Economic implications
From an economic viewpoint, through falling business and consumer confidence, the credit crisis is likely to cause a protracted economic slowdown, and more than likely a recession in the global economy, and maybe even in the Australian economy.

As we have witnessed throughout the last 12 months, several global financial institutions have collapsed with significant debt that they have not been able to refinance, due to the underlying mortgages (via collapsing property values) that back their debt being worth nothing, or close to nothing.
The growing concern is that each time an institution falters, the other firms with which it does business internationally also suffer, and they then become less willing to lend or invest, and another source of credit dries up. Then the next troubled firm trying to bail itself out by borrowing money finds that no one will lend to it, and it collapses. And so it spreads.

The effects of this are devastating on an economy already reeling on the bankruptcy of old and very large multinational financial firms. It means a loss of jobs, resulting in less income and tax receipts, which leads to a decrease in consumer consumption, and which ultimately leads to suppliers decreasing production, ie. classic signs of an impending recession.

The even more troubling development is that this credit (or lack of) crisis is no longer confined to the financial sector. Effectively any firm, or even a government, that requires liquid funds to run their everyday operations, which they usually finance through borrowings,
is running into problems when they go to credit markets for finance. For instance, in the U.S., the state of California has a USD$7b funding shortfall, with the money needed to pay its day-to-day bills in coming weeks, including those to school districts and municipal (local) governments. The shortfall is partly due to a lower tax base, but is predominantly due to the fact that investors are not willing to provide credit to the state of California (which coincidentally, is about the fifth largest economy in the world).

Now, whether Australia will experience a full-blown recession or merely an economic slowdown is unclear, and the answer will not become clear until sometime in the future. However, what is clear is that the Australian economy is certainly experiencing some early signs of a significant slowing.

Over the last year or so, Australia has experienced and continues to experience the following recessionary indicators:

• flattening and declining house prices as interest rates were raised to fight the threat of inflation
• softening commodity prices, as the credit crisis is expected to dampen world demand and slow-down growth
• negative consumer sentiment, which will likely result in a slowdown in demand as consumers ‘tighten their belts’ and curb spending
• reduced consumer spending will lead to businesses cutting back on expansion activities, which will manifest in reduced capital expenditure and job losses
• this process has already commenced with several large financial and non-financial companies ‘restructuring’, merging or similar, with consequential job losses.

Whilst recessions are never pleasant, it is important to put all this into context. Australia’s previous recession ended in 1992 (the ‘recession we had to have’), which means that we are now into our 16th successive year of economic expansion. Given that in general terms, it is normal to expect a recession, on average, every eight years or so, in economic terms it is safe to say that we are well overdue. The unfortunate aspect of this pending recession (if it in fact develops) is, it’s less cyclical and more crisis driven in nature, and could be more drawn out and damaging than usual.

Financial implications
Unfortunately, the financial implications of the credit crisis will be far-reaching and will affect all of us in more ways than one.
Share markets, both globally and in Australia, have been in constant downward movement since the start of the crisis in August 2007.
Whilst it is generally the financial and listed property sectors that have suffered the most (retail banks, investment banks and listed property trusts), essentially any highly leveraged firm (ABC Learning, Centro, Allco, Octaviar - formerly MFS - etc.) has been devastated. There are varied reasons for this; the inability of companies carrying high levels of debt to refinance (particularly in light of the increased price of money, the opaqueness of a firms structure and a lack of clear disclosure, the savage short-selling by brokers when they sniffed out a troubled company, and a general loss of confidence in markets.

The hardest hit by the abysmal returns will be people who are highly geared. Anyone with a margin loan is likely to have already been faced with several margin calls, and either had to front up with excess cash, or was forced to sell. Those investors that did not have spare cash and were forced to sell would have driven down prices even further. This will cause further margin calls, further sales and so on. Not to mention a series of interest rate hikes (although the RBA’s 7 October 1 percent rate cut should provide some relief).

With the share market in sharp decline, unfortunately, so too are most investors’ super accounts. All superfund members would have received their end of year super statement by now and been faced with a negative return for the first time since 2003. Younger members that have time on their side can endure a 10 percent drop in their portfolio and focus on the long-term retirement savings plan that super is designed for. However,
for those at or nearing retirement (2.6 million Australians aged between 50 – 65), a 10 percent drop in their portfolio could see them having to reassess the timing of their retirement.

One of the other areas where investors are likely to feel pressure is on any of their borrowings, eg. home, investment, personal loans etc. This is because the price of money, at which banks (and non-bank lenders) borrow, to then on-lend, has suddenly got very expensive.

The big four Aussie banks rely on their deposits for around 50-60 percent of funds that they can then use to lend to borrowers, with the other 40-50 percent being borrowed from overseas sources. The bank then relies on the loan interest from its customers to fund interest payments to its overseas lender/s. Obviously, if a bank is borrowing money overseas to fund its lending business, those borrowed funds must be ‘cheap’ enough
to enable the bank to include its profit margin in the rate it lends to its borrowers. However, if the overseas money suddenly becomes very expensive, the bank is faced with a dilemma. Either it has to absorb the price increase, or it has to raise the interest rate it charges to borrowers. It is for this reason that Aussie banks have been forced to increase interest rates outside official increases by the RBA.

What does all this mean? Essentially, when the RBA reduced its cash rate by 1 percent on 7 October, banks could only reduce their lending rates by 0.8 percent due to the high cost of borrowing overseas – caused by; you guessed it; the lack of ‘cheap’ credit due to the unwillingness of other financial institutions to lend money. Unfortunately, this issue is likely to persist for future rate decreases, until such time that credit becomes freely (and at reasonable cost) available again.

What can you do?
So, the world and Australian economies are showing all the signs of entering a recessionary slowdown with all the usual negative outcomes,
and investors are already feeling the effect of the crisis on their share portfolios, their super funds and their mortgages. What can you
do to lessen the impact on you?

The first and most important thing that you absolutely must not do is panic. Do not rush into selling your share portfolio, changing
your super investment option to cash, or throwing in the towel if you cannot meet your mortgage repayments.

Selling your shares or switching your super to cash now is the single worst decision you could make and is akin to ‘throwing the baby out with the bathwater’. With world share markets already down between 30 – 50 percent below their previous peak, selling or switching now is only going to crystallise those losses. Worse still, it means that you will not be invested when the recovery comes and it will come – history shows us that.

Whilst it is true that past performance is not an indicator of future returns, past patterns should not be ignored.

By way of example, the tables in Figure 4 show the returns over nearly 30 years (1 January 1980 – 31 August 2008) for
the global and Australian markets.