The current “credit crunch” can be simply explained.
Technically put, the leveraging has to be wrung out of the system before the system can work again.
In words of one syllable, more or less
Let us say you have made a bet, which the local branch of Ladbroke’s or your local betting shop has accepted, of $100 that we will have a white Christmas. $100 has certainly disappeared from your wallet, or large men in dark suits will be round to break your legs, but what is the value of what you have received in return? If you win the bet, and snow falls abundantly around December 24 and 25, the betting shop will pay you $150, true, but what is the exact value of your betting slip while we wait for Christmas to arrive? Put another way, what would one of your acquaintances pay you to take over the bet because you need money in a hurry? Certainly something less than $100, but while you wait you may be tempted to say the value is the $100 you paid, [Note: If true, betting shops would soon be bankrupt, rather than being the reliable money spinners they have always been.] and your natural greed may persuade you to say the value is $100, or even $150. If you are a private punter, no one will take much notice of what you say, but if you are a corporation, nothing can stop you, except the credulity of your creditors, from making the value anything you choose. The bet is certainly an asset, since profit may arise from it, [though its value may be zero if you lose the bet] but the exact current value of the asset is a more doubtful matter.
Now suppose you decide not to sell this asset – the $100 bet you have at the betting shop – but to use it as a deposit, to borrow money against it. You go to your local bank, and sweet talk the manager – who may have his own reasons for going along – into having you deposit your betting slip at the bank, and allowing you to use it as security for $50 of credit to be used for other purposes. Bravo! You have now leveraged your asset, though its value has not changed by a whisker. Wouldn’t it be simpler to keep your $100 in your wallet? Indeed it would, but you’d then be simply Joe Bloggs, owner of $100, with no leveraging involved.
It was customary in the past for companies to put you in their pension plan, meaning that if you turned up for work every day for forty years, the company would continue to pay you almost the same amount as your salary for the rest of your days.
According to all judicial decisions handed down by US courts recently, the company is free to say, after your forty years, sorry, we need the money to pay our chairman his golden parachute, and so we can not, after all, pay you the promised pension.
The obvious counter to this, to refuse politely every offer of pension plans, get every penny you are owed the moment it’s due, and stick it under the mattress or buy your kids some decent food while there’s still any to be had, is resisted fiercely not only by companies for obvious reasons, but also by the government, which really needs to know how much you’re good for that it can get its hands on. The great advantage of leveraging, from both their points of view, is that every penny is accounted for in a clear paper trail. Getting the security lads to dive under your mattress every so often would take a great deal more effort.
If you have a job, and get a credit card on the strength of it, you’re leveraging a bet that you won’t be fired, or that, even if you keep your job, you’ll overspend. (Credit card companies make no money out of people who settle their accounts every month.) If you have a house and a mortgage, you’re leveraging a bet that the house will be worth more in thirty years than all the principal and interest you’ve paid in that time. If the price of houses suddenly goes down instead of up, you’re screwed, of course. You still owe all the money you borrowed to buy it.
Mr. Alan Greenspan, head of the US central bank, the Federal Reserve, during all of George W. Bush’s presidency up to the time that Bernanke, the current head, took over, is now a consultant in a private company, and correctly considering himself now a private citizen has recently published a book, The Age of Turbulence. One quotation from this book immediately hit the headlines, that “the reason for the invasion of Iraq was oil, as every one has known all along,” a statement rather refreshing in its openness. Every one has indeed known that all along, just as the US installation of the Shah in Iran was also to get hold of their oil, which even the most rabid Republicans have so far not denied. Clearly, however, the White House decided they can not have their main financial expert say that, and Mr. Greenspan has done a series of TV interviews, around three a day by my count, - rather like General Petraeus, who had an immediate lunch break declared on him when he said that he did not know if the invasion of Iraq made America any safer, and came back after lunch with some qualifications – in which Mr. Greenspan used his considerable learning and charm to run through various episodes of his early life, and tied the oil question firmly to preventing Saddam getting his hands on sixty per cent of the world’s oil supplies by attacking Saudi Arabia from Kuwait in the first Gulf War. So it goes.
On the question of the housing situation, however, Mr. Greenspan remained truthful and illuminating. It is not merely that homeowners can not sell their houses and are having them re-possessed and auctioned off at a record rate because no one can obtain a loan to buy them, nor even that a number of mortgage companies and builders have gone bankrupt and more are likely to. Worse than either is the overhang of about two hundred thousand new homes that the builders have constructed that remain unsold. For the builders, to maintain a new house with no one in it is an exorbitantly expensive and ultimately pointless process likely to drive many more house builders to bankruptcy, but until this overhang of 200,000 homes has disappeared, owners of houses presently occupied are not likely to have much luck trying to sell their houses, and hence the gloomy forebodings of experts on the housing crunch. The bet made by house owners that their houses would be worth more in thirty years than the principal and interest they have been paying for thirty years turns out to be a losing bet as the price of houses goes down ever further though their debt to the mortgage company goes higher as unpaid interest is added, and makes it very unlikely they’ll be rushing off to the department stores to spend lots of money, and so the department stores are in trouble too. This is called “the effect on the economy.”