The Global Financial Crisis; Causes and Effects on The UK Economy (Four Years After)

On December 7^th 2006, Ownit Mortgage Solutions Inc., a California based home lender part owned by Merril Lynch and Co., closed its doors and told more than 800 workers not to return just days before Christmas. The collapse of this wholesale mortgage lender, 11^th largest United States (US) issuer of subprime mortgages, marked the beginning of the global financial crisis (GFC) which would later turn out the largest global economic downturn not seen since the great depression.

The GFC took roots in the second quarter of 2008 with estimates from the International Monetary Fund (IMF) putting the cost of the crisis at a staggering £7.1 trillion. At the epicentre of the crisis, tensions continued to mount all over the world and in March 2008, the US Federal Reserve brokered a deal that allowed JP Morgan to acquire Bear Stearns, and by September 2008, Lehman Brothers (the fourth largest investment bank in the US) filed for chapter 11 bankruptcy protection following drastic losses in its stocks and devaluation of its assets.

In the United Kingdom (UK), the Northern Rock was the first high profile victim of the crisis as it was forced to apply to the Bank of England for emergency financial support on 13^thSeptember 2007 (Hoson and Quaglia, 2009) after it became the first run on a British bank since 1866 (Hodson and Mabbett, 2009).

More than four years into the crisis, the global financial system still remains in turmoil and recent data has shown a renewed slowing down of the global economy US first quarter 2012 Gross Domestic Product (GDP) dropped to 2.2% from 3% seen in the last quarter of 2011 and below projected estimates of 2.5%. News of China’s first quarter GDP result was not better as the economy grew at 8.1%, the slowest in more than three years. The report from the Office of National Statistics in the UK were even gloomier as GDP contracted by 0.2% in the first quarter of 2012, putting the economy back in recession and compared to the Great Depression of the 1930’s, the weakest recovery from any financial crisis in modern history.

Causes of Global Financial Crisis

The factors that led to the GFC are varied and complex Acharya and Richardson (2009) noted the fundamental causes of the crisis was the combination of a credit boom and the housing bubble.

In attempting to examine the factors we use the findings identified by the US government appointed Financial Crisis Inquiry Commission as our template.

a) Behaviour of Large Complex Financial Institutions (LCFI)

Diamond (1984) noted that the simple theory of banks was to act as intermediaries between depositors and borrowers, and in order to protect depositors from losses banks were required to hold a minimum amount of“Capital” which is defined by regulators. Under the Basel accord, banks must maintain 8% capital buffer against risk adjusted measures of their assets and in the US 10% capital buffer was designated to “well capitalized banks”. In an attempt to circumvent this capital adequacy requirement the LCFI turned to securitization,which is the pooling together various types of contractual debt (e.g. mortgages) and selling them as standard securities. This allowed the banks to avoid holding costly capital by turning them into underwriters that still originate the loan but sell them off to others (Acharya and Richardson, 2009). This behaviour of banks altered the original idea of banking; banks are now intermediaries between investors (rather than just depositors) and borrowers.

The process of securitization allowed the banks to reduce their reliance on deposits and obtain funding for their loans through the capital markets by using asset-backed securities (ABS) that could be sold to investors (Wilmarth, 2009). The ABS were created from pool of mortgages and sold in tranches called Collateralised Debt Obligations (CDOs). The tranches were accorded different ratings and the ratings were supposed to be based on the riskiness of the debts. Another benefit of securitization was that it offered banks with less than a “AAA” to create ABS that qualified for “AAA” ratings, while also earning sustainable fees for originating and securitising loans.

The period 2002 to 2007 saw a staggering increase in structured securities as banks extended the prime-mortgage securitisation model to other riskier asset classes. This allowed banks to transfer risk from the balance sheet to the broader capital market including pension funds, mutual funds, insurance companies and foreign based institutions (Financial Crisis Inquiry Commission, 2011). With the loans placed in conduits rather than on the banks’ balance sheet, the banks did not need to maintain capital against them and these conduits funded asset backed securities through asset-backed commercial papers (ABCP). Conduits are entities set up by the financial institutions to enable then more easily sell their loans to investors in the secondary market; they are also known as special purpose vehicles. To be able to sell the ABCP, the bank would have to provide the buyers with guarantee of underlying credit – essentially bringing the risk back onto itself. The aggregate securitization worldwide went up from $767 billion at the end of 2001 to $1.4 trillion in 2004 and by 2006 (at the peak of the bubble) had reached $2.7 trillion (Acharya and Richardson, 2009).

During the period preceding the crisis, conglomerates significantly expanded their presence in the securitization market as Lehman Brothers and Bear Stearns were the top underwriters for residential mortgage-backed securities (RMBS) during 2004 to 2007, while Citigroup was the top underwriter for ABS backed by other types of consumer debt (Wilmarth, 2009).

