A Dummies Guide to the Credit Crunch

Oh you who believe! Fulfil (your) obligations (towards the lawful contracts and transactions you have made). [EMQ 5:2]

Unless you’ve been living in a cave for the last 18 months you would no doubt have heard about the Credit Crunch. Many of the western economies are heading into recession (some analysts are predicting a repeat of the era of depression witnessed in the 1920’s) this article with briefly try to explain what exactly happened. I will not go into too much depth – rather I will highlight some of the main culprits.

From an Islamic perspective the culprit is obvious – Riba (usury or more commonly known as interest today). Allah (swt) clearly forbids usury yet the entire global financial world is driven by it.

Oh you who believe! Eat not Riba (usury) doubled and multiplied, but fear Allah that you may be successful. [EMQ 3:130]

Money does not have any real value anymore so it can ostensibly be created out of thin air – I will leave the discussion of money and it’s history for another article Inshallah.

Before explaining the credit crunch we need to understand the sub-prime mortgage crisis – which was the linchpin to this entire financial debacle.

Sub-Prime Mortgages

Since the millennium property prices have been on the rise at an alarmingly fast pace. On the surface, it was almost a no-lose investment and many people became very wealthy riding the wave. Now picture this…

Scenario 1: Joe Bloggs visits the mortgage broker

Joe Bloggs wants to buy a house he has bad-credit history, a few county court judgements against him, earns a minimum wage and can barely make ends meet. However, despite all of this he is determined to keep up with the Jones’s. He has seen so many inviting mortgage deals that he is sure that he can get a mortgage and become a landlord (This is not about Joe becoming a landlord but rather to own a home he can call his very own – which is everyone’s dream). So Joe visits one of the countless mortgage brokers that are advertising 100% mortgage deals. The conversation may go something like this… (this is flippant representation – but you’ll get the gist of what the real issues are)

Joe: Hello I would like to apply for a Mortgage. I live hand-to-mouth so I don’t have any savings for a deposit, I also don’t think I can make the repayments. Is there any chance I can get a mortgage?

Mortgage Broker. Of course Joe! Houses prices always go up so we really don’t need a down payment anymore. In fact we can offer you a 100% mortgage; we can even get you a really low interest rate for a few years to help you out early on, after that it will go up. Is that OK?

Joe: Yes that sounds good but I do have one other issue and that is that I am on a minimum wage and the house that I want is way out of my financial reach. My employer will only verify how much I really earn. Not how much I would like to say I earn. Is there any way you can help me with this situation?

Mortgage Broker: Don’t worry about that. We have ways of getting around that issue – if you catch my drift (nudge nudge wink wink).

Joe: Fantastic! Lets get started. I really appreciate you people working with guys like me.

Mortgage Broker: No problem Joe. We don’t actually lend you the money its the banks that do all that stuff.

Mortgage Broker (thinking): We really don’t care whether you can pay back the loan or not. We’re only brokers and will still get our commission come rain or shine. Banks will lend money to anyone these days. What Joe doesn’t know is that maybe for 2 years he will pay 1 or 2% interest on his loan. He may well be able to afford to do that. However, after this it will rise to around 8% (and quite possibly go a lot higher). That would really hurt Joe. Soon he will be in negative equity – where the amount you owe is greater than the value of your property. It won’t be long before he defaults on his loan obligations.

Scenario 2: This time we are at the offices of the lending banks.

Banker 1: Gosh we have had a lot of bad mortgages on our books – they are not prime candidates. In fact they are sub-prime candidates. I didn’t think that so many would default on the mortgages. We need a way to get our revenues up.

Banker 2: I know…why don’t we contact the smart investment bankers in Wall Street and sell these bad debts to them. They’ll know what to do with them and we’ll all be quids in.

Banker 1: Good idea. I’ll do that right away. Remember in the real world there are countless Joes and many Banks eager to lend. These bad loans have built up to billions of pounds worth of debt.

Scenario 3: At the offices of the Investment Banks in Wall Street

Junior Investment Banker: Gosh! We have bought a lot of toxic mortgage debt. What are we going to do with it?

Senior Investment Banker: Don’t you worry. I have a plan.

Junior Investment Banker: Really…What is it?

Senior Investment Banker: Listen up. First we’ll take all these mortgages and turn them into security – something that we can sell to other investors. We’ll call this type of security a CDO – Collateralised Debt Obligation.

Junior Investment Banker: A What?!

Senior Investment Banker: It’s a fancy term for packaging these bad mortgages in such a way that will make it easier for us to sell on. We can use these bad loans as a guarantee (collateral) and tell our investors that as the mortgages are paid off so will they. They should receive money every month.

Junior Investment Banker: But who would want to buy this rubbish. It would be a really bad investment. No?

