What were the causes of the financial crisis and could such a crisis happen again?

Hello readers, welcome back to my blog.

This week I thought I would share with you my research that I have done on the 2008/09 financial crisis.

The 2008/09 financial crash led to a prolonged period of low/negative growth, high levels of uncertainty and rising unemployment. It was the largest and most dramatic recent example of financial systems being threatened by systemic failure. In 2013 the effects of the crash were still rippling through the world economy, GDP was still below its pre-crisis peak in many rich countries, especially in Europe, where the financial crisis had evolved into the euro crisis and banks were still reluctant to lend as they had been scarred by previous events which has reduced the overall effectiveness of Quantitative Easing programmes. Today most countries are on the rebound; however, other political shocks such as Brexit in the UK stand in the way of increased economic prosperity.

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It is important to note that there was not one sole cause of the financial crisis; rather there were a combination of factors, which led to this economic downturn. The primary cause of the financial crisis however, was the credit crunch (sudden shortage of funds for lending, leading to a decline in loans available). This was driven by a sharp rise in the defaults on ‘sub-prime’ mortgages, which were mainly in America but the shortage of funds spread across the world. Sub Prime mortgages were essentially mortgages sold to customers generally with low income, poor credit and very small, if any deposits. The housing market in the US at the time was booming and there was little regulation on the sale of these products. Mortgage brokers were given commissions for selling mortgages, even if they were too expensive and had a high chance of default.

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The problem was further exacerbated when mortgage companies bundles the debt into consolidation packages and sold the debt onto other finance companies. The issue was that sub prime mortgages had a high risk, although when the mortgages got bundled and passed onto other lenders, rating agencies such as Moody’s and Standard & Poor’s gave these risky products a better rating and thus the true risk in the financial system was denied. These were known as Collateralized Debt Obligations (CDO’s) and it involved mortgage companies borrowing to be able to lend mortgages. Financial intermediaries and investment banks such as JP Morgan bought these debts and the idea was to spread the risk, although it actually spread the problem at hand. Lehman Brothers has become synonymous with the financial crash and the idea of ‘Bank Failure’. They acquired five mortgage lenders including sub prime lenders. Given the size of its company and its status as a major player in the U.S. and the international economy, Lehman’s collapse created a state of turbulence in global financial markets. Many questioned the governments decision to let Lehman fail as it led to more than $46 billion of its market value being wiped out and served as a catalyst for the purchase of Merrill Lynch by Bank of America in an emergency deal.

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Not only were these mortgages sub prime but they also had an introductory period of 1-2 years and at the end of this period, the rates increased significantly, something which consumers had been myopic about. In 2007, inflation in the US was rising and so the Federal Reserve had to increase interest rates to curb inflation, which made homeowners who had taken out mortgages during the introductory period, ‘feel the pinch’ even more as they faced extortionate payments. This was coupled with rising health care costs, rising petrol prices and food prices, reduced disposable income to a point where people were struggling to make ends meet and made defaults almost inevitable. This signaled the end of the housing boom and US house prices started to fall, which caused even further issues e.g. people with 100% mortgages now faced negative equity (the value of the loan is greater than the value of the house). Not only did this create a negative wealth effect, lower animal spirits and reduce confidence and spending but people could no longer rely on re-mortgaging to gain equity withdrawal. It also meant that these loans were not secured meaning the bank could not recoup the initial loan. This meant banks had to write off massive losses and this made them reluctant to make further lending. The result was that all over the world it became difficult to raise funds and borrow money and so ‘markets dried up’, and halted investment into startups, tech companies and many other firms, increasing unemployment, reducing productivity and above all slowing economic growth.

In the UK mortgage lenders did not lend so many bad mortgages as there were more stringent controls in place than the US. However, the credit crunch did have serious problems for Northern Rock who could no longer raise enough funds in the usual capital markets. It was left with a shortfall and eventually had to make the humiliating step of asking the Bank of England for emergency funds. Since the Bank asked for emergency funds, this caused its customers to worry and start to withdraw savings (even though savings weren’t directly affected), thus reducing the bank’s liquidity. The recession led to a rapid rise in levels of government borrowing to finance the growing deficit. In response, the UK and many Eurozone economies pursued a degree of fiscal austerity – cutting spending on services/higher taxes to try and reduce levels of government borrowing; but austerity in a time of recession, led to a further decline in aggregate demand. Perhaps Keynes’ idea that ‘governments should spend their way out of a recession’, would have been a better approach.

Screen Shot 2017-10-11 at 20.35.16.pngThe global nature of the crisis meant that there was a drop in world trade. Countries saw a drop in exports as the global downturn led to lower demand. In 2008, there was also a peak in oil prices. This complicated matters because it caused cost-push inflation. This cost-push inflation made Central Banks more reluctant to cut interest rates. Also, higher oil prices reduced disposable income and led to lower spending. Usually, in a recession, oil prices fall. However, because of rising demand in China and India, we saw rising oil prices – even as Europe and the US went into recession.

