The 2007 Sub-Prime crisis and the current Credit Crunch David Allen Senior Lecturer School of...

The 2007 ‘Sub-Prime crisis’ and the current Credit Crunch

David AllenSenior Lecturer School of EconomicsBristol Business School, UWE

The purpose of this session is to explain:

the background to current credit crunch

the short-term & long-term implications of this credit crunch

the possible impact it will have on your future employment prospects

The implications are fairly obvious

If there is less lending

there will be less spending

less spending means less output

less output means higher unemployment

Credit Crunch = shortage of bank credit

However we need to know WHY it has happened, to then understand whether this is a short-term problem or a long-term problem and, to assess whether it will happen again.

This in turn means we have to explain the workings of the Financial Sector in a modern global economy.

FACTORY

UK

UK

HOUSEHOLDS

FOPsY CdO

WMTS

J G

E

Banks Fiscal Policy Trade

XI

FACTORY

UK

UK

HOUSEHOLDS

FOPsY CdO

WMTS

J G

E

Banks Fiscal Policy Trade

XI

The Financial Sector & the Circular flow of Income

The question is: How do SAVINGS get turned into INVESTMENT (I) and CONSