Right, so we hear news about recession, global economy crisis, credit crunch and etc… What does it all means? What cause it and what would happen?

To people who don’t read news like me, I had a hard time understanding it fully. Most of the time, I have no idea what’s going on until it became big news. Then my dad tried to explain it to me, and I still didn’t really get it. Just now, Aik Howe GoGo explain it to me in “kiddy term” so I think I kinda understand a bit as to what is credit crunch all about. At the same time, I tried to check out some terms online to gain a bit more understanding. So in case there is anyone out there like me, I shall take this opportunity to share what I had learn in simple terms.

What is Credit Crunch?
It means that loans (which are the credit) are no longer easily available, banks aren’t willing to lend money, or have no money to lend and the interest rate (of paying back the money) increases. This causes a huge problem as it will affect a lot of stuff as credit is important for economy growth.

What is the cause?
From what I read, most people blame it on greedy investors, mortgage brokers (people who determine who gets mortgage and who don’t from the bank) and also the borrowers are partly to blame.
In case you don’t know, mortgage is mostly properties/houses that acts as a security to the banks that lend you money to but that house in which you must return the money with interest in due time, mostly by monthly payment.

It all started with borrowing money to buy properties, as it is common. House prices are expected to rise and increase, so people borrow money to buy them, and expecting to sell them off at a higher price so that it could cover the cost of buying it and perhaps with some added profit. So mortgage brokers, lenders and banks lend money out to people and collect them back in due time with added interests.

Then, maybe due to greed, they started lending out money carelessly and making mortgage easily available even though it might be risky (means that the person who borrowed the money might not afford to pay it back). Packages like interest-only loans came up, meaning people can just pay the interest first before paying the sum they borrowed. So means you can pay the interest which is a smaller sum then pay the bigger sum (which is the money you borrowed) in later years when your salary rise in later years as you work longer.

So this mortgage thing act as an investment. Because banks earn money through the interest paid by the mortgage. Mortgage brokers are like middle-man who get some money by arranging the mortgage and then sell it off to other people as investment. So, they sell risky mortgages(high possibility the borrower cannot return money) with other mortgages as ‘investment’ so they are no longer responsible of having getting the money back.

Economic Bubble – Over investment
It keeps growing and growing like a bubble, people borrowing money to buy houses and banks lending money to them and then selling off the mortgage to other banks when they need money and the buying and selling continues. Why would banks want to buy mortgages? As I said, it would be considered as an investment as they would earn interest and could generate millions even though it may take some time. These loans that become sell-able assets are known as securities and the process of selling and buying is known as securitization.

Then suddenly the bubble burst! And here it refers to when the prices of houses and properties falls. Why? I asked. Nobody is entirely sure but according to my cousin, it might be due to higher inflation and rising gas prices (due to war) and people no longer wants to buy houses to save money. So demand for houses drop, too many houses and too little people wants to buy them. The value of the house then decreased. Let’s say I bought one that cost 1000, then it’s value drop to 500. So where did the other 500 gone to? Nowhere I guess, because value of something is a subjective thing. Based on people’s wants.

Okay, so I actually borrowed 1000 from the banks to buy this house. Now that its value has drop, I realize I can only sell it for 500 now and that would not be enough to pay back the bank. At the same time, mortgage and credit are no longer easily available and the interest rate increases. When I’m no longer able to pay back the money,the mortgage become default, goes into foreclosure and the bank have to take the properties. However, banks are holding on to properties that are worthless and cannot be sold, because nobody wants to buy. And the inflow of money has stopped because many people aren’t able to pay back with the interests. Especially when they have to pay back the bigger sums which are the money they had borrow.

Then other people confidence fall, they aren’t so sure about whether all these stuff might be worth investing. (one of the reasons people stop buying houses?) Banks are not willing to lend money any longer and when they can’t get money back from the borrowers and does not have enough deposit or money, it might go bankrupt. So banks loses money. And it is not only one bank or banks in the US, because due to globalization, banks buy and sell to banks from other countries and international banks,etc. That’s why it becomes more of a global thing.

So what are the effects of banks not willing to lend money or going bankrupt?

Big time effect. The economy basically stop growing. When people can’t borrow money or not willing to due to the high interest rates, the buying stops. Companies can’t borrow money to expand their business and they can’t earn more profit, thus their growth rate falls to zero. Then when companies have zero growth rates or start losing money, they try to cut cost by reducing workforce, causing many people to become jobless. At the same time, people would start to spend less and save more due to the fear of this crisis and when the buying stops, selling stops, business stops for companies and people lose jobs.

How does this affect Malaysia?
While not many of our banks involves in buying and selling of loans, Malaysia relies heavily on exports and US is one of the biggest consumers. So when the US people stop spending more, demand falls, companies in Malaysia cannot sell and export their stuff, and they fall or stop growing, and the people suffer too. Also when companies that sell products can’t sell, they reduce the buying of raw materials, and manufacturers business falls too.

All in all, money stop flowing and cannot generate growth. So beware, out country will get affected sooner or later. After all this is a global economic crisis. China has started getting affected too.

So I asked, then people should spend money to get the money flowing, no?
But then, nobody dares to spend. Because prices are still dropping, and if you buy you might lose money. And when you’re not earning well or losing job, you definitely would spend more carefully. Normally, when things quiets down and no more bad news continue coming in, probably means it has hit rock bottom and people would start buying and it grows again. (I think? I’m not very sure about this.) The question is how long will it be and how much damage would it cost?

That’s why, the government comes in, drawing on their reserve fund to bail-out banks so they won’t go bankrupt and cause worse conditions. Two ways, they either lend money to the banks, or buy the properties from them and hold on to it until the economy start growing and they can sell back. And what does the bank do when they got some money from the government? They loan it out to people and companies to earn interest. Companies can continue growing and expanding then. See what a cycle it is? And it is explained that the US economy is built on credit.

By the way, the reserve fund that came from the government are taxes from the people! So if they don’t help out and the crisis becomes worst, government would become poor too because citizens aren’t able to pay their taxes.

I cannot claim that my explanation is correct because I don’t think I understand it fully either, so please don’t take this as perfectly correct and true as I’m not so sure myself. Try to find out more for yourself if you really want to know and do correct me wherever I’m wrong.

Sources and for more understandings
Global Financial Crisis
2008 Financial Crisis – Cause and Effects
Wiki Interest only loan
Wiki Credit Crunch
Timeline : Global Credit Crunch
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Kay time to sleep… ZZzzz…