Is the credit crunch finally over?

“So is the crisis over, or are there still some big problems remaining?”

Bad Debt data embedded in complex systems ... the chaos began to unravel in 2007 for pension funds and hedge funds businesses and continues to create a storm of destruction in its path

WHERE'S THE BAD DEBT?

The crisis began when US mortgage companies made hundreds of billions of dollars of inappropriate loans to individuals with poor credit histories.

These debts were then packaged up and sold to financial institutions around the world, who then sold it on to pension funds and hedge funds.

We still don't know where these bad debts are concealed in the financial system.

And until we do, banks will still be reluctant to lend to each other, and investors will be suspicious of the health of the financial sector.

UNFREEZING THE CREDIT CRUNCH

The reluctance by banks and other financial institutions to lend money, because they are not sure how risky it might be, is gumming up the financial system.

Despite the injection of hundreds of billions of dollars and euros, interest rates on inter-bank lending are still unusually high. And banks are tightening up on their lending to individuals and companies, restricting the amount of lending as well as making loans more expensive.

There are also hundreds of billions of dollars worth of short-term debt obligations that will fall due in the next six months, which could further depress the market if no buyers can be found for them.

WILL THE HOUSING MARKET CRASH?

The overhang of bad mortgages is depressing the US housing market. Thousands of people are having their homes repossessed, and with a glut of homes on the market prices are dropping.

Mortgage companies are finding it difficult to raise money even to lend to sound borrowers. So despite a pledge by the US government to help, house building is at a record low.

Although there are far fewer sub-prime mortgages in the UK, mortgage lenders like Northern Rock are also finding it difficult to raise the cash to pay for additional mortgage lending. So it could become harder to get a mortgage, and it could cost more - and both these expectations are lowering house price inflation.

WILL THERE BE A WORLD RECESSION?

A big slowdown in the housing market could have serious economic consequences.

Construction is a big part of the economy, and people who move house are also more likely to buy consumer goods like washing machines. The tightening up of credit and worries about mortgage repayments may make everyone more nervous about borrowing money to buy big-ticket items like cars.

There are already signs of an economic slowdown in the US, the world's biggest economy. And if it deepens, it could dampen down the economic recovery underway in Europe and Japan. The UK, as a major exporting nation, would also be affected.

WILL THE DOLLAR PLUMMET?

The effect on the rest of the world economy could be worse if the US dollar begins to fall in value.

The dollar is already weak because of the huge trade deficit the US runs with the rest of the world - nearly $1 trillion - which has been a big boost to the world economy. But if the US economy slows, and interest rates are cut sharply, the dollar will become a less attractive currency and could fall further.

This in turn would make imports into the US more expensive, and make it harder for exporters like Britain to win orders. A big decline could also force countries like China, which hold $1.3 trillion in currency reserves, mainly in dollars, to diversify their holdings, further depressing the greenback.

WHO'S TO BLAME?

Politicians and financial institutions are trading accusations about who is to blame for the crisis.

In the UK, the governor of the Bank of England is under fire for not intervening earlier to prevent the Northern Rock crisis from getting out of hand.

In the US, the central bank, the Federal Reserve, is under fire in Congress for not regulating sub-prime mortgage lending properly.

And both bankers and politicians have blamed the credit rating agencies for certifying as safe many of the bad debts which had been bundled up and sold. There is a growing move to tighten up international regulation of the financial sector - but worries about whether this can be done without inhibiting financial innovation.

IS THERE A SILVER LINING?

Many economists believe that the crisis is also an opportunity for rebalancing the economy, which has become overly dependent on consumer spending financed by cheap credit and government borrowing.

An increase in household savings, encouraged by higher interest rates for savers, could lead to more long-term investment.

And a mild economic slowdown in the US, coupled with a gradual reduction in the value of the dollar, could help rebalance the world economy, which has become overly dependent on the US as the engine of world economic growth.

Source: BBC September 2007