An idiot's guide to the Credit Crunch

I've read lots of printed and online articles and watched lots of TV programmes about the economic situation. As I'm so interested in the causes of the economic situation, let me misquote some of the things I've mislearned:

1) A key cause of the problem was the trading relation between USA and China. It went something like this:
a) China's economy depended on cheap manufactured exports to the US. To keep these cheap, it was important to keep the Yuan low against the US Dollar. This was done by buying US Dollars with Yuan, so keeping the price of one high (high demand) and the other low (high supply).
b) China ended up with lots of US Dollars, and they put these to work by lending them so that Americans could buy even more manufactured goods.
c) This resulted in a very high supply of money available for loan at good rates, with the broker making a margin. There was so much supply that "normal" loan demand was satisfied and new destinations for loans had to be found. These new destinations were (necessarily) those not favoured before, such as less good risks.
d) In America, borrowers representing a good risk get a good "prime" interest rate. Borrowers representing a higher risk (less likely to repay) have to pay higher "sub-prime" interest rates to cover the extra risk. As we know, these guys toppled the house of cards.

2) Imagine someone has to pay you money over the coming years, perhaps because you made a loan that they will must repay by instalments. There is a "debt obligation" to you. That represents an income stream in the future, and you could sell that to someone now. For example, I'm owed $200 over the next 10 years so I could get someone to pay me $100 now (so I can spend it), and then they get the future repayments. This is a "collateralised debt obligation" (CDO).

3) There was a business model that many banks used, but Northern Rock (for example) specialised in. This involved borrowing money from another institution, lending it for a mortgage, then selling the resulting CDO and repaying the first institution. This is fine as long as the money flow continues.

4) CDOs didn't stay with the first institution to buy them, but got bundled with other financial instruments of varying quality and resold (and bundled again and resold again and again). The value of such bundles should depend entirely on the quality of the CDO (the risk that the underlying loan won't be repaid). There are companies whose business is to provide credit ratings on such things, and they were overoptimistic because high estimates made their customers extra money. Hence institutions overpaid for the bundles.

5) This wasn't a problem until some of the sub-prime borrowers started to default on their mortgages. Suddenly, whoever was holding the CDO wasn't going to get as much money as they expected. Trouble was, with all the rebundling and reselling, who could tell how much bad debt any institution owned?

6) Being unable to tell which institutions were holding how much bad debt, and so might not have enough assets to meet their liabilities, no institution could afford the risk of lending to any other. This was a huge problem because most money is tied up most of the time, and much of the operation of banks involves rapid movement via short-term borrowing of a relatively small amout of money (in bank terms), perhaps during the night-time on the far side of the world. This is like the "oil" that keeps the cogs of the financial machine running. When the oil dried up, the international machine siezed up pretty much much immediately.

7) When Northern Rock's money-go-round came to a sudden halt its own reserves, fairly small compared to its business volume, were insufficient to support its daily needs and it couldn't borrow enough money to make up the shortfall. An inability to meet ones liabilities is the practical definition of bankruptcy.

8) In 2000, the money source for UK loans and mortgages was mainly from UK savings. By 2007 the source was mainly foreign financial institutions. When they wouldn't lend any more the supply of loans to business or to individuals as new mortgages dried up.

9) The big government "bail-out" of the banks failed for two reasons. Firstly, it came as loans to be repaid in something like 5 years. Lending to a bank amounts to owning part of it, and having the Government own large parts of banks for longer than 5 years amounts to nationalisation of the bank. The repayment has to come from money received by the banks (e.g. savings). The loans are so huge that it might take all of the money received over 5 years to repay them. In other words there is no spare money to lend onward. This is compounded by a demand that banks increase the ratio between their reserves and their liabilities, and so they need to keep incoming money to build their reserves. Again no onward lending.

10) Reductions in interest rates are supposed to make money cheaper for banks to borrow, and so stimulate the money flow. However, this has little impact against the needs for reserves and repayments described above and can't actually make the banks start lending to each other again.

11) There is a view that the situation will cause the population to reduce and delay their spending. This will impact the cashflow of retail businesses and their suppliers, and they will not be able to borrow to tide them over. This would result in high-profile failures, including of otherwise-healthy businesses. Enough failures would result in enough existing loans to businesses going bad that more banks will fail. Resulting loss of confidence could damage the banking sector beyond a point of recovery by normal means.

12) Another concern arises from the practical/short-term privatisation of an increasing share of UK banks. It could be seen that the liabilities of the privatised banks (even pro-rata) are part of the national debt. I understand that this would make the national debt about 500% of GDP (the total cost of all finished goods and services produced within the UK during a whole year). As a guide, in 2007 Zimbabwe's debt:GPD was the world's highest at 218%, one of only 7 countries over 100%. So 500% would be quite bad then.

13) Such a fear undermines confidence in Sterling itself. This is partly because, after exhausting all other available measures, the option of "printing more money" (or other steps that amount to it) would make the currency worth proportionately less against money of other nations (buy less foreign goods). In the nightmare scenario, the UK government could default on foreign debts, rendering the nation effectively bankrupt (although that isn't actually possible). Sterling has already fallen heavily on foreign exchange markets, and could fall much further.

Are we facing a financial apocalypse despite the underlying "health" of the British economy? I can't tell, but counsels of despair seem to be becoming more common amongst those supposed to be "knowledgeable commentators".