The financial crisis

In 2008 there was global banking crisis which then led into a credit crunch and, for many countries, recession. This section looks at the causes of the banking crisis and the knock-on effects mentioned.

Causes

There was no single cause that resulted in the credit crunch and financial crisis. Rather a range of contributory factors can be identified.

US sub-prime mortgage lending

In 2001 the US faced recession, due partly to the events of 9/11 and the Dot com bubble burst, so the US government was keen to stimulate growth. As part of this in 2003 the Federal Reserve responded by cutting interest rates to 1% – their lowest level for a long time.

Low Interest rates encouraged people to buy a house, resulting in house price rises. As house prices began to rise, mortgage companies relaxed their lending criteria and tried to capitalise on the booming property market.

This boom in credit was also fuelled by US government pressure on lenders to grant mortgages to people who, under normal banking criteria, presented a very high risk of default. These were the so called ‘sub-prime mortgages’, with, many borrowers taking out adjustable rate mortgages that were affordable for the first two years.This 'subprime market' expanded very quickly and by 2005, one in five mortgages in the US were subprime.

Banks felt protected because house prices were continuing to rise so if someone defaulted the bank would recover its loan.

In 2006 inflationary pressures in the US caused interest rates to rise to 4%. Normally 4% interest rates are not particularly high but, because many had taken out large mortgage payments, this increase made the mortgage payments unaffordable. Also many homeowners were coming to the end of their 'introductory offers' and faced much higher payments. This led to an increase in mortgage defaults.

 As mortgage defaults increased the boom in house prices came to an end and house prices started falling. In some areas the problem was even worse as there had been a boom in building of new homes which occurred right up until 2007. It meant that demand fell as supply was increasing causing prices to collapse, meaning that banks were no longer able to recover loans when borrowers defaulted. In many cases they were only ending up with a fraction of the house value.

'Collateralised debt obligations’ or CDOs.

Normally if a borrower defaults it is the lending bank or building society that suffers the loss. As a result they are very careful to verify the credit worthiness of potential borrowers and whether they have the income and security to repay loans. However, in the US, mortgage lenders were able effectively to sell on mortgage debt in the form of CDOs to other banks and financial institutions. This was a kind of insurance for the mortgage companies. It means that other banks and financial institutions shared the risk of these subprime mortgages.

Using the income from their mortgage book as security, banks sold CDO bonds with a three tier structure:

(1) Tier 1 was "senior" or "investment grade" and supposed to be very low risk but with a low return.

(2) Tier 2 was the "mezzanine tranche" and had medium risk and return

(3) Tier 3 was the "equity tranche" and had highest risk and return.

As money was received on mortgages, it was used to pay the Tier 1 bond holders their interest first, then Tier 2 and finally Tier 3, so if borrowers defaulted, then Tier 3 holders would suffer first and so on, like a waterfall effect.

Unfortunately losses were so great that Tier 3 and Tier 2 and in some cases Tier 1 investors were affected. At the very least, the value of Tier 1 bonds fell due to the perceived risks.

Debt rating organisations

The CDO bonds were credit rated for risk, just like any other bond issues. Risk agencies gave risky Tier 1 debt AAA safety ratings. Normally AAA would denote extremely low risk investments.

This encouraged many banks and financial institutions to buy them, not realising how risky their financial position was. The trillions of dollars of subprime mortgages issued in the US had thus become distributed across the global markets ending up as CDOs on the balance sheets of many banks around the world.

Many commentators have seen this factor as an example of a regulatory failure within the financial system.

Banks' financial structures

Unlike most other commercial enterprises, banks are very highly geared with typically less than 10% of their asset value covered by equity. A major loss of asset value can soon wipe out a bank’s equity balance and it was this risk which led some banks to start selling their asset-backed securities on to the market.

However, the sellers in this restricted market struggled to find buyers. As a result, the values at which these "toxic assets" could be sold plummeted and many banks around the world found themselves in a position with negative equity.

Credit default swaps or CDSs

As an alternative (or addition) to using CDOs, the mortgage lenders could buy insurance on subprime debt through credit default swaps or CDSs.

For example, AIG wrote $440bn and Lehman Brothers more than $700bn worth of CDSs. These were the first institutions to suffer when the level of defaults started to increase.

Implications and consequences

The failure of major financial institutions

Some very large financial institutions went bust and others got into serious trouble and needed to be rescued.

For example,

• In September 2008 Lehman Brothers went bust. This was the biggest bankruptcy in corporate history. It was 10 times the size of Enron and the tipping point into the global crash, causing panic throughout the financial system, freezing short term lending, and marking the start of the liquidity crisis.
• Also in September 2008 the US government put together a bail out package for AIG. The initial loan was for $85bn but the total value of this package has been estimated at between 150 and 182 billion dollars.
• In the UK the Bank of England lent Northern Rock £27 billion after its collapse in 2007.

