Is the Credit Crunch the Fault of America?

Just 8 months ago it was a term that hardly anybody had heard of, or used, now, we turn on the radio, TV or pick up any paper and there it is …. Right in our face… ‘Credit Crunch’. In fact it has become so common in its use, it is now difficult to understand just what it means to business and the individual. Of course, we understand that those with a dubious credit rating, who therefore represent a high risk for a funder, now have no chance of obtaining finance in today’s market, but what about those with no debt or well controlled and managed debt, a good credit history, a solid job or business with decent accounts? Just how will the ‘credit crunch’ affect them? The answer, surprisingly, is very hard.

Credit ratings for the individual are assessed on a points system from 0-1000

Although these ratings do differ this is a guide on the scores and what they mean. Under 400 v.poor: 400 to 600 poor: 600 to 700 average: 700 to 750 above average: 750 to 800 good: above 800 is First Rate.

Businesses also get a ‘roughing up’ by funders today. Even if your company has excellent accounts for the last 3 years but one of the directors has less than a v.good personal credit rating you are likely to get refused Prime funding. Today, not only has the company accounts got to show enough profits but the directors, all of them, have to be squeaky clean.

No matter where or who you deal with, if you want ANY form of funding, you will be “Credit Searched” as the very first hurdle. Any one who tells you differently is simply lying to you or giving you very bad advice. If you pass this first hurdle the chances are that the potential funder will ‘drill down’ through your personal finance files and then may request further information. This is a relatively new requirement by most funders, created due to the funders need to minimize losses from possible defaults.

In this article I am going to deal with the two major purchases that you are ever likely to make in your life, Property and Vehicles. We will see how the lenders attitude has changed and just how that will affect those of us who, historically, have never had a problem obtaining funding.

I don’t think I need to explain how funding for property works but many people don’t give any thought to how vehicle purchases are funded. Take vehicle leasing, it is the fastest growing method of owning a new vehicle. You see an advert for a vehicle you like with a monthly amount you know you can afford. In order for you to have your vehicle delivered, there is a complicated process that very few customers ever give any thought to.

A good broker will first run a Credit score search on you. This is so that he can offer the very best advice to you and put your proposal to the most likely funder for you. Assuming your credit search is ok; the broker locates and negotiates the lowest price for your chosen vehicle with a registered ‘main dealer’ to ensure you get the best deal. Next, the broker has to find a funder who is willing to purchase outright your chosen vehicle from the dealer, but before the funder will consider this he wants to know what sort of a risk the customer will be. The broker needs to be one jump ahead hear to protect your interests because if he doesn’t skilfully match YOU to a lenders criteria then you will be rejected and each rejection may affect the way the next funder views your application.

Poor brokers, and there are a lot of them, are like cheap salespeople. They will tell you what you want to hear, make promises they have no hope of keeping, just in order to reel you in and tie you down. They don’t care if you get rejected and that it may affect future applications. They will blindly submit applications for you without credit searching in the vague hope you might go through. In short, they won’t tell you the truth about your true position in today’s difficult market and gradually the truth dawns on you but by then the damage to your credibility may have been done.

A good broker will be Data Protection registered and able to perform a credit search, before he makes an application to a funder on your behalf. A basic credit search does not affect your record and assesses your chances of being accepted by a particular funder, because the broker is in a unique position and will know what their particular criteria currently are. The broker will determine if YOU fit their criteria maximizing the chances of acceptance first time. If you have anything in your credit record that the funder may challenge, the broker will ask you about this and if he submits to that funder then he will add a note of explanation which greatly increases your chances of acceptance. If they feel you will not match any of the ‘Prime Lenders’ criteria (and since the criteria have been significantly raised due to the credit crunch, more than 66% of applicants will not now meet that criteria) the broker should not try to make an application but should tell you the very thing you don’t want to hear! “I think we ought to make a sub prime application for you because of ‘xyz’.” Of course, many uneducated customers refuse this advice since the vehicle of their choice may cost an extra few quid per month with a sub prime lender and so insist on making the prime application, which inevitably, will be rejected. Remember the broker wants you accepted so he will give you the best advice he can to make this happen. A good broker knows his market. He only gets paid if he is able to get you what you want, so working against him is not in your best interest.

