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Why this credit crunch is the crunchiest yet?

Posted 7th April 2010.

The continuation of the current economic crisis even in what are supposed to be post recession times, has a lot to do with banks not lending money to us whether it is by way of a loan or a mortgage enabling us to spend. To explain why banks are making it so difficult for obligo.co.uk explores the murky world of banking and finance.

It is fact that we need money circulating in the system. When we spend money we are helping businesss etc to grow which in turn increases production to meet demand and in turn leads to a healthy economy.

So why are mortgages much harder to get?

The lack of money available for mortgage purposes today is largely due to banks not being able to lend to us. The reasons for this can be explained fairly simply.

Firstly, the current mortgage market is not normal. The best example of a normal market is one whereby we can obtain mortgage finance to 95% of a properties value, providing we can afford it and that we can show that we pay our debts. Under these circumstances we would have a variety of mortgages available to us at competitive rates.

The main reason today that the market is not normal is because banks have available about 150 billion of funds against demand for regular mortgages i.e. not 100% or sub-prime etc of about 200 billion. So why dont banks just get more money to lend?

In terms of making money available it is important to understand where the money comes from to fund our mortgages. In the main the money comes from investors investing money with banks for a return, thereby enabling the bank to lend the money by way of mortgages to us at a rate enabling the bank to make a profit. The problem here is that there is only a certain amount of investor money available. This problem becomes worse for the banks as under a revision of the rules that banks have to abide by for every £1 lent the banks have to make a further provision of funds to cover any future losses that may arise from the mortgages they make. The increased provision is there to protect against another lending disaster. So £1 lent may mean a £2 provision meaning even less money available.

In the past to cover the shortfall in the amount of money available the banks sold on their mortgage assets i.e., mine and your mortgages, to outside investors. What this meant was that our mortgages were owned by another organisation such as a local authority, pension fund or an unrelated company. The affect of this was to replace the money originally lent, thereby allowing the bank to lend the money again! The more it sold the more it could lend.

As you can imagine the banks made a profit on every sale so were happy to keep doing it. This part of the process is known as securitization.

Now heres the rub. Banks in an effort to make more profit were prepared to increase their risk when lending to insure that they maintained their market share. Banks began to look at mortgages of 120% of the property value, would lend to applicants that had not been properly screened in terms of affording the loan, would lend on sub-standard property and to people who had a bad record when it came to paying their debts.

This relaxation by the banks of their guidelines led to thousands of the loans that were sold to the investors and many held by the banks going bad, leaving the investors and the banks without any profit from their investment and worse still massive debts. These loans are referred to as toxic loans because they were inherently bad. The net result of these loans cost the banks and their investors billions of pounds.

As you can imagine after such drastic losses buying these mortgages the organizations previously involved were not prepared to invest any further. It may actually be sometime before these markets are functioning again. One thing is certain, until they are, getting a mortgage will remain hard for the majority of people due to a lack of money.

Secondly, the body that regulates the banks, the FSA (The Financial Services Authority) due to what it would term irresponsible lending by the banks as described above has tightened the rules on banks making it vey difficult for them to offer flexibility when lending. Whether we think this is right or wrong isnt important what is important is that banks are not behaving normally adding to the problems we are having getting a mortgage.

The main changes are that banks now have to hold more money against the loans they make reducing the money they have available to lend to us, particularly where flexibility is needed. They also have to prove fully that we can afford the loan and that we will pay it back. This is making it particularly difficult for some of us particularly, the self-employed who in many cases have trouble proving their income. Furthermore, whilst there is not a ban on high percentage loans current rules are making it hard for banks to take any risks that they do not need to. If you think about it why would you take a risk that might get you into trouble when you can lend the money you have without any exposure. This situation is awful for first time buyers, the self employed and generally for people needing a bit of flexibility.

So there you have it. Banks cant raise enough money to lend to us and even if they could they are being discouraged from doing normal lending by their governing body. Unfortunately until investors regain their confidence and trust mortgage assets again and the FSA starts to trust the banks lending decisions things will not change.