Monday, Feb 18, 2008
The Credit Crunch is spreading to other parts of the market
Economist: Still here
THE credit crunch is simply not going away. Every week another arcane area of the bond market seems to be dragged into the crisis. The underlying problem is as old as finance itself—borrowing short to lend long. As a strategy it can be extremely profitable but it is very vulnerable to crisis. Three things can go wrong: the costs of borrowing can go up, access to borrowing can dry up, or the assets bought with borrowed money can fall in value. All three have happened at various stages over the last six months. When credit booms unravel, another problem tends to emerge. Lax lending standards apply during booms; we have already seen that in the case of subprime mortgages. The same may have applied to corporate lending
Posted by who stole my pension? @ 05:35 AM (282 views) Add Comment
3 Comments
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1. Uncle Tom said...
Quote: "The underlying problem is as old as finance itself—borrowing short to lend long"
Wrong. Lending long without the option of changing the rate of interest has always demanded a guaranteed source of funds if it is to be done in a prudent manner. Traditional banking practice never allowed commitments to be made that might later prove impossible to honour.
The recent fad for securing short term funds at a favourable rate, and then lending them on in a manner that demands a renewal of the short term funding on equally favourable terms, was always a ticking time bomb, and should have been strangled at birth by the financial regulators.
2. 51ck-6-51x said...
Actually the statement you refer to, above, is true Uncle Tom - yes, you are right that there was not always the opportunity for directly borrowing short, as there is today. However, the traditional banking system does effectively borrow short from the economy as a whole.
Banks get deposits, they place a small percentage (say 6%) into their reserves and lend out the rest, which then allows for the economy to make further deposits into the banking system and the money goes around again, creating leverage - they lend out money they have already lent out, thus effectively borrowing from the economy.
This has led to credit crises ever since whatever swindler first thought of it, I'm sure! A good example was when the Goldsmiths of London in the 16th century provided promissory notes backed by much more gold than had actually been deposited with them.
"I promise to pay the bearer, on demand, the sum of…", well, therein lies the rub.
3. sold 2 rent 1 said...
Nicely explained 51ck-6-51x,
"they lend out money they have already lent out, thus effectively borrowing from the economy."
But the term "lend" implies that banks lend out other people's money. This is of course the myth of modern banking.
Your statement should say
"they create new money from money they have already created, thus effectively creating debt into the economy"