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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The end of the era of low interest rates?

On Thursday 2nd November, the Bank of England increased interest rates. Although the increase was not large (from 0.25% to 0.5%), possibly it marks the end of an era. It was the first increase since 2007 and follows the cut in rates in 2009 from 4.5% to 0.5% after the collapse of Lehman Brothers. The rate was further cut in 2016 to 0.5% following the Brexit vote.

Traditionally the rate rise should benefit savers and make it more expensive for borrowers, particularly those with mortgages. However the UK economy has changed in the ten years since rates were last increased. Banks have been far slower to reward savers  than to punish borrowers when rates rise so savers should not get too excited by the rise in interest rates. More importantly, the number of homeowners with variable rate mortgages has fallen significantly, with The Times estimating that only 10% of households will be affected by the rate rise. This is partly because of the shift to fixed rate mortgages, which now account for 60% of mortgages, the increase in renting and the repayment of mortgages among older households.

Secondly, although in percentage terms the rise is large, in absolute terms it is relatively small and, for a family with a £250,000 variable rate mortgage, they will currently be paying approximately £1,125 per month and their payments will rise about 2.25% or £25 per month. This will reduce discretionary income and consequently consumption is likely to be slightly reduced. There are however two more significant effects. Those borrowing via  credit cards or taking out loans for large purchases such as cars or furniture, will see borrowing costs rise and this could deter future consumption. Another issue is that people currently with very high borrowing, particularly those on low incomes, might find it increasingly difficult to repay the interest on their existing borrowing, with an impact on bankruptcies. Most important is likely to be the psychological impact of the rate increase since a signal has been sent out that the era of ultra-low interest rates is coming to an end.

The rate increase is not unexpected, having been forecast in the press for some time. The recent rise in inflation to 3% made it more likely. However it is worth assessing the decision  in more detail. Normally interest rates increase as inflation rises in order to reduce inflationary pressures in the economy and keep inflation within the 1% – 3% band set for the Bank of England by the Government. According to the traditional Phillips Curve idea, rises in inflation are likely to occur simultaneously with falls in unemployment as increases in aggregate demand in an economy work simultaneously to increase prices and reduce unemployment as firms attempt to hire more workers to increase output, thereby putting an upward pressure on wages which then feeds into higher inflation. One could therefore easily argue that, at many times, an increase in interest rates is a sign of a strong economy experiencing rapid growth.

The current situation is slightly different. The increase in UK inflation can be partly explained by the fall in the value of sterling following the Brexit vote and this will drop out of the CPI index over the next few months. Secondly, although unemployment is at a record low at 4.3%, there has not been the rise in earnings which, in the past, we would have expected to accompany the strength of the labour market, thirdly there has been a slow-down in the UK’s rate of growth and finally there is still considerable uncertainty in the economy about the outcome of the Brexit negotiations which is affecting confidence among businesses. So why the rise in rates?

One explanation for the rise in interest rates comes from Ed Conway, the Economics Editor of Sky News who suggests that the UK’s ability to grow without inflation has fallen in recent years because of our poor productivity growth. Whereas in the past we might have been able to sustain growth of 2 – 2.5% without inflation, he thinks the maximum figure for non-inflationary growth might now be 1.5%. Therefore, without compensating action, inflation is likely to increase.

 

What’s going on in the UK economy?

Trying to understand what is going on in an economy can be difficult. Running the economy has been described as similar to trying to drive a car while only being able to look in the rear-view mirror. You know where you have been but cannot see what is ahead. Economic forecasters today probably look back to the period before the financial crash when the UK was in the NICE decade (non-inflationary, continuous expansion) as a golden period. Today life is more complex and one cannot help but feel sorry for the Chancellor busy preparing his November budget and the Monetary Policy Committee of the Bank of England when they meet in November and have to decide whether to increase interest rates.

On the one hand, implying  a rate rise is not yet needed, the Office for National Statistics has just announced that GDP growth has fallen from 1.8% for the first quarter of 2017 to 1.5% for the period April to June which is below expectations and the weakest figure for four years. This is partly down to a fall in services of 0.2% which comprise 80% of GDP inflation. Furthermore discretionary income (what you have left to spend after tax and spending on essential items such as food, energy and transport, has fallen and 60% of households are worse off than they were a year ago as a result of wages rising at 2.1% while inflation is currently 2.9%. Another piece of evidence is that a survey published over the weekend by the Nationwide  reported that house prices dropped in London by 0.6% between July and September compared with the same period last year. This is the first such fall for eight years. 

However the high rate of inflation combined with the fall in unemployment  to 4.3% would suggest it is now time  to reduce the level of aggregate demand by raising interest rates.

Just to make the whole picture more confusing , there is the danger of depressing demand at a time when the economy is fragile because of uncertainty regarding Brexit and one does not want to do anything to discourage business investment which is supposed to be weak because of low confidence. Yet business investment actually rose by 0.5% in the second quarter of 2017! Furthermore, although the current account deficit rose to £23.2bn in the second quarter from £22.3bn in the first quarter, exports of goods and services actually rose by 1.7% while imports increased by 0.4%. Finally, just when you might think you have taken account of all the main variables – what about oil prices which have a significant impact on inflation and discretionary income. OPEC’s decision to curb production is intended to keep prices high and, although this looked to be failing earlier in the year, the combination of hurricanes damaging US oil refineries and the OPEC production curbs have started to have an effect on fuel prices.

 

Carney rips his shirt off – BBC News

The Monetary Policy Committee has thrown the kitchen sink at the stuttering UK economy. But the governor knows he’s not Superman.

Source: Carney rips his shirt off – BBC News

The cut in the bank rate, the first in 7 seven years and at the lowest rate in history, demonstrates that the Bank of England is not particularly confident about UK economic prospects. With falling confidence indicators, such as the Purchasing Managers’ Index (PMI), as a result of the uncertainty caused by Brexit, the Bank has acted quickly to loosen monetary policy to encourage spending by both households and firms. Lower rates reduce the incentive to save and encourage borrowing as the reward for the former falls and the cost of the latter decreases. However, will a 0.25% cut make a real difference? Rates were already at a historic low – will we see negative rates, used by Japan, ECB, Sweden, for this first time in B of E history? Either way, growth forecasts have been slashed, as predicted by most economists prior to the Brexit vote. In the short-term, at least Brexit appears to be making the country worse off than it would have been otherwise. Long-term, well time will tell.