Senior Investment Banker: Yes, as it currently stands. But we both know that only a certain percentage of people will default. So we can segment these mortgages and sell each segment to different types of investors.

Junior Investment Banker: You mean it’s a bit like slicing a cake horizontally. The top portion is the ‘good investment’. The middle portion is the ‘ok’ investment. And the bottom slice is ‘rubbish’. The top slice will pay the least amount of interest with the bottom slice paying the most. So depending on what slice you buy determines how much risk there is which determines the return you get on your investment.

Senior Investment Banker: Exactly. But just to make it more complicated we’ll call each slice a ‘traunch’. Not only that. We know that some people will default on their mortgage. We’ll promise to pay the investors holding the “good” investment first, the “Ok” investment 2nd and so on.

Junior Investment Banker: I’m starting to understand this.

Senior Investment Banker: Wait! It gets better. We can buy insurance (credit default swap) for the ‘good’ investment. That way the credit rating agencies will rate these investments as ‘AAA’. We all know when something is rated as ‘AAA’ it’s regarded as a no-lose investment. They will probably also rate the ‘ok’ investment as ‘BBB’ which is still pretty darn good.

Junior Investment Banker: Gosh, you’re a genius. You have taken a pile of rubbish and turned it into a 1st rate AAA graded investment.

Senior Investment Banker: Yes, I know.

Junior Investment Banker: So who are we going to fool, erm I mean sell this too.

Senior Investment Banker: Well, we can sell them to other banks, hedge funds and countries like Iceland. At this point I would like to point out that there are a lot of things that I have not explained – space does not permit me. For example how credit default swaps work, how off-shore accounts in the Caymen Islands were used to hide bad debt and a raft of many other things that created this mess. Suffice to say that from the tongue-and-cheek fictitious conversation above you should have an idea of what when on.

Scenario 4: A few years later. An Icelandic investor who bought the CDO ‘good’ investment calls the investment bank. The conversation may go something like this…

Icelandic Investor: Hey, I’ve stopped receiving my monthly payments from that ‘good’ CDO AAA investment you sold us.

Senior Investment Banker (Wall St): Erm, yeah. I meant to call you about that. It seems that the people who backed that investment i.e. the mortgage payers have defaulted on their mortgages.

Icelandic Investor: Hold your horses! We bought the AAA CDO from you. You promised us that even if some people defaulted we’d still get paid first.

Senior Investment Banker (Wall St): Yeah. That was the theory. Unfortunately the loans were a lot worse than we thought. So there is very little cash coming in. That’s why you have stopped receiving your monthly returns. We are pretty disappointed too. We made a mistake.

Icelandic Investor: But you told me that house prices always go up and the people can always refinance the equity they have in their homes.

Senior Investment Banker (Wall St): That was a mistake too. Sorry about that.

Icelandic Investor: Sorry. Is that all you can say?! These CDO’s were AAA rated by the credit rating agencies weren’t they?

Senior Investment Banker (Wall St): Yep. They made a mistake as well.

Icelandic Investor: What about insurance? Weren’t they supposed to be insured?

Senior Investment Banker (Wall St): Are you crazy? There is no way that these insurers can pay-up. The only reason they insured the CDOs in the first place was to get the premium. And they thought nothing would go wrong. To them it was free money, I guess they messed up too.

Icelandic Investor: Well that’s just great. What am I supposed to tell my people? Due to your greed and dishonesty our country is on the verge of bankruptcy….

The above is just the tip of the iceberg. If you can imagine that this is happening with Trillions of dollars of debt in almost every 1st world country you’ll get to appreciate the size of the problem. It’s not just countries but other hedge funds, banks and insurance companies that are suffering too.

Of course with the lying, deception and cheating that these banks perpetrated liquidity in the markets dried up. None of the banks trusted each other and it became difficult to do business. Remember banks buy and sell money i.e. they borrow off each other. If nobody wants to lend to one another or it’s very expensive the credit (loans) will dry up.

As mentioned previously, space has not allowed me to go into much depth. But hope with by the grace of Allah (swt) it has allowed you to get a better understanding of the Capitalist Credit Crunch.

In a nutshell, what can we attribute all this too?

The simple answer is the absence of a divine law and order (Islam) which would manage and control wealth in real terms rather than let everything spiral out of control. Usury, lying, cheating, speculation and greed being the fruits of a failed manmade economic system are here for all to see.

Give full measure, and cause no loss (to others).And weigh with the true and straight balance.And defraud not people by reducing their things, nor do evil, making corruption and mischief in the land. [EMQ 26:181-183]


One Response to “A Dummies Guide to the Credit Crunch”

  1. khilafaharmy Says:

    I was looking for this.. thnx..

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: