be no more than minimal.