Credit's getting harder to come by

One million people in the UK used credit cards to pay their rent or mortgage in the past year. And they'll be the first to feel the pinch as the credit contraction tightens.

The reason that most people do not understand the seriousness of this credit contraction is because they have no up close experience of a credit expansion and what it entails. Only by understanding the nature of the credit expansion can you properly understand how serious the subsequent contraction is for both the economy and investments generally.

Fortunately, the writer has up close personal experience of credit expansions in the past, the most recent of which ended in the early 1990s. Characteristics remain the same, except that this most recent one was the grand daddy of them all. We expect the contraction to be similarly spectacular.

In normal economic conditions the amount of business done by banks changes broadly in line with GDP growth. Banks can only grow their businesses by taking business from other banks, but it is no more than moving the deckchairs around. Broadly speaking credit applications with a bad credit record or insufficient collateral are refused. Only those with sufficient collateral and a good credit record are approved.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

What is unique about the latest credit expansion is that banks seemingly do the impossible; they all dramatically grow their business simultaneously. The way they achieve this is to lower their barrier to entry by relaxing their credit and collateral rules. By doing this, the number of potential purchasers of assets is enlarged, as some of those who previously could not buy a house, now can and the bank's business grows faster.

The immediate consequence of this relaxed credit action is increased economic activity, as houses are bought, furnished, decorated, and enlarged by people who were previously refused mortgages. No wonder asset prices rise and the economy grows faster.

By the end of year one of this increased banking activity, asset prices are higher. Collateral values have improved and so far the behaviour of the previously unsuitable borrowers has been OK; delinquencies are very low. The wrong read of that situation is to think that the previously refused borrowers were OK after all. It is more likely that their credit card debts, store card debts and bank overdrafts have increased by the unaffordable amount of their higher outgoings, although the mortgage itself has been paid on its due date.

After a year of successfully growing their businesses, the banks say: Well, that's OK, let's do it some more". In order for all of them to grow their businesses more; they have to further relax their lending standards. The consequence is further economic activity and higher asset prices.

This process continues ad nauseum until forces of circumstance dramatically trigger a credit crunch!

The key point to understand is that, as measured by pre-credit expansion rules, most new lending is sub-prime in spite of much of it appearing prime.

A prospective buyer of a house during a credit expansion would be aware of this own financial frailty and might, as a consequence, apply to a sub-prime lender. The lender makes it quite clear that although the cost will be higher, the loan will be successfully granted. The borrower can't afford the mortgage, but his expectation is that the property will grow in value more quickly than the debt will accrue, thereby giving him an opportunity to serially refinance to ease his burden. Not that the cost becomes any more bearable after refinancing, he just keeps buying more time. As long as property prices keep rising, he doesn't worry.

However, what is interesting is how the non sub-prime market works. Here, there are subtle differences in procedure. It is likely for somebody wanting credit to go to his bank for an interview, the result of which determines whether the loan is granted or not. The writer has, in the past, sat in on such meetings. The applicant may own property worth £200,000 and need a loan of £150,000, partly to repay existing debts with a surplus for other purposes; it may be to invest in his struggling business.

The potential borrower would be asked a series of questions, which he answers satisfactorily and then everybody would know that the next question to be asked could be the deal-breaker. The tension rises, but the bank manager doesn't ask the question, instead he approves the loan. After the meeting, the puzzled successful applicant says "Why wasn't the question asked?". The answer is that the bank manager wanted to make the loan.

Similarly, at times of credit expansion prime lenders choose not to verify information given, therefore, the aware applicant has the chance to misinform don't think the banks don't know this. So, in effect much of the prime lending is really sub-prime in disguise.

The latest news is particularly scary. In the US, loan defaults have spread to cars and credit cards and non sub-prime mortgages. Delinquency is spreading and it is becoming quite clear that credit cards are being utilised to meet mortgage payments. Similar news in the UK, where apparently one million households used credit cards to pay mortgages or rent in the past 12 months. That data came from the housing charity "Shelter". Those with credit cards, who are making minimum payments on their credit cards in order to afford their mortgages, are pretty much the same as those using a credit card to pay the mortgage.

Over the next months, those borrowers, of which there are huge numbers relying upon further credit to finance their current debt, will slowly run out of support and default. The fact that they haven't defaulted yet is irrelevant. What is relevant is that the credit contraction has now started and the purpose of it is to lend fewer people less money, especially those who need it most.

The stock market sees all this; two of the worst-performing sectors are banking and general retailers. There is very little likelihood of an escape, as the credit contraction tightens more, so economic activity will slow, putting more pressure on the over-borrowed, causing more of them to default, and causing economic activity to slow further. Business profits will decline, as supply swamps a decline in demand. The inevitable recession will follow.

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

For more from RHAM, visit