The Causes of the Financial Crisis

INTRODUCTION: In a recent editorial (September 8th), the Economist suggested that  the financial crisis of September 2008 will be regarded as one of the defining  events of the early 21st century, alongside 9/11.Hence the importance of knowing  what caused it ten years ago and preventing another similar crisis

For most people, the story  started in August, 2007, when BNP Paribas, a major French bank, stopped customers withdrawing money from three sub-prime, largely US-based mortgage investment funds. (Sub-prime mortgages are those to less financially secure borrowers). By doing this, BNP Paribus was implying that money invested in these funds might not be repaid. Banks rely on borrowing from other banks via the inter-bank market. The BNP action cast doubt on the stability of the banking system and made banks less willing to lend in this market, causing increased interest rates and a lack of liquidity, despite central banks trying to offset this. As the inter-bank market froze, more financial institutions such as TSB, Bradford and Bingley, Lloyds, Alliance & Leicester and HBOS, found themselves in difficulties and confidence among banks fell further. A month later the reality of the crisis reached British high streets when Northern Rock suffered a “bank run” –  the first in the UK for 141 years – after doubts were cast on the BBC over its solvency. It had invested heavily in the sub-prime market and the value of its assets fell as house prices fell in the USA. Then, ten years ago on 15th September, 2008, Lehman Brothers, the fourth largest investment bank in the US collapsed and the world entered the worst financial crisis for decades.

THE CAUSES:

FUNDS SEEKING A HIGH RETURN – An early cause  can be traced back to  the late 1990s when vast quantities of money from Asian countries with large balance of payments surpluses were invested in the USA and Europe, seeking high returns. This increased the supply of money, reduced interest rates and  discouraged saving. It also encouraged banks and other financial institutions to look for areas with a high rate of return, particularly in the booming housing market and to lend to mortgage borrowers. This caused large increases in house and share prices and helped create the asset price bubble which preceded the crisis.

THE RISE OF NEW FINANCIAL PRODUCTS – As the quantity of loans increased, there was a huge expansion of new financial products particularly CDOs (collaterised debt obligations), which were intended to spread risk but ultimately made it worse. They work as follows: imagine a bank makes five loans of $200,000 each to housebuyers at 5%, guaranteed by the value of the houses. It finances this by bundling them together into a bond (called a CDO) and selling it for $1m (5 x $200,000), paying 3%, thus making a profit, and uses the money to lend again. This process is securitisation – transforming a stream of cash payments into an asset.  To understand the concept, think of a butcher taking different types of meat (mortgages), mincing them all together and making sausages (CDOs) from the mixture. In theory, the CDO was safer than individual loans since, if a bank made one loan and it failed, it lost all the money but, with a CDO, where it had a slice of many loans bundled together, one individual loan failing was relatively insignificant. The CDOs were involved in long chains – banks might buy CDOs, then re-bundle them into new CDOs and sell them to other financial institutions who sold them again with borrowed money (sometimes from the original institution) financing many of these transactions, like the butcher then taking the sausages and mixing them together to make different sausages from the mixture.

SUB-PRIME MORTGAGES – A significant component  of the CDOs were sub-prime mortgages  which had increased during the early 2000s since they provided a higher return. Although offered to low-income households, they were regarded as a safe investment since housing markets were booming and if the borrower defaulted, the lender would re-possess the property and sell it at a profit. There was a failure of ratings agencies to properly assess the risk of these new financial products in the USA, which were highly-rated, because they focussed on the credit risk (the risks arising from non-payment) rather than the liquidity risk (the risk of not being able to sell the CDO).  This was combined with a lack of awareness by government regulators of the possibility of a financial crisis since they focussed on CDOs spreading risks and did not anticipate the possible risk of a housing collapse.

When the US sub-prime market collapsed, due to rising interest rates, deemed necessary to reduce inflation, and falling house prices, the CDOs, despite their high rating, were seen to be risky and quickly depreciated in value. They  became illiquid since no one wanted to buy them, so their holders were unable to sell them to realise even part of their value. Simultaneously banks became reluctant to lend to other banks holding CDOs in their assets and first Northern Rock and then other banks failed. However because the original mortgages had been converted into CDOs and often re-bundled into other CDOs, it was not easy to tell which assets were safe and which were not, and therefore all such products were assumed to be risky, the institutions which held them were avoided by lenders and liquidity in the financial system evaporated. Because these products were bought and sold  by financial institutions in USA, Europe and Asia, the crisis spread quickly between the continents.

LOW BANK RATIOS – Banks need a balance between the loans which they make and their share capital and liquid reserves which can be used in case any of their loans fail. In the approach to the crisis, their leverage ratios (loans:capital) increased greatly, meaning that they were supporting their loans on a much smaller base. Lehmann Brothers, for example, had a ratio of 35:1. When the housing market fell, the banks wished to build up their capital by selling the properties on which the loans were based. However the increased supply of housing onto the market further reduced house prices and the value of the sub-prime mortgages, making the crisis worse. It should be noted that it was much easier for a US mortgage borrower to abandon their property without a financial penalty than in the UK. What many sub-prime borrowers did when they could not afford the higher interest rates and house prices fell below the value of their mortgage  was to drop the keys back to their lender and move into rented accommodation. It was then up to the bank to try to sell the house and get their capital back.

POOR REGULATION – Another contributory factor was the level of regulation of the financial sector. Authorities such as the IMF focussed on how securitisation reduced risk and global bank  reforms aimed to make it easier for banks to lend. in the UK there was also a change in the financial regulatory framework. Previously the Bank of England had been responsible  for the regulation of the banking system and the operation of monetary policy. Following the election of the Labour Government in 1997, Gordon Brown, created a three-way structure involving the Bank of England, the Treasury and Financial Services Authority. The FSA was responsible for maintaining confidence in the financial system, preserving financial stability, protecting consumers and reducing financial crime. The move from a single body regulating the financial system to a tripartite arrangement possibly hindered a speedy response to the crisis.Subsequently, in 2013, the FSA was replaced by the Financial Conduct Authority which is responsible for regulating 56,000 financial services firms to protect consumers, protect financial markets and promote competition).

THE SOCIAL CLIMATE – There has been much media attention in the last ten years blaming the crisis on the greed of bankers, earning enormous salaries and bonuses from their activities. . The FT, in a series of articles on the crisis talks of “Massively leveraged investment banks engaged in socially useless trading of huge volumes of complex credit securities.” However it is not only bankers who were keen to make money. Housebuyers borrowed more than, in retrospect, was sensible and even everyday savers  used their savings to dabble in financial products they did not understand in a bid to obtain a higher return.

Then, on 15th Sept 2008 Lehman Brothers filed for bankruptcy protection. It was not the first chapter in the financial crisis but its size and the probability that it would be allowed to fail, can be regarded as the moment when the crisis became apparent. Within two weeks of Lehman’s collapse the global interbank money market had frozen, creating fear of economic collapse in the USA, Europe and Asia and the Dow Jones Index experienced its largest drop since the September 11 attack in 2001.

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