Just What Is a Credit Crisis?

An old friend, an 81 year old mathematical physicist, posed that somewhat astonishing question last October by email and again a couple of days ago in London when we visited where he lives. He wanted it in about 750 words.

Here is what he got. He was sufficiently satisfied to suggest that it could be useful if seen by a lot of ‘civilians’ who he believes, perhaps correctly, are too embarrassed to ask the same dumb question.

The answer begins by explaining that the word credit is derived from the ancient word “credere” meaning to believe, to trust.

For example, your credit card is based on the issuer’s, for example Visa, trust that you will pay them what they have advanced on your account to your “creditors” — the people who sold something to you and trusted you and Visa to pay them for what was sold.

Then the question begins to gets a bit more complicated. The balance in your bank account is called a credit balance because you trust your bank to keep it safe and pay it to you or, on your instruction, to someone else, whenever you want.

In the meanwhile your bank constantly has dealings with lots of borrowers and other banks and lends its depositors’ money, including yours, to those banks and other borrowers trusting them to pay fully and in a timely way.

When you buy your car on credit you promise the auto finance company that you will pay monthly over, say, three years the money you borrowed to buy the car. The auto finance company pays the car manufacturer the full purchase price and in turn borrows that money from all sorts of other lenders, who all trust your promise to pay what you owe when you owe it.

Similarly, when you buy a house, you take out a mortgage from a lender, which is a promise secured by your house, to pay over, say, 30 years the full price you had agreed to pay the seller. That lender in turn borrows the money to lend to you from a lot of institutional investors, including government backed companies which specialize in housing finance, all based on everyones’ promises to pay. That obviously again involves trust on all sides by everyone involved.

At this point the subject gets pretty complicated. Your promise to pay for your house can get packaged with the mortgage company’s promise to pay into another whole different type of loans called “derivatives” because they are derived from your original promise to pay. Those derivatives contain many different types of original buyers [old, young, rich and poor] and different types of mortgages [fixed rate, variable rates of interest etc] which are in turn sold to another different collection of institutional investors who trust that virtually all the participants will pay what they owe on time for years into the future.

And, to add another complication, some of those derivatives divide the risks they contain into different pieces that can be sold separately, for example early versus later pieces or interest versus principal. Believe it or not, simply because those packages contain blends of separated risks, they are presumed or alleged to be overall less risky than all their various separate underlying pieces. Therefore at least parts of them sell for a “better” price [profitable to them] than you paid for your original mortgage. These fancy instruments became very plentiful and supplied ‘wonderful’ profits for many years to many eager people up and down the marketing chain. Talk about¬†trust!!!

In the meanwhile more housing was being encouraged in every way, by public and private policies, and more and more buyers were lured into the housing market at ever rising prices to the point that many people began to think they were really getting rich from their rising home prices and some started speculating by buying more houses simply to resell them at ever higher prices. Is that trust or greed or what??

And, in the meanwhile bankers of all stripes, conservative and ‘modern’ alike began senselessly buying more and more of these “riskless” derivatives without taking on more protective capital, because it appears they truly believed there were no real risks involved. They saw what they did as a public good because it helped finance more houses and because, by the way, it also generated giant trading profits for all the intermediaries along the way including lots of needy traders and bankers.

Trust in the power of profit incentive really did its work.  Then, lo and behold, after many years of uninterrupted continued success, suddenly , within about one year, there became many excess houses, cars and credit card overdue balances, and more and more owners/debtors could not meet their obligations and began to default on their promised payments. The overall default rate of broken promises began to rise rapidly and ripple throughout the whole economic system. That, of course, led to drops in sales of houses, cars and everything else everywhere and in turn led to lay-offs of workers, who of course were also borrowers, owners and investors, and, thus many more failed promises to pay on time. Trust in all its forms swiftly began to melt away.

That is a full blown credit crisis. Banks stop trusting each other as well as everyone else. Nearly everyone stops lending because they are all over extended, so that very few people now can borrow to buy a house, car, vacation, or whatever, and the whole economy begins to grind to a halt because there is no credit to supply the cash to power the economy in any direction except down.

Whatever happened to “trust but verify”?