Typically, at this stage a customer may remember another advert for the same car that was cheaper than is now being proposed by the broker but if you ‘jump ship’ now the likelihood of you getting your vehicle (at any cost) diminishes with every credit application from a sub standard broker. By performing a credit search for you at the very outset, the broker is doing you a huge favor by preventing you making a funding application that he knows will fail and ultimately may affect your ability to secure your new vehicle. Those requiring funding in today’s tough market conditions have to realize that funders are no longer falling over themselves to do business with you. There are far more wanting their services and so little funding to go round.

Let me put you in the position of the funder for a moment:

You and a group of friends all have money to lend but it is very limited. Your friends are broadly split into two groups those that will lend only to very low risk applicants (prime lender) and those who will take a slightly larger risk at an additional 3% interest per annum. (sub prime lender – pretend you are one of these lenders) A central data base is kept, where all applications for funding and the outcome of those applications are recorded along with any payment record of similar such funding going back years. You can all access this data but you have no need to unless you receive an application.

An application is received by one of your ‘Prime’ colleagues from a broker to lease a car for an applicant; we’ll call him “JOE”. Under the data protection act you are not aware of this at this time because the application has not been made to you. The car Joe wants costs £10,000 to buy from the dealer. The lender needs to know what sort of risk Joe is so looks at his credit record. He finds that despite a basic good credit score and sound record there has been one or two late payments by a few days over the last 12 months on a store card and he decides that he doesn’t wish to lend to this client because he has other applicants which have an unblemished record, so he won’t entertain Joe.

The broker reports back to Joe and tells him funding was refused by the Prime lender and recommends an application to a sub prime lender. Joe refuses to take the advice because he doesn’t want to pay the extra monthly amount and insists on another application to another prime lender. This is made and again, is rejected for the same reasons. Joe has seen another advert from another broker and decides to switch brokers and starts again (of course he is not going to tell the second broker he’s been rejected twice already!) and Joe repeats the same mistakes again. Finally Joe agrees to pay the £25 extra to get his vehicle and to be put forward to a sub prime lender.

You, as that sub prime lender, receive the application from Joe’s broker along with another customer, Bill who is also making a similar application. You have enough money available this month to lend to only one of them. Which one? You look through both credit records both are similar, both have a couple of late payments, Bill has one missed mortgage payment 8 months ago but this has subsequently been ‘satisfied’ and a note accompanies the application and his recent credit history looks good. Joe’s application however, shows 4 very recent funding rejections. You don’t know if the rejections are from prime or sub prime lenders or what they are for, you just know that 4 of your colleagues don’t consider him a good risk despite his credit score being ok. Anyhow, perhaps there is something going on in Joe’s very recent history which is dubious. Why should you take the risk or spend time looking for reasons to justify lending to Joe when Bill already meets all your criteria?

Bill gets the funding and his car. If only Joe had taken the brokers advice or had not changed brokers, chasing a deal that he was never going to get in today’s tough market! It would have been him in that new car. 12 months ago lenders would have been falling over themselves to lend to Joe, now due to market changes and Joe’s stubborn streak, he is unlikely to get funding anywhere for his new car and the more times he tries, the worst it gets!

This is the reality of today’s market for those even with good credit.

MOVING THE GOAL POSTS: In the past, lenders would have lent a mortgage to those with a score in the range of the top end of “poor” credit rating and funding, for example, for car leasing, if they had a “good” credit rating. In today’s ‘Credit Crunch’ market those same people would have to have a “good” and “excellent” scores respectively to get exactly the same consideration. Many of those, who would have flown through finance 6 months ago for vehicle leasing, would now be rejected by the Prime funders. As a result, many people feel offended and insulted when they are told they have been rejected for ‘prime lending’ when they know that their credit rating is “good”. The problem is that GOOD is no longer acceptable to a lender specializing in the ‘Prime’ market. All is not lost however! There are still a few ‘sub prime’ lenders who will provide funding so you can get that vehicle for business or pleasure, providing your credit history is reasonably clear and you are prepared to pay a little extra each month in repayments AND…. Take good guidance from your broker.

