Credit Crunch: The Effect on Consumers

Times are relatively uncertain in today’s financial and lending environment.  We have in our midst what can be called a “credit crunch”, circumstances during which lenders are weary to lend (and, to some extent, lack the resources necessary to do so) on a wide scale.  

The development of this environment has been building for the past few years, and new financial ideas have sprung up as a reaction.  The so-called “merry-go-round” loan is one such product.  It is important for consumers to understand this new transaction because novel financial activity of this scale affects all consumers.

These past several years, it has been easier than ever for prospective homeowners to obtain mortgages.  (Truthfully, it has been easier than ever for individuals to obtain loans, period.)

Because of a number of factors, including relaxed eligibility requirements for loan approval, and “cheap” mortgages, such as those that require no down payment, many new homeowners have been able to purchase homes that they would not have been able to in the past.

Predatory lenders especially deserve blame for this situation; such lenders purposefully offer loans to borrowers who should not be approved because they cannot afford the loan.  It might seem counterintuitive for a lender to seek business with someone who cannot afford to pay them, but the goal of these lenders is to make money through interest and late fees.  Predatory lending is against the law.


For all of these reasons and more, the result has been that many new homeowners have discovered that they purchased more home than was within their means.  People are finding it difficult to make their mortgage payments, which has led to an increased amount of foreclosures.  

Unfortunately, this problem likely will multiply in the near future.  Specifically with the many adjustable rate mortgages (ARMs) that are about to reset, the monthly payments of many homeowners may very well increase significantly.  This can become unmanageable for individuals who already are struggling with payments.  Mortgage foreclosures are just one indicator that that it currently is a slippery slope in the lending world.

Merry-Go-Rounds

When a borrower cannot afford his or her home and it is foreclosed upon, then the lender of the mortgage does not get repaid.  If the lender is not making money (or is losing money, as it may be), then the institution will be much more strict about who can obtain a loan.  It also will want to protect itself better against lending, such as by raising interest rates.  Thus the credit crunch comes into play.

It is not just individuals who fail to repay their loans, but also businesses too -- and business loans sure can be expensive.  What is a lender to do when large debts that they have lent cannot be repaid?  In many cases, they sell them to private equity firms.


A number of notable private equity firms, including Apollo Management LP, Bain Capital LLC, Blackstone Group LP, Carlyle Group, Kohlberg Kravis Roberts & Company, Thomas H. Lee Partners LP, and TPG (according to several industry sources), seek to purchase these debts.  Generally they are sold for a fraction of the cost, but for a lender to get repaid in part certainly is better than not getting anything, so most are open to such activity.

Now, here is where the whole situation becomes very ironic.  In most cases, these private equity firms do not have the available funds to pay for the debts that they purchase, so they borrow money from the same banks that are selling these debts!  What results is what The New York Times dubbed the “trading-in-a-vacuum phenomenon”.  Transactions are occurring back and forth across the lending realm, but little money actually exists.

What does this mean for me?

Generally speaking, this type of situation can lead to a recession.  Alternatively, some experts believe that this whole scenario really is a readjustment of sorts, and that the market naturally will return to “normal”.

For you, the consumer, this means that you should take the time to understand the unique lending market of today so that you are your assets can be prepared for the future.  If you currently are paying off an adjustable rate mortgage with a “reset” date approaching, then you need to plan for that more fully perhaps than was necessary in the past.  If you would like to purchase home, be prepared for stricter eligibility requirements, and save for the largest down payment that you can make.  High interest rates are likely.

As always, if you have any questions about your mortgage or about shopping for a mortgage in these relatively uncertain times, speak with a trusted professional.