Financial conglomerates aggravated the risks of nonprime mortgages by creating multiple financial bets based on those mortgages. LCFIs re-securitized lower-rated tranches of RMBS to create Collateral Debt Obligations (CDOs), and then re-securitized lower-rated tranches of CDOs to create CDOs-squared. Some of these tranches were then rated again and some were given “AAA” ratings, thus adding to the risk and complexity of the debt instruments. LCFIs also created synthetic CDOs and wrote Credit default Swaps (CDS) to create additional financial bets. One of the major problems with CDS is that CDS can be purchased without having an underlying security. Goldman Sachs played a major role in the trading of CDS. By the end of 2007, outstanding CDS amounted to $62.2 trillion (Wilmarth, 2009).

When the collapse occurred the ABCP could not be rolled over and the banks had to return the loans to their balance sheets which effectively wiped out significant bank capital and thereafter the bank solvency. The chart below shows movement in securitisation in the UK between 2000 and 2009.

b) Widespread failure in financial regulation and supervision

The scenario highlighted previously was able to take place because of what FCIC succinctly described as “the sentries were not at their post, in small part due to the widely accepted faith in self-correcting nature of markets and the ability of financial institutions to effectively police themselves” (Financial Crisis Inquiry Commission, 2011).

After more than fifty years without a financial crisis, financial firms and policy makers began to see regulation as a barrier to efficient functioning of capital markets rather than a necessary precondition for success (Congressional Oversight Panel, 2009). The change in attitude resulted in more than 30 years of deregulation and reliance on self-regulation championed by Alan Greenspan, the former Federal Reserve chairman (Financial Crisis Inquiry Commission, 2011). This hands-off approach gave rise to a nearly unrestricted marketing of increasing complex consumer financial products which was even poorly understood by the regulators. The net effect was the failure to effectively manage risk as well as ensure transparency and fair dealings in financial transactions, all culminating volatile practices by the financial industry that led to the global crisis.

The United States special report on regulatory reform (2009) noted that markets have become opaque in multiple ways as some markets such as hedge funds and credit default swaps, provide virtually no information, while off balance sheet entities and complex financial instruments reveal the lack of transparency resulting from wrong information disclosed at the wrong time and in the wrong manner. Mortgage documentation was also highlighted as problematic as borrowers were intentionally thrust with reams of technically worded contact too difficult for them to understand the complexity. The panel identified eight specific areas most urgently in need of reform.

• Identify and regulate financial institutions that pose systematic risk.
• Limit excessive leverage in American financial institutions.
• Increase supervision of the shadow financial system.
• Create a new system of state regulation of mortgages and other consumer credit products.
• Create executive pay structures that discourage excessive risk taking.
• Reform the credit rating system.
• Make establishing a global financial regulatory floor a US diplomatic priority.
• Plan for the next crisis.

TheDodd-Frank Wall street reform and consumer protection act was passed by the US congress and signed into law by president Barack Obama on July 21 2010, in response to the loop holes that led to the global financial crisis with the aim of “creating sound economic foundation to grow jobs, protect consumers, rein in Wall street and big bonuses, end bailouts and prevent another financial crisis (Dodd-Frank Wall Street Reform And Consumer Protection Act, 2010).

c) An unsustainable Credit Boom

The United States experienced an enormous credit boom between 1991 and 2007 as credit markets owned by all sectors tripled from $1.4trillion in 1991 to $46.9 trillion in 2007 (Wilmarth, 2009), while non-governmental domestic debts quadrupled and rose by $29.6 trillion accounting for ninety percent of the overall growth. In the UK similar picture was observed and this resulted in a sharp increase in household debt and disposable income.

The credit boom was facilitated by a combination of low interest rates and large inflows of foreign funds with net increase in availability of credit to higher-risk consumers and commercial real estate developers (Wilmarth, 2009).The Financial Crisis Inquiry Commission noted that many mortgage lenders exploited the availability of cheap funds and set the bar so low that lenders took eager borrowers qualification on faith, often with wilful disregard for the borrower’s ability to pay (Financial Crisis Inquiry Commission, 2011). When these borrowers stopped making mortgage payments, the losses – amplified by derivatives – rushed through the pipeline, and as it turned out, these losses were concentrated in a set of systematically important financial institutions that kicked off the global financial crisis.

