(Glenn Musson (GM) qualified as a Chartered Accountant in 1991 after training with KPMG. He has worked in various business environments gaining valuable expertise before joining Rimor in mid-May. In this issue we've asked Glenn for a view of the credit crisis.)

GM: For several years the global economic situation looked very favourable with low interest rates and good growth in most areas across the world. Investors increasingly took higher risks in the search for increased returns. Many individuals invested in the buy to let market for the first time, often re-mortgaging their existing properties when they increased in value to provide a deposit for the next property. Similarly companies were encouraged to load balance sheets up with debt to increase their gearing and thus the return to shareholders when times were good. This created strong demand for financial services which, together with mark to market gains from rising asset prices boosted financial institution’s profitability leading to further expansion of credit.

The creation of structured credit vehicles, whereby loans are bundled together and then sold on to another institution, together with inadequate risk assessment on behalf of the purchasing institutions spread ‘toxic’ loans throughout the financial world. A key point to what follows is often the purchaser didn’t understand what it was buying.

The deterioration of the US housing market led to rising arrears in the ‘sub-prime’ market and consequently losses on the structured credit products. The failure to understand what they had purchased made institutions realize that their competitors were probably in a similar position. As there were no willing purchasers for the structured credit products, that they had previously bought, the liquidity of this market disappeared and hence pricing the products proved very difficult. Accounting requirements forced institutions to provide for potential losses even though it was virtually impossible to value them. This led to the drying up of the inter-bank lending market, and large increases in the LIBOR (London Inter-Bank Offered Rate), as all institutions hoarded cash and caused massive de-leveraging in the market i.e. a reduction in borrowing. Ironically as this crisis was caused by excessive risk taking financial institutions have become very risk averse (only wanting to lend mortgages to borrowers with high deposits, for example).

What industries is this affecting?

GM: Initially the finance industry was impacted followed very swiftly by the house building industry in US and UK. The construction slowdown has spread very quickly to related industries (now may very well be the best time to start that new extension, especially if you don’t need to borrow the money to do it). The banks wish to rebuild their balance sheets and improved profitability by increasing lending margins and other charges, and minimizing future bad debts is going to play a large part in their tactics. Many institutions are also pursuing large rights issues e.g. RBS £12bn. So ultimately the whole economy will be impacted because people will not be able to borrow as much as they could before and rates, for many borrowers, will also have increased.

When will the crisis finish?

GM: The main problem at the moment is lack of confidence in the financial market as a whole. Bad news has dripped onto the front pages of the newspapers since before Christmas (Northern Rock) and carried on up to the time of writing. Bradford & Bingley, Fannie Mae and Freddie Mac, Lehman Brothers Bank and XL Holidays all appeared in the news with bad news. The central banks have made huge efforts to improve liquidity in the banking markets, but I believe we need several months without any further bad news for confidence to slowly improve. You have to remember confidence is like oxygen – you only miss it when it’s not there!