If you haven’t heard enough about a “Credit Crunch” don’t worry we expect there to be a lot more talk about it soon, and unfortunately real outcomes that will impact you and your clients.
So, you might be wondering what is a “Credit Crunch”, how it happens, and most importantly, how will it impact you and your clients.
In this finance market update we cover all of this and also discuss an increasingly scary and relevant term for many borrowers “Negative Equity”.
What is a Credit Crunch
The term ‘crunch’ sounds overly serious, and there are indicators that show we are not in a serious liquidity event at the moment.
The aim here is to alert you to the current market conditions, how they develop and importantly what the potential outcomes are for you.
To begin, let’s define what a “Credit Crunch” is - “The sharp reduction of lending and credit available”
Which is caused by - “Banks and other lenders tightening/reducing their lending to avoid loss” (or for example in Australia, being very cautious with lending in the wake of the Royal Commission).
Which results in - “Borrowers (particularly businesses) not being able to access credit” and – further downward pressure on house prices, lower investment debt capital available for businesses.
A “Credit Crunch” is effectively ‘liquidity’ (cash and credit) leaving the market (by lenders reducing lending). This is what partly caused the ‘GFC’ in 2009 - a lack of liquidity in the market.
We see banks continuing to be ‘overly’ cautious in new lending as they do not want their arrears or ultimately losses to rise. New lending will become even more difficult if a crunch really hits.
Credit Crunch on Property
Less available credit drives down property prices. This is known as the Supply-Demand equation. It is the ‘Supply of Credit’ (how much lenders are prepared to and can lend) which determines property prices in the short term, not the supply of physical property.
Over a longer time horizon of 20-30 years physical housing supply and population growth definitely impact property prices. In the short (to medium) term it is the availability of credit.
The housing market, accurately depicted as willing and able buyers and sellers of property, often rely on ‘credit’ to complete a property transaction.
In most cases a buyer is not able to pay fully with cash and needs to borrow money (credit). If they and other potential buyers can borrow more, they will have the capacity they have to offer higher amounts to purchase the property – this drives up prices. As we have seen in Australia over the past 5-year boom, more credit results in higher prices.
This means that sellers can expect higher prices for their properties. More buyers have access to more money to offer, higher and higher offers are made in a competition to buy a property, so prices go up.
As lenders tighten their standards for issuing credit, credit is less available, so prospective buyers can’t borrow as much or offer as much – which means downward pressure on house prices. Sellers either sell for less or hold.
Therefore, we ultimately see that house prices are driven by the availability of credit.
Most would be buyers have access to less credit today than they did 12 months ago. Reasons are banks are taking a closer look at expenses, Royal Commission, and lowering debt to income levels.
Credit Crunch for Business Businesses, particularly small to medium sized businesses, can be the hardest affected in a liquidity crisis or credit crunch.
Almost every business relies on credit to operate. From credit cards, to lines of credit, car loans and equipment finance. Sometimes during a crunch it is challenging to maintain certain facilities as lenders, particularly banks, lower limits or call in debt. This means businesses could lose access to debt capital they have been relying on to operate and can cause a business to collapse.
Cash flow must be managed carefully, and the right mixed use of cash and credit should be planned. Skyward Financial can assist businesses to plan and manage their debt facilities and financial projections.
Credit is also a key funding source for the growth of a business, so when credit becomes less available it immediately impacts businesses trying to grow. Whether they need finance for a new vehicle, marketing, equipment or cash to pay suppliers, credit is often a source of capital for growth.
Research from EY’s annual Growth Barometer report shows 24% of Australian business which were surveyed mark ‘access to credit’ as the greatest external risk to growth. This is a realistic concern, as many businesses during a crunch will find it hard to access debt capital.
SMEs that have property they can use a security for a business loan are in a better position, but the debt on that property and the value of it (refer Negative Equity) will determine borrowing capacity against it.
Business that do not have property still have options. There are many specialist and non-bank lenders that will look at certain loans to businesses. For example, there are specialist business lenders that will lend based on a business’ cash performance over the past few months. This means that if a business has strong positive cashflow, but low assets, they can still access debt capital.
At Skyward Financial we are specialists in business finance, from commercial property to asset finance for all business equipment through to invoice financing for cash flow.
If you, or your business clients want to manage or improve your cash flow, we offer a free consultation to analyse your situation and options. We then find the right products, restructure your finances, implement the optimal solution and manage this whole process, which is free to our clients.
“Negative Equity” is when a borrower has a mortgage that is higher than the market value of the property that it is secured against.
This is going to become a pressing issue for many buyers who bought at the top of the property cycle, took out big mortgages and are facing falling property prices. Particularly at risk are investors who took out interest only loans.
For example. an investor bought an apartment off-the-plan for $955,000 and it is due to be completed in 3 months. They also need to pay stamp duty of ~4% / $38,465 + legal costs which we won’t factor in. The bank conducts a valuation of the apartment by comparing it to recent sales in the area of a similar property and conclude that it is worth $905,000. The investor still has to pay the full purchase price of $955,000 + tax $38,465 but now could likely only borrow ~90% of the valuation price, which is $814,500 (90% of $905k). This leaves the investor with a cash shortfall of a staggering $83,465!
(Calculation: $955,000 + $38,465 = total cash required of $993,465. Total cash available we assume 10% deposit of $95,500 + 90% mortgage of $814,500 = $910,000. A difference of $83,465)
It is not only investors who face this scenario. Many borrowers who are living in their family home could potentially end up with negative equity. However, the loss is only realised if the property is sold.
What can a borrower do if they find themselves in such a scenario? Usually options are limited, but they do exist. These include personal loans, or using a specialist lender that might give a higher LVR to free up more cash. Skyward Financial can source all of these types of loans and help clients in challenging situations.
Referring Clients to Skyward Financial
To submit a referral please use this link www.skywardfinancial.com/referral
All information in this update is general and not to be taken as advice.