d) Poor Credit Rating

The FCIC indicted the credit rating agencies as key enablers of the financial meltdown as the mortgage-related securities at the heart of the crisis could not be sold without their seal of approval (Financial Crisis Inquiry Commission, 2011). Investors relied on their approval and in some cases were obligated to use these rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havocs across markets and firms. FCIC identified flawed computer models, pressure from financial firms that paid for the ratings, relentless drive for market share, lack of resources and absence of meaningful public oversight as reasons for rating agencies in-appropriately awarding AAA-ratings to securities that were ultimately downgraded.

e) Systemic Breakdown in Accountability and Ethics

The soundness and the sustained prosperity of the financial system and the economy rely on notions of fair dealing, responsibility and transparency. But a close examination of the actions of financial institutions in the periods prior to financial crisis revealed a systematic lack of accountability and a relaxation of ethical standards. The FCIC (2009) catalogues the rising incidence of mortgage fraud, which flourished in an environment of collapsing lending standards and lax regulation. Reviews by the FCIC (2009) showed that the percentage of borrowers who defaulted on their mortgages within just a matter of months doubled from the summer of 2006 to 2007 indicating that they likely took out mortgages they never had the capacity or intention to pay. The report summarises that the crisis was as a result of human mistakes, misjudgements and misdeeds that resulted in systematic failure of the financial industry.

Effects on the UK Economy

The UK economy has been hit hard by the financial crisis with early casualties being the first run on a British bank since 1866 and a near melt down in the banking system afterwards. Business in the UK have since struggled to stay afloat but the economic news keeps tracking in the wrong direction despite the government’s effort to spur economic growth while also attempting to control the deficit. The UK economy which is the 7^th largest in the world as measured by GDP (International Monetary Fund, 2012) officially entered a recession in the second quarter of 2008 according to the Office of National Statistics (ONS) and exited it in the 4^th quarter of 2009, only to enter a double dip recession in the first quarter of 2012 (Office for National Statistics, 2012). The graph below shows UK GDP growth rate from 2006 to 2011.

As of the end of November 2009 the UK economy had shrunk 4.9% from the pre-recession level with the ONS reporting that in the 3^rd quarter of 2009, the economy experienced a 0.2% negative growth compared to 0.6% fall experienced in the previous quarter with further improvements seen in the third quarter of 2010 as the economy grew by 0.8%, the fastest third quarter growth in 10 years. But the positive news was short lived as by the fourth quarter of 2010 the economy had shrunk 0.5% with mixed results seen in 2011 and by the 4^th quarter of 2011 the economy shrunk by 0.3% culminating in a double dip recession in the first quarter of 2012 after a decline in GDP of 0.2% (Office for National Statistics, 2012).

The effects can also be seen in the unemployment figures which have been very disappointing. When the GFC hit, the unemployment rate was a little over 5.6% (1.6 million people). By the end of 2009 it was almost 8.5% (about 2.5 million people unemployed), and by the end of 2011, 2.7 million people were unemployed, the highest in more than 17 years. At the individual level, about 13.5 million people in the UK are currently living in households below the low income threshold representing an 11% increase compared to 2004/2005.The UK manufacturing sector also suffered a big blow from the recession. According to the Markit Purchasing Managers Index (MPI), this surveys business conditions, dipped to 50.5 in April 2012 down from 51.9 in March, raising fears of the weakness of the sector. The ONS notes that even though the manufacturing sector recovered following the recession, it returned to contraction in June 2011 with overall manufacturing output down by 2% as at April 2012 when compared to this period (Office of National Statistics, 2012).

Following the recession in 2008, bank lending to small businesses dropped significantly, but in the last 12 months, compared 2009 and 2010, it has improved significantly only to drop 10.9% in March 2012, down from 11.7% figure reported in February 2012. Small bank lending remains flat at a 47.6% approval rate, alternate lenders picked up slightly (0.5%) to a 63% approval rate and loans made by credit unions barely increased (up 0.1%) to a 57.9% approval rate by March 2012 (Arora, 2012). Under project Merlin, banks agreed with the government to increase lending to SMEs to £76bn, an increase from £10billion compared to 2010, however the first quarterly lending data report of 2011 showed that five banks lent £16.8billion instead of the targeted £19 billion per quarter (Broughton, 2012). The chart below shows reduction in lending to small and medium scale enterprises in the UK between 2008 and 2011. Financial Institutions are becoming even more cautious in their lending particularly with the not so rosy economic outlook (Arora, 2012).

Conclusion

 

The issues highlighted above were some of the major activities that led to the financial crisis and the effect is still being felt worldwide today. The UK economy has experienced negative growth in GDP as various sectors of the economy have been affected by the GFC, also it is becoming more difficult for businesses to access funding to grow their business as a result of reduced lending by financial institutions.

In order to overcome the financial crisis it is imperative that a long-term, non-ideological realistic approach be adopted by all governments else we might see the global economy slide into a double-dip recession.

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