As a result, out of every 5 that would have passed a finance check for Prime funding 12 months ago, only 2 of those will do so today. The remainder will need to go to the sub prime lenders and even they are only lending to those who would have passed as ‘prime’ 12 months ago. It is equivalent to an exam pass mark being 65% one day and then the pass mark is raised to 85% the next day! Your abilities haven’t changed but the bar has been raised all the same, many more will now be unable to reach that pass level.

To understand things better, here are some facts and then explanations of how the changes, in the money lending market place, will affect those of us with good, excellent and even first rate credit scores.

8 months ago 60% of those who applied for vehicle funding passed credit checks with a Prime lender. Today only 20% pass credit checks with those same prime lenders.

12 months ago there were more than 300 mortgage products in the UK available to a home buyer; today this has been cut to around 90. Deals are not such good value and the lender has little to no competition so they dictate who they lend to, using much tighter criteria and higher interest rates.

A typical mortgage 12 months ago would be for 95% of the property value. This is called “Loan to Value” or LTV for short. Today the LTV is typically reduced to just 75% or 80%. This means that even if property prices fall 4% (as they have over the last 9 months in most areas of England, but much more in Ireland, Scotland & Wales bringing the average price drop for the UK as a whole to 8%.) the lender faces next to no exposure to risk since the property would have to fall 20% or more before it became a worry.

Financiers earn profits only when they lend their money. Over the last 6 months mortgage lenders have lent 33% less funds than they did for the same period last year. Funding other than for mortgage purposes for things like vehicle leasing etc is down by whopping 66% Yet they are still all under pressure to maintain profits for their share-holders. How can they achieve this? A three pronged attack!

1) Excluding risk. They reject 60% + of those they would have previously given funding to and only pick those with the very cleanest records.

2) Reducing the amount loaned. Meaning that higher deposits or up front payments are needed. Since only those with the very highest credit can comply, this tactic goes hand in hand with tactic 1 and also helps cut the risk.

3) Make more profit from each funding case. Mortgage application fees have seen increases in the last 6 months of between 400% & 600% and we all know what has happened to interest rates. Prior to the credit crunch only those with less than “good” credit (sub prime borrowers) would have their loans loaded in this way, but now, even “Prime Borrowers” are treated this way and the reason is simply because the lenders are trying to maintain profits while only lending out a fraction of what they did 12 months ago.

Banking is global. The largest banks control the worlds’ finances. The banks are centred on 3 major countries, the UK, China and USA. When one makes an error of judgment in one country, everybody suffers.

There are 3 basic types of lending (or borrowing, depending on which side of the fence you happen to be)

1) Secured – This is where the loan is totally secured against a real, cash convertible asset, such as property. If you default, the lender recoups his money by seizing and selling your asset. A mortgage is a typical example, but you may take out a loan to buy a car for example or machinery to further you business and the lender may insist on securing that loan on property. Property (real estate) is king! Even in today’s market of so called ‘falling house prices’ Lenders prefer bricks and mortar or land, to any other asset. Why? Because despite recent months where overvalued property has dropped marginally in value, the ‘core’ value of property is solid and safe. History has shown us that the property market always increases and appreciates over the mid to long term (7yrs plus). It’s as “safe as houses”.

2) Unsecured / Indemnified – This is where the loan is made for a specific purpose, for goods which do not appreciate over time but depreciate in value with use. A vehicle for example. The item in question remains yours to use as your own but the ‘title’ belongs to the lender, just like your mortgaged home. If anything goes wrong they take back the goods, sell them for their used value and recoup some of their capital outlay. But what about the depreciation you ask? How does that get paid? This is included in your monthly repayments in one of two ways.

Let’s take a vehicle for example;

a) You may choose to buy it on some form of finance. You would be required to put down a deposit (often 20% or more) and the remainder would be paid to the car provider direct from the lender under an agreement you sign. Under the agreement the lender remains the ‘title holder’ of the vehicle until the last payment is made despite the vehicle being registered in your name. If you fail to meet your monthly commitments you lose your car and any ‘equity’ you may have in it in the form of any deposit you have put down to secure the initial deal.

