Royle-Davies KS (Eton College)
Causes of the Crunch and Policy Responses
United States - GDP and Interest Rates
Percent
Percentage rate of growth year on year at constant prices
5.0
5.0
4.0
4.0
3.0
Economic Growth
3.0
2.0
2.0
1.0
1.0
0.0
7
Percent
6
0.0
7
US Base Rates
6
5
5
4
4
3
3
2
2
1
1
0
0
98
99
00
01
02
03
04
05
06
07
08
Source: OECD
During the boom years of 2003 to 2006, and the first half of 2007, credit all over the world
was at its cheapest point in history. In 2003, the US policy base rate was 1%, and even after a
series of rises over the next 3 years, peaked at 5.25%. Similarly, UK interest rates were
between 4% and 5% during this period. This cheap credit boom spurred a rise in both UK and
US house prices fuelled by sub-prime lending. This involved mortgage lending to NINJAs,
i.e. lending to those with No Income, No Job or Assets. They were unlikely to be able to
repay the loan made to them, and would have been rejected by traditional bank managers, but
as house prices were rising, this did not worry those making the loans. On default, the bank in
question took possession of the house, which had risen in value, and they sold it on at a profit.
This strategy was immensely profitable for banks, yet it relied on rising house prices and it
came to an end in 2007, when the US housing market began to decline. When sub-prime
mortgages were defaulted, the banks now took on a debt instead of a profit. This could have
been an almost uniquely US crisis, except for the fact that US banks had not kept all these
mortgages on their balance sheets.
Securitisation
The mortgage securitisation business took mortgage loans, and packaged them up as
structured investment vehicles (SIV). These were then split both geographically and in terms
of quality, so sub-prime loans from California could have been in the same tranche as a more
traditional loan from Illinois. These SIVs took on many names, including Collateral Debt
Obligations (CDO), and Mortgage Backed Securities (MBS).
They were often given AAA ratings by credit agencies, as the historical models used to
predict the probability of all the mortgages defaulting showed that this was extremely
unlikely. This meant that sub-prime mortgages were thought to have the same likelihood of
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Royle-Davies KS (Eton College)
default as the US government! These SIVs were then sold globally, for millions of dollars, as
safe investments which yielded multiples of US Treasury bills. This meant that investors from
Switzerland, say UBS, could have had exposure to the US mortgages market, lending to
debtors they had never met, who had little chance of paying. This put the global financial
system dependent on the US housing market.
Beware – unexploded toxic debt
When the price of US houses began to fall, it was not immediately clear to those who held
MBSs that the value of their asset had fallen, as the market was illiquid and opaque. It was
not until sub-prime defaults became more frequent that their value was written down. When
investors came to sell them, realising that the sub-prime market had collapsed, no one wanted
to buy them, as they could see the impending fall in the US housing market, so their value
was suddenly drastically lower, which surprised even large investment banks, such as
Citigroup, who have so far written down more than $60 billion in MBSs.
Property price falls
United States, Consumer Confidence and House Prices
Index
Conference Board, Consumer confidence, Seasonally adjusted index
230
220
210
200
190
180
170
160
150
140
130
230
220
210
200
190
180
170
160
150
140
130
House Prices, OFHEO, USA (Purchase-Only), Seasonally adjusted
150
150
Conference Board, Consumer confidence, SA, Index, 1985=100
Index
140
140
130
130
120
120
110
110
100
100
90
90
80
80
70
70
60
60
50
50
00
01
02
03
04
05
06
07
08
House Prices, OFHEO, USA (Purchase-Only), Seasonally adjusted
Conference Board, Consumer confidence, SA, Index, 1985=100
Source: Reuters EcoWin
The fall in US house prices meant that banks became unwilling to lend to NINJAs again, and
credit became more difficult to obtain throughout the financial system, even in the wholesale
markets, as banks were unsure about who had the ability to pay back loans. The first
noticeable casualty of this credit freeze was Northern Rock, which in September 2007 was
nationalised by the UK government. This was because its business model relied upon
borrowing money in the wholesale markets, and lending it on to consumers at a greater rate of
interest. This strategy unwound when their stream of cheap credit dried up, and they were
forced to ask the Bank of England for emergency funding, which caused a run on Northern
Rock, from which it never recovered.
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Royle-Davies KS (Eton College)
Trying to Stem the Credit Crunch
Percent
Percentage, since May 1997 base rates have been set by the Bank of England
7.0
7.0
6.5
6.5
6.0
6.0
5.5
5.5
5.0
London Interbank 3-Month Interest Rate
5.0
4.5
4.5
4.0
4.0
Bank of England Base Rate
3.5
Jan
3.5
May
Sep
04
Jan
May
Sep
Jan
05
May
Sep
06
Jan
May
Sep
07
Jan
May
Sep
08
Source: Bank of England
The credit crunch started when banks became reluctant to lend to anyone, even each other.
