Credit Crunch in simple terms: a story of four friends

You've heard the news, read the doom-mongers in the tabloids, and feel a bit uneasy about the credit crunch. But are you wondering what exactly this 'crisis' engulfing us all is? If you're struggling to tell your sub-prime from your prime cut, or your money-markets from your supermarket, then this is the guide for you.

At the bottom of it all is a lack of trust between the banks that circulate money around our country, and an unwillingness to lend to each other. Let's get personal, and imagine four friends - Matthew, Mark, Luke and John - who represent three types of financial institutions. Their story tells what went wrong. Matthew is a conservative type, and saved up some money during the good times in the 1990s; Matthew is a depositor. Mark inherited some money and wants something to do with it; Mark is an investor. Luke is the go-between and broker; Luke acts like a commercial bank in this story. And John is the dreamer and schemer; he thinks he can do something better with his life if he gets the money; he is the borrower.

The story starts in the good times in 2005, before the credit crisis. Matthew goes to Luke and says he has some extra cash under his mattress. Luke knows there are ways to put this cash to use, and accepts the money on deposit in exchange for paying Matthew regular interest on the money. Matthew is very happy, as Luke the banker has a great reputation for making money.

Now Luke approaches John, who has been asking around for a loan to buy a new house. He offers to lend John some money. He knows there is a risk John might not be able to pay back, because he hasn't got a regular job, but Luke will take the risk. (In banking terms, John is 'sub-prime' - he is not the best person to lend money to). But John is going to pay a lot of interest on the loan, and Luke gets greedy thinking about this. Instead of lending just the money Matthew deposited, he agrees to lend more than he has.

So Luke approaches Mark, who needs something to do with his money. Luke agrees to sell Mark part of the loan to John (along with loans from other borrowers like John). He assures Mark that there is very little risk of John not repaying in full, and anyway not all the other borrowers would stop paying at once. Mark is effectively buying a mortgage-backed security. Now Luke can lend more money to John and others by selling on the risk.

Fast forward to 2007 and Mark starts to worry about his investment. Rumour has it that John's latest scheme has come to nothing, and he might not be able to pay interest in the future. Mark tries to sell the investment on to another friend, but no one wants to buy the part of John's loan. Mark talks this over with Matthew, and then Matthew gets worried about his deposit with Luke. What if Luke doesn't have enough money to pay Matthew back as well? Matthew goes round to Luke's house and asks for his money back.

This is the last thing Luke wants. If he repays Matthew, he will need to call in the loan to John. And since John is not likely to pay up now, that will mean Mark will loose his money too. Luke actually asks Matthew for more money, but Matthew refuses: he doesn't trust him at all now. Now they are both caught in a bind: Luke can't lend more money to John or others, and Matthew and Mark won't deposit or invest any more, thinking they will loose out. The credit crunch has begun.

The irony is that John would be just fine if he could get a further loan. His new business is growing, and after a few years he would be able to pay his mortgage back. But now John is caught in the credit crisis, and his customers are unable to borrow as well. As his business slows, John really is in danger of loosing his house as he stops repaying the interest. And if he can't repay his loan, then Luke is bust: and Mark and Matthew both loose their money.

This is the simple version. Now imagine that there are hundreds of Johns borrowing from dozens of Lukes. None of them really know how much they stand to loose, and so none of them will lend to each other. As the lending stops, the weaker ones (without lots of cash reserves) will go bust, and pull others down with them. The point of this story is that if John continued to get funding, he would pull through and all the others would get their money back.

The government solution in the US and UK is to tax each person more and give this money to Luke, effectively forcing them to lend so that Luke stays solvent. This certainly should help John and others, and in reality Matthew's deposit at the bank was safe anyway. The problem is still Mark, the investor. The combined money from all the investors in the world is a lot more than the amount governments can borrow. So unless investors can be attracted back into the market for loans, and especially mortgage-backed loans, the future is not so bright.