b) By far the most cost effective (both tax efficient and for cash flow) is to Lease your vehicle. This requires an extremely small deposit (often equal to just 3 to 6 months normal payments) and a monthly payment by DD which covers the depreciation on the vehicle over whatever period you choose to keep it (usually 2yrs to 3 yrs) and a profit margin for the funder. Leasing is the fastest growing way of obtaining a new vehicle. The advantages include; better tax efficiency. Top vehicle discounts negotiated by your broker. No hassle or dealing with salespeople from car dealerships. Care free vehicle running which usually includes automatic road fund licensing by the funder so that the vehicle never runs out of tax and you don’t even have to do any paperwork to renew it. And, massive advantages to your cash flow by not using your own capital for large deposits now required by HP deals etc. Leaving your cash free to spend elsewhere. At the end of the lease period the vehicle is collected and you don’t have to try and sell it or worry about advertising it or the price you might get for it before you can get your next new vehicle replacement. It is ‘peace of mind’ motoring that individuals, small businesses and fleet users are turning to in increasing numbers.

3) Unsecured – Typically credit and store cards. This money is lent at ‘high risk’ as a default means that recovery of the loan may not be possible. Therefore you get charged very high fees. Credit card providers will lure you with 0% transfers and the like for a fixed period, knowing that in excess of 95% of those that join those schemes will be unable to pay off their debt in the ‘fixed offer period’, the loan reverts to high interest rates, usually around 16% to 25% p.a. the lender makes his profit – and then some! The interest rates are high because the ‘good’ payers have to pay for the defaulters!

SO HOW IS THE MONTHLY AMOUNT WORKED OUT FOR VEHICLE LEASING?

The monthly amount you will be asked to pay for your vehicle is broadly made up of four things.

1) The total depreciation of the vehicle for the mileage and period it is leased divided by the number of months. Different makes and models depreciate at different rates. So in simple terms if your car cost £10,000 and at the end of say a 36 month term is has completed 30,000 miles it will be worth £5,500 then you will experienced a £4,500 drop in value (depreciation) / 36 = £125 p.m. Therefore the ability for your broker to have good contacts with car main dealer groups is essential to being able to negotiate you the lowest price. If a cars retail price is £12,000 and he manages to negotiate a price of say £10,000 (based upon the level of business the broker places) then clearly he has wiped off £2000 of depreciation that you would otherwise have to pay for.

2) The broker’s payment for his work in brining the customer, the car dealer and the funder together, is built into the price. Usually around £5 to £15 per month

3) The profit the funder makes is in the form of interest or ‘return on investment’ (ROI). Prime Rates usually offer slightly better interest rates and therefore slightly lower monthly payments. They also usually require only 3 months deposit payment. A Sub Prime rate, will offer a slightly higher rate of interest to reflect the ‘added risk’ and usually up to 6 months deposit. As a guide, the difference between a ‘Prime Deal’ and a ‘Sub Prime’ may be between £5 & £25 p.m.

4) Up front deposit. This is usually equal to 3 months payments for Prime deals and up to 6 months for Sub Prime and includes your first monthly payment.

Therefore the formula is: depreciation (spread over the lease period) + Brokers Commission (paid by the funder) + Interest on the vehicle cost (spread over the lease period) which equals your regular monthly payment. + initial deposit and first monthly payment. All this is worked out by the broker and put into a proposal for both you and the funder.

WILL MY BUSINESS SURVIVE THE CREDIT CRUNCH?

That largely depends on how far ahead you can plan and take actions now, to bring about those plans, rather than reacting too late. What this latest round of ‘economic problems’ is bound to unleash is a long term ‘clearing out’ of businesses who have no vision, little planning or idea of where they are heading. In effect, it should clear out the weak, the clueless & the cowboys! This will, eventually be to the advantage of those who have planned, have taken action and who ultimately survive. Those that come out the other end will be stronger, better equipped and more profitable with far less competition. So what tips should you consider?

Work out realistically what business you can reasonably expect to win over the next 12 months, 24 months & 36 months respectively. What cash flow or Capital will you need to achieve this? Where is this cash or capital going to come from? What will finance cost and how can I factor that cost into my product/service? The banks and lenders already realize and accept that they will be doing up to 30% less business over the coming years so they have put in place plans to earn almost as much profit from the remaining 70% of the customers as they did 12 months ago with many more customers. Can you put in place a similar plan of action? Remember, unless your business is one which your customers cannot do without, an increase in prices must be accompanied by an increase in ‘customer value’ so think of ways of providing ‘added customer value’ to your service that will cost you nothing but a bit of organization and ingenuity.