This meant that readily available cheap credit was suddenly a thing of the past. The UK 3month LIBOR, (London Inter-Bank Offered Rate), which is a measure of the cost of debt,
rose from 10 to over 140 basis points above the Bank of England base rate in the aftermath of
the Northern Rock debacle, and has still not returned to June 2007 levels. Once banks stopped
lending to each other a global credit freeze occurred, whereby lending simply did not take
place on any level, which affected anyone who needed to borrow money to stay in business.
The UK housing market has fallen a record 11% this year, as consumers struggle to gain
mortgage approval, and potential buyers wait for the market to bottom out. Those who did
buy at the peak of the housing bubble are likely to face negative equity problems as the value
of their house is eroded.
Negative multiplier effect takes hold
This is exacerbated into the wider economy via the multiplier effect, as industries dependent
on house sales, such as estate agents, home decorators, and DIY chains lose business. Last
week the average estate agent was selling just one house per week. There will also be a
negative wealth effect for house owners. While the finger of blame for the UK housing bubble
could be levelled at speculative demand, the solution to the problem is far from clear.
Traditionally the Bank of England would step in by lowering interest rates, which would
reduce the cost of buying a house, to stimulate demand in the housing market.
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Royle-Davies KS (Eton College)
Stagflation-lite?
UK Inflation and Crude Oil Prices
USD/Barrel
Annual percentage change in the Consumer Price Index and monthly average for Brent Crude
140
140
120
120
100
100
80
60
60
40
40
20
20
0
0
5.0
5.0
4.5
4.5
4.0
3.5
Percent
80
Crude Oil Price
4.0
Consumer Price Inflation
3.5
3.0
3.0
2.5
2.5
2.0
2.0
1.5
1.5
1.0
1.0
0.5
0.5
00
01
02
03
04
05
06
07
08
Source: UK Statistics Commission and IPE
Yet this solution has been neutered due to the inflationary pressures affecting the UK
economy. The price of a barrel of crude hit an all-time high of $149 hit during June this year,
and increased demand for metals from China pushed the price of iron ore, aluminium, copper,
and nickel higher. This has resulted in record inflation in the UK. The CPI rose to 4.4% a year
in July, a change of 0.6% since June, the highest monthly rise since 1997, and over double the
Bank of England target of 2.0%. This was due to large increases in the prices of food and fuel
which have been most keenly felt by consumers in UK, with families especially hard hit
during the summer holidays. Rising inflation means that the monetarist Bank of England
cannot lower interest rates in order to stimulate the housing market, as this will only inflate
prices further. Evidence of their hand-tied situation is clear in the fact that they have not
lowered interest rates from 5% since 10th April 2008.
Thus the credit crunch is due to the fact that no one in the financial system wants to lend
money, whether it is because they do not have the money to lend, or they are unsure about
who is holding ‘bad debts’, i.e. CDOs. This has led to the downfall of several high profile
Wall Street firms, including Bear Stearns, who was sold to JP Morgan Chase, and Lehman
Brothers, who filed for bankruptcy protection earlier this month. Even AIG, one of the
world’s largest insurers, had to ask the Federal Reserve for funds when it had a liquidity
crisis. Illiquidity has proven to be Achilles heel of firms who rely on leverage, such as hedge
funds, and those who rely on loan-fuelled expansion, such as private equity firms. The
traditional method of lowering interest rates to revive growth has been negated by high
inflation, which has left governments with only exceptional measures to tackle the credit
freeze.
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Royle-Davies KS (Eton College)
UK Net lending to individuals, secured on dwellings
11
10
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
billions
GBP (billions)
£ billion per month, seasonally adjusted
11
0
00
01
02
03
04
05
06
07
08
Source: Reuters EcoWin
Which of the remedies for the credit crunch proposed so far
will be the most successful?
The western world, especially the US and the UK, has become extremely reliant on its
banking system to keep economic stability. The banks’ ability to do this comes from their
large deposit bases, which keeps them well capitalised, and the infrequency of ‘runs’ on
banks. If all a bank’s customers ask for their money at the same time, as happened with
Northern Rock, the bank will not be able to produce it, no matter how well capitalised it is.
The problem that governments have is that letting retail banks fail spells disaster for the
economy, as if consumers lose their savings, they will cut back on spending, which multiplied
by millions of customers at an average bank, would mean a large fall in retail spending.
Although there are safeguard systems in place whereby governments guarantee the first
£50,000 (UK from 7th October), and $100,000 (US), it is not certain that governments could
come up with this money if their entire banking sector was to fail.
The UK government has used nationalisation in order to stop retail banks failing. This became
known as the ‘too big to fail’ policy, as they knew that letting retail banks fail would have
caused catastrophe for their economies. When the UK government nationalised Northern
Rock, they bought all their assets, and now the UK taxpayer is liable for any losses that
Northern Rock incurs, which could total billions of pounds.