Another potential cause of the financial crisis was the partial repeal of the Glass-Steagall Act. The Glass-Steagall Act’s primary objectives were twofold – to stop the unprecedented run on banks and restore public confidence in the U.S. banking system; and to sever the linkages between commercial and investment banking that were believed to have been responsible for the 1929 market crash. During the 2016 presidential campaign, Donald Trump inferred the reinstatement of the Glass-Steagall Act. After his election to the presidential seat in 2017, his head of the National Economic Council, Gary Cohn, revived talks of restoring the Act to break up the big banks. By creating a wall between commercial banking activities and riskier financial institutions, ‘too big to fail’, banks will be forced to shrink in size, making them smaller and more secure for depositors, the financial sector, and the economy. Breaking up the large banks, which have been found to be larger in 2017 than they were before the 2008 financial crisis will also mitigate the risks of a government bailout in the future.

In addition, banks panicked when they realized they would have to absorb the losses. Consequently, they stopped lending to each other. They didn’t want other banks giving them worthless mortgages as collateral and as a result, interbank borrowing costs (known as LIBOR) rose. This mistrust within the banking community was a major contributor to the severity of the financial crisis.

In terms of whether such a crisis could occur again, there have been numerous changes across the world from the potential revised glass stegeall act to the increased role of the Financial Policy Committee (part of the Bank of England) and the Financial Conduct Authority (not part of the Bank). Further, investment banks are now separate from retail banks so that they do not use people’s deposits for riskier investments. Following the publication of the final version of the Vickers Report in September 2011, the retail banking activities of banks operating in the UK must be ring fenced from their investment banking activities by 2019. This is likely to reduce systemic risk i.e. the breakdown of the entire financial system caused by inter-linkages within the system. Central banks have also imposed larger minimum required capital ratios on the banks. If banks hold more capital, they are less likely to become insolvent if there is a fall in the value of their assets-for examples, as a result of customers being unable to repay the money they have borrowed. At the same time, the UK has seen a change in the mortgage market: Mortgages have become more expensive and risky mortgage products like 125% mortgages have been removed from the market. Due to a shortage of supply, UK house prices have recovered much more quickly than abroad. Therefore it is unlikely that history could repeat itself in terms of sub prime mortgages, a run on the banks, and a housing bubble explosion. That being said in London, foreign investors who have purchased property, which is mostly unoccupied, have pushed houses prices up making them unaffordable for many. An interest rate rise by the Bank of England in the near future, coupled with the uncertainty from Brexit could lead to a fall in the value of prices and perhaps causes prices to crash.

What is more likely however is a potential crisis with PCP car loans. PCP car finance relies on the lenders’ ability to realise guaranteed future values, which can only happen in a strong used car market; but if hundreds of thousands of diesel drivers were to use consumer law to return their PCP-financed cars early – passing the early-termination losses back to the lenders – the cost would be so great that many finance companies wouldn’t be able to cope. It’s no exaggeration to speculate whether this could become the next financial crisis.

Screen Shot 2017-10-11 at 20.38.09It is clear that this ‘four-wheeled binge’, which reached a record £31.6bn in car loans last year, could have consequences if it ‘veers off the road’. What makes matters worse is that it takes just 20 minutes to fill in the forms for a new kind of loan that cuts the cost of financing to levels that allow people on modest incomes to afford the latest cars. This is compared with the three-hour affordability interview that mortgage applicants are now subjected to. The car financing industry is confident that this new breed of ultra-low-cost loans, which account for 82% of all new car registrations are a safe and secure way of financing new cars. It says sub-prime lenders, who offer loans to people with erratic incomes and damaged credit ratings, account for only 3% of the market and the industry can cope with any destabilising events coming down the track.

In conclusion the financial crash was caused by the credit crunch, which led to a fall in bank lending, due to a shortage of liquidity and a run on the banks. This triggered a chain of events: a fall in consumer and business confidence resulting from the financial instability, a fall in exports from the global recession and a fall in house prices leading to negative wealth effects. In Europe, the single currency created additional problems because of over-valued exchange rates. As the crisis highlighted, banks are sometimes tempted to take too many risks in pursuing the huge profit that lending long allows. It can be argued that they do this because they believe that the Bank of England in its role as lender of last resort, and the government through its bailouts, will not allow banks to fail. This illustrates the problem of a moral hazard whereby if something goes wrong firms know that someone else will bear a significant portion of the cost. It was clear that in the period leading up to the 2007-08 financial crisis insufficient attention was paid to tackling risks and vulnerabilities across the financial system as a whole. In light of what happened, new financial regulators and more rigid controls have been implemented to prevent another crisis. The FPC now fills that gap by identifying, monitoring and taking action to remove or to reduce systemic risks to the resilience of the financial system. Although we must be careful not to overlook the fact that PCP’s could become the new CDO’s.