If you need vehicles to operate your business you will need to be able to fix those costs and reduce capital outlay, the best way of doing that is to lease and reserve what capital you have. Get rid of old vehicles that cost a hidden fortune on maintenance, breakdowns, fuel efficiency, security etc. All these are ‘unknown costs’ and could put you out of business in a single stroke! I know a business that spent over £17,700 on unforeseen repairs and maintenance on three old vehicles in a single year, he replaced those with 3 new leased vehicles which cost him only £1100 per month for all 3 – with KNOWN costs. The fact is that you can budget and plan with known costs but unknown costs can be the killer.

Plan your tax affairs in advance with your accountant.

How can you cut overheads to maintain profits? Monitor the effectiveness of everything you spend on advertising and promotion, if it is not cost efficient, drop it. Attention to detail. Duncan Bannatyne (of Dragons Den fame) once ordered his staff not to order paper clips because they were unnecessary as they received more in than the sent out….. Attention to detail!

A crisis market is no time to get into a price war, instead, increase your perceived value to allow you to raise prices, not drop them, separate yourself for your competition or you may die the death of a thousands discounts before you even know you are dead!

To sum up:

If you have had no problem obtaining credit or passing finance in the past, then 3 out of 5 of you won’t now be able to get funding from a ‘prime lender’, have one stab at passing as a Prime application, then realistically get what you need via sub prime.

What does the future hold? It is now July 2008 and I foresee a slight ‘softening’ of the criteria of lenders by October 2008 onwards simply because they will be unable to maintain profits unless they lend their money and that means lowering their sights a bit! House prices will stabilize around this time. The government can still pull strings behind the scenes to build confidence back up between the banks moving money between each other again and that will help free up more money for the finance industry.

The situation though is set to be problematic with minimal economic growth until around late 2010. It is possible that we may officially hit a ‘recession’. (Officially 3 consecutive quarters of negative equity growth in the economy) Although, for many, it may feel that we are already in a recession, we can take heart that our financial and economic situation is only 30% as severe as that faced by the USA. Finance is going to continue to be hard to come by and more costly than we have been used to for decades.

We are not in recession, yet! In fact, the economy still retains a small annual growth rate despite the odd quarter being in negative growth. Despite the media’s best efforts to talk us into a recession, (apparently doom and gloom sells!) the economy remains fairly resilient with good ‘mid’ to ‘long’ term prospects. There is one proviso however, if access to finance (especially to developing businesses and individuals) dries up for those looking to ‘buy’ the two biggest purchases of their lives, their property and their vehicle/s or plant, then the economy could be forced into deeper trouble; For a healthy economy to exist, money must freely circulate.

But, we are a long way from that problem yet. Meanwhile, we are just going to have to get used to jumping through more hoops than ever before to get finance and paying more for it. Get used to it, it is the foreseeable future! Cheap finance has gone, if not for good then for a good while!

WHY IS THERE A CREDIT CRUNCH?

Over the last decade credit has been very easy to get. Employment was high, wages high, the economy was booming and everything looked rosy. Mortgage lenders and other funding methods were prepared to lend to just about anyone who had a pulse.

The Major Banks are global players and the basis for providing credit. If one bank committed to providing more funding than they had access to, they would simply cover it by borrowing from another major bank. Banks would lend freely to each other in the UK at a set percentage rate this is known as LIBOR (London Inter-Bank Offered Rate). Due to London’s importance as a global financial centre, LIBOR applies not only to the Pound Sterling, but also to major currencies such as the US Dollar, Swiss Franc, Japanese Yen and Canadian Dollar.

Reality began to hit home around 2006 when banks realized that more and more mortgages were being defaulted on and more and more repossessions were taking place. Nothing to worry about, these major loans were secured on the property; except, that the mortgages loaned in many cases, exceeded the market value of the property and the banks began to experience negative equity. Normally, banks who don’t have the money to make new loans, borrowed it from each other on short term lending using the LIBOR exchange. No one seemed too bothered. Everything tripped along.

We, and other countries will be affected by this knock-on effect but it is, in the main, essentially a USA financial problem because no one thought to regulate and lend sensibly there, we all have to suffer! Thanks President Bush! (that’s irony by the way George, if you are reading this!)