The credit crunch

Banks usually rely on lending to each other to conduct everyday business but, after the first wave of credit losses, banks could no longer raise sufficient finance.

For example, in the UK, the Northern Rock was particularly exposed to money markets. It had relied on borrowing money on the money markets to fund its daily business. In 2007, it simply couldn't raise enough money on the financial markets and eventually had to be nationalised by the UK government.

In addition to bad debts, the other problem was one of confidence. Because many banks had lost money and had a deterioration in their balance sheets, they couldn't afford to lend to other banks. Even banks that had stayed free of the problem began to suspect the credit worthiness of other banks and, as a result, became reluctant to lend on the interbank market.

The knock on effect was that banks became reluctant to lend to anyone, causing a shortage of liquidity in money markets. This made it difficult for firms to borrow to finance expansion plans as well as hitting the housing market.

Many companies use short term finance rather than long term.

For example, rather than borrowing for, say 10 years, a company might take out a two year loan, with a view to taking out another two year loan to replace the first, and so on. The main reason for using this system of "revolving credit" is that it should be cheaper – shorter term interest rates are generally lower than longer term.

The credit crunch meant that these firms could not refinance their loans causing major problems. 

Government intervention

Many governments felt compelled to intervene, not just to prop up major institutions (e.g. Northern Rock and AIG mentioned above) but also to inject funds into the money markets to boost and stimulate liquidity. Efforts to save major institutions involved a mixture of loans, guarantees and the purchase of equity.

For example, in 2008/9 the UK government invested £45.5bn in the Royal Bank of Scotland, ending up with an 82% stake.

Usually, central banks try to raise the amount of lending and activity in the economy indirectly, by cutting interest rates. Lower interest rates encourage people to spend, not save. But when interest rates can go no lower, a central bank's only option is to pump money into the economy directly. That is quantitative easing (QE). The way the central bank does this is by buying assets – usually financial assets such as government and corporate bonds – using money it has simply created out of thin air. The institutions selling those assets (either commercial banks or other financial businesses such as insurance companies) will then have "new" money in their accounts, which then boosts the money supply.

By March 2012 the UK Government had injected £325bn into the financial system through quantitative easing.

The end result was that many governments found themselves with huge levels of debt with the corresponding need to repay high levels of interest as well as repay the debt.

Recession and "austerity measures"

The events described above resulted in a recession in many countries. Despite the falling tax revenues that accompany this, some governments would normally try to increase government spending as one measure to boost aggregate demand to stimulate the economy.

However, the high levels of national debt have resulted in governments doing the opposite and making major cuts in public spending. This is partly to be able to reduce the level of debt but also because of fears over credit ratings. If the rating agencies fear that a country will default on its debt, then its credit rating will be downgraded resulting in higher costs for future debt.

Problems refinancing government debt

In 2010/2011 some countries tried to refinance national debt by issuing bonds:

• A problem facing the Spanish government at the end of 2010/2011 was the need to raise new borrowing as other government debt reached maturity. Spain successfully sold new bonds totalling nearly €3bn on 12/1/11 in what was seen as a major test of Europe's chances of containing the debt crisis gripping parts of the region. This was in addition to the Spanish government cutting spending by tens of billions of euros, including cuts in public sector salaries, public investment and social spending, along with tax hikes and a pension freeze. 
• The problem of refinancing is more severe for countries whose national debt has a short average redemption period (Greece is about 4yrs) but much less of a problem where the debt is long dated (e.g. the UK where the average maturity is about 14 years).

For others they needed help from other countries and the IMF. For example:

• Greece received a €110bn rescue package in May 2010
• At the end of 2010 Ireland received a bailout from the EU, the UK and the IMF. The total cost is still being debated but could be as high as €85bn
• In May 2011 Portugal received a bailout of €78bn.

For many, this was compounded by seeing their national debt downgraded by credit rating agencies:

• For example, on 20 September 2011, Italy had its debt rating cut by Standard & Poor's, to A from A+.

The Eurozone crisis and fears over "contagion"

The above issues of governments trying to boost their economies while reducing national debt have been particularly visible within the Eurozone. This due to a number of factors:

• As well as trying to manage their own economies, governments of countries within the Eurozone are committed (at least in theory) to staying within the rules of the Eurozone for example, that debt should not exceed 60% of GDP. 
• Concerns over the possibility of Greece defaulting on its loans have resulted in Eurozone ministers insisting on even greater austerity measures before they will release further funds. At one point commentators wondered whether Greece would vote to stop being part of the Eurozone. The cost of Greece dropping out of the Eurozone was estimated at over one trillion euros.
• Credit rating agencies have been concerned about "contagion" i.e. the possibility of problems in countries such as Greece spreading throughout the Eurozone, possibly resulting in the collapse of the Euro as a major currency. For example, on 13 January 2012, credit rating agency Standard & Poor's downgraded France and eight other Eurozone countries, blaming the failure of Eurozone leaders to deal with the debt crisis.

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