Thursday, January 29, 2009

why there is a credit crunch

Money is too cheap.

Let's talk supply and demand. When i sell eggs, let's say they're normally priced at $2. Let's say i go to the market and mark them at $2.50. nobody is going to buy them because they're too expensive. I mean with a dozen eggs, people are price sensitive. If i go to the store, and the grocer says that i have to sell them at $1.50, then i'm not going to sell them because i can't turn a profit on them.

So now what? And what's this got to do with the credit crunch?

Well, the Federal Discount is what, .50%. Which is zero for real. A year ago it was 4%. This is the rate that the fed charges when it lends money to banks. The banks then lend money to everyone else, at prime rate, which was 6.5% a year ago and 4% now.

Now what bank in their right mind would want to lend money at 4%? There's no supply because the banks won't make ANY money at that rate. At 6.5%, those were profit margins they could work with, but 4%? That doesn't qualify anyone for a loan except those who have impeccable credit. Banks charge higher interest rates to people with bad credit, so if they have to write-down money on a loan, they write most of it off. But they make less money on lower interest rates, and can only write down less money.

So the Fed has made money so cheap, that it is unprofitable for banks to lend to people.

The other consequence of this is that the only credit available are the high-interest rates of credit cards. So now you borrow money at 15% instead of 6%. This further taxes the underpaid American worker and consumer. Apparently, the people with all the money consistently want to fleece us broke folk.

I was talking with an old friend on how I think there should be a limit on the percentage of debt a person can take on. Just like new mortgages, you have to have verified income, and when you borrow, you can only borrow enough to spend some proportion of your income (28% i think). I think this should be extended to consumer credit also. That means that no matter how much you earn, you can only borrow unsecured credit to the amount that you repay is no more than 20% (or some number) of your income. This creates a ceiling of debt. I think this will be good for the consumer. This is a pro-consumer measure, not a pro-business measure. A loophole for this is that someone can get a waiver if they borrow against some asset aside from their primary home.

The credit crunch will continue until the fed raises its discount rate to about 3%, then lending could be profitable for banks. When that happens, more businesses will get credit to go into business, selling us crap that we buy with credit cards. I think to prevent our country from disaster again, we need to put a ceiling on the amount of credit a person can hold, indexed to their income. We can also factor in the value of their assets if they need more credit. In effect, they could get a line of credit based on the value of some asset besides their primary home. Oh yeah, did i say that we should abolish home equity lines of credit? Yeah, we should.
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