The Financial Crisis – 10 Years On

August 9th, 2007, is sometimes cited as the start of the financial crisis which has impacted on world economies for the last ten years. This was the day when BNP Paribas, a major French bank, stopped customers withdrawing money from three sub-prime mortgage investment funds, largely operating in the USA. This might not seem particularly significant, but what it suggested was that it was possible that money lent to a bank might not be repaid. Another key date for the UK was 14th September 2007 –  the date when Northern Rock suffered a “bank run” – the first in the UK for 150 years – and the news was full of pictures of people queueing outside Northern Rock branches to get their money out. For those in the USA, 15th September 2008 was significant since it was the date Lehman Brothers filed for bankruptcy protection, leading to the largest drop in the Dow Jones Index (similar to the UK FOOTSIE Index) since the September 11 attack in 2001.

Almost every bank in Europe and the USA relied on borrowing from other banks. The borrowing was via the inter-bank market (loans from one bank to another) and Northern Rock, like other banks, lent money to customers for long periods (e.g.  a 20 or 25 year mortgage) using both its customers’ deposits and money borrowed from other banks on a short-term basis in the money market. The BNP action made banks less willing to lend in the inter-bank market and as a result interest rates rose and the duration of loans fell despite central banks trying to inject liquidity into the market. As the inter-bank market froze, more financial institutions such as TSB, Bradford and Bingley, Lloyds, Alliance & Leicester and HBOS in the UK,  found themselves in difficulties and confidence among banks fell further.

However, although the BNP Paribus action was significant, there were other factors which created the circumstances which made its action so important. Firstly, there had been an excessive expansion of the money supply, particularly in the USA, in the years leading up to the financial crisis caused by excessive lending and borrowing. This excessive money supply growth caused an increase in asset prices, especially housing.

Secondly, in the late 1990s there was a vast quantity of savings looking for a reasonable return, a large part of which came from Asian countries running large balance of payments surpluses seeking somewhere to invest their surpluses. This excess of savings resulted in low rates of interest and encouraged banks and other financial institutions to look for areas with a high rate of return. One of the most attractive areas was to take advantage of the property boom and lend to mortgage borrowers, particularly those classified as “sub-prime”, who were less financially reliable and paid a higher rate of interest than lenders could obtain elsewhere. In the climate of the early 2000s, this was a safe investment since housing markets were booming and if the borrower were to default, the lender would re-possess the property and sell it at a profit.

A third factor was the way in which financial organisations making these sub-prime loans combined them into packages to create a new financial asset consisting of a bundle of these individual loans, called CDOs, or collateralised debt obligations, which could then be sold on to other financial institutions. Further bundling then took place as financial institutions bundled CDOs together and sold off slices to other financial institutions. In theory, the CDO was safer than the individual loan since, the argument went, if one made one loan and it failed, one had lost all one’s money. However, if one invested in a CDO, where you might have a slice of 100 loans bundled together, one individual loan failing was relatively insignificant.

Unfortunately, as it transpired, when the sub-prime market as a whole collapsed, due to rising interest rates and falling house prices in parts of the USA, the CDOs were equally risky and quickly depreciated in value. They also suddenly became illiquid meaning that their holders were unable to sell them to realise even a part of their value.

A fourth factor to consider was the separation of responsibility for the regulation of the UK banking system from the operation of monetary policy, both of which were previously the responsibility of the Bank of England. However, in 1999, the Chancellor, Gordon Brown, created a three-way structure involving the Bank of England, the Treasury and the Financial Services Authority. The FSA was responsible for maintaining confidence in the financial system, preserving financial stability, protecting consumers and reducing financial crime. Following the crisis, the FSA was replaced by the Financial Conduct Authority in 2013 which is responsible for regulating 56,000 financial services firms to protect consumers, protect financial markets and promote competition). The move from a single body regulating the financial system to a tripartite arrangement possibly hindered a speedy response to the crisis.

In retrospect, a final factor must be the failure of the US authorities to arrange a bail-out for Lehman Brothers. It is difficult to speculate on what would have happened had Lehman Brothers not been allowed to collapse, but one can reasonably assume that there would not have been the same collapse in confidence which affected financial markets world-wide.

It is worth reflecting on the effects of the crisis by looking at what has happened to the UK economy in the decade since the crash. Since the third quarter of 2007 UK GDP has grown by approximately 11%. This was one third of the growth in the previous decade. As a result, economists talk of a  ”lost decade”.   The situation is even worse if we focus on the growth in GDP per head where we are only 3% up on where we were ten years ago. Focussing on real average weekly earnings shows an even worse picture. Although average weekly earnings are up 19% over the decade, the CPI has risen by  26%, showing that workers are 7% worse off in real terms. There has also been a shift in the distribution of income with the elderly gaining at the expense of workers through the triple lock (the commitment to link the increase in the value of pensions to inflation, the rise in average earnings or a minimum of 2.5% whichever is higher). As a result, the median income of retired households has gone up 13% compared to a fall of 1.2% for non-retired households.

Interest rates have fallen from 5.75% before the crisis to 0.25% today (31st October 2017).  Therefore homeowners with mortgages have gained significantly. For example, mortgage payments on a £150,000 fixed rate mortgage would have been £1355 per month in 2007 compared to £871 today, and an additional benefit has been that average   house prices have risen by 10%, although there have been significant regional variations. This is a further benefit to the elderly although since many of them might be savers, they have lost out from the low interest rates.

The National Debt has soared as a result of the measures taken by the government to reduce the effects of the crisis. In August 2007, the national debt was £534bn; it is now approximately three times as large at £1.6tr. The value of sterling has fallen from £1 = $2.11 to $1.3 today (but the implications of this deserve a separate article) and, on the positive side, UK unemployment is at a 42 year low.

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