So what was the credit crunch and is it now over?

The “Credit Crunch” was a term originally coined by journalists following the sudden reduction in available credit and the sudden increase in the cost of credit brought on by the world’s economic turmoil.

The global problems were rooted in the US Sub-Prime market where mortgages were given to people who didn’t have the means to pay them back. The sub-prime mortgages were then lumped together and sold off in parcels called Collateralised Debt Obligations (CDOs) to various banks and financial institutions around the world. These CDOs were often then sold on again several times.

The original idea to this methodology was that if small parcels of debt went to many banks then the overall risk would be reduced to a negligible level – in reality it left many ticking time bombs all over the financial and banking sector without the means for anyone to identify exactly who had what toxic asset on their balance sheet. This was so pronounced that by August 2007, banks had practically stopped lending even to each other in case they didn’t get their money back. This quickly resulted in the Northern Rock collapse and nationalisation by Alistair Darling in September 2007.

Banks started declaring some sub-prime losses and began writing them off their books. But with a need to keep the required level of capital ratios to lending in place, assets had to be sold to balance the books. Accounting rules stated that the assets must be held at “Fair Value” (market value). For banks desperately trying to sell assets to cover their position, and the lack of confidence they now engendered, an environment of fire sales was created with the result that asset prices (market value) plummeted and thereby decimated the banks balance sheets.

In the meantime, there were several multi billion pound initiatives by governments around the world to kick start the lending again (both between banks and from banks to businesses), with very patchy results. And still the economy worsened, the job losses mounted and the UK (amongst others) officially entered recession (defined as two consecutive quarters of negative growth).

What options remained to the banks? Initially they went to the market to raise new capital. Subsequently, when this clearly wasn’t enough to maintain requirements, the only realistic course of action was a mechanism to allow them to be bailed out and part nationalised by the government to stop the whole banking system from collapsing.

The banking system now appears to have stabilised somewhat, although it is debateable as to whether the credit tap is fully open to business again (with future business spending therefore needing to be financed out of income, rather than borrowing, benefiting cash generative companies). And in the mortgage market, even though interest rates are at an all time low, fixed rate products are more expensive than they were before the crisis when interest rates were at 5% - 6%. The banks, however, seem to be doing alright and are already looking to repay the government as quickly as possible to get back control (and allow the bonus culture to return).

So are we now seeing the green shoots of recovery or another false dawn? In recent days we have we have been informed of a number of positive signs that suggest the economy is finally emerging from the painful recession. Job losses in the UK and US are slowing (although they are still going up) and the service industry grew last month for the first time in more than a year, with manufacturing output rising by 0.2% in April. We are told that house price falls have slowed and demand for housing is firming up, while the survey of purchasing managers (covering construction, manufacturing and services) showed a sixth consecutive month of increased score (the current climb over the 50-points mark suggests that contraction has turned to expansion). Indeed a leading economic think tank, the National Institute of Economic and Social Research, suggests the recession is over and that GDP actually grew in April and May.

However, there is no room for complacency as inflation in May remained higher then many had expected, which leaves little room for further easing of monetary policy to further boost the recovery of the economy. CPI, at 2.2%, is still above the Bank of England’s 2% target which could leave the MPC having to raise interest rates sooner rather than later. We have also seen oil creep up ominously to a 7 month high, and pass the $70 per barrel mark.

Some commentators have warned that the green shoots of recovery we are currently seeing may not last, and rather than a “V” shaped recession/recovery that many expect, we could be heading for a “W” shaped profile where there is another downward period before a sustained recovery takes place.

So is the recession over? It’s a hard one to call. But the evidence would seem to suggest “not quite yet”. However, despite the potential for a bumpy ride ahead of us, we do appear to be on the road to recovery at last.