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Royle-Davies KS (Eton College)
Northern Rock Ordinary Share Price
GBP
Daily closing price, £s per share
13
13
12
12
11
11
10
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
0
97
98
99
00
01
02
03
04
05
06
07
08
Source: Reuters EcoWin
While it is clear that letting Northern Rock fail could have resulted in something much worse,
the decision to nationalise is an expensive one, yet it appears to have become the default
option for the UK government, who used the same strategy to nationalise Bradford &
Bingley. Seeing as nationalised banks are not allowed to be competitive, according to EU
competition regulation, this means that the UK taxpayer is underwriting banks which cannot
hope to resume profitable lending. The US government nationalise Fannie Mae and Freddie
Mac, the two largest mortgage lenders in the USA, by buying up their entire $5 trillion
mortgage book. This meant that the US taxpayer had underwritten all mortgage lending, but it
did restore confidence in the mortgage market, which had been in short supply as they were
failing.
Another option used widely on both sides of the Atlantic is the sale of a failing firm to a more
stable one. This was the case with the sale of Bear Stearns to JP Morgan Chase, HBOS to
Lloyds TSB, Merrill Lynch to the Bank of America, and Wachovia to Citigroup or Wells
Fargo, depending on their imminent legal battle. Takeovers have the advantage that the
taxpayer does not have to bear any excessive risk, though the government may have to
provide exceptional liquidity to ensure that the deal is done. Keeping the banks in private
hands is also appealing to those who think the government should keep interference in the
markets to a minimum. The downside of this policy is that mergers can create firms with
significant monopoly power in the market. For example, the Lloyds-HBOS merger will give
the resultant firm a 33% share of the UK mortgage market, and the competition rules were
purposely ignored in order that HBOS did not fail. If the merger had been proposed two years
earlier, it would not have been approved on anti-competitive grounds.
The third option for governments is to selectively pick which firms it lets fail, based on a
decision of how important each individual firm is to the economy. For example, the US
government let Lehman Brothers, one of the oldest firms on Wall Street, fail earlier this
month. This was despite the precedent it had set with Bear Stearns for helping to find a
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Royle-Davies KS (Eton College)
merger solution. One of the most important factors in letting Lehman Brothers fail was its
status as an investment bank. It was not primarily a retail bank, with depositor customers,
which meant that Lehman going bankrupt did not lead to millions of Americans with no
savings. However, the US government did introduce significant moral hazard in cherry
picking which firms can fail. It became a case not of ‘too big to fail’, but of ‘too retail to fail’.
This means that only retail banks are likely to be bailed out from now on, which could explain
why Goldman Sachs and Morgan Stanley gave up their business model as investment banks
to become retail ones.
Bail out
The US government took the bold step of deciding to create a single ‘bad bank’, which would
use $700 billion to buy bad debts from banks, in order that they could rebuild their balance
sheets. Though this was at first rejected by the US House of Representatives, it was revoted
and passed on Friday, albeit with moderating measures, including caps on executive bailout
severance pay, and help for smaller companies. This solution could end the vicious cycle of
falling prices for MBSs, which weakens banks, and forced sales of assets, which drives their
prices down further. However, ownership of MBSs is not a fundamental problem for UK
banks, rather the illiquidity in the wholesale credit markets. It is also difficult to value MBSs,
due to their opaque nature. The cost of the US scheme may also deter European governments
from implementing such a scheme.
The most likely solution to the credit crisis will be special liquidity schemes by central banks.
These involve banks swapping MBSs for Treasury Bills or Gilts, and does not involve
taxpayer risk. Banks do not have to sell assets at lower prices, however, this scheme is not
suitable for undercapitalised banks who thus cannot lend. This scheme can be combined with
nationalisation, as was the case with the US government’s $85 billion loan to AIG, which saw
the US government take a large stake in AIG, yet this has helped it overcome its liquidity
troubles.
The search for liquidity
Therefore, I think that the best solution to the credit crisis will be a scheme which reduces
illiquidity, as this is the source of most of the trouble in the financial markets. This has been
tried both directly and indirectly. The direct approach is central banks pumping cash into the
market, in an effort to try to get banks to begin lending to each other again. However, as
overnight lending rates have peaked at over 6%, many firms have chosen to buy short-term
government bonds instead, which means that money is flowing in the opposite direction to
that in which the central banks wish. The indirect approach is to guarantee all deposits in
banks. This has been done in Ireland, and is the most risky solution for the taxpayer. Moral
hazard is rife as the private sector banks return to making profits, and the taxpayer has to foot
the bill if anything goes wrong. This is a desperate attempt to stabilise the banking system, yet
it appeared to calm the Irish banks, and Germany have announced a similar scheme, which
means that the UK or the US may soon follow. However, a liquidity crisis must be solved
using liquidity measures, and this is where central banks must concentrate if they are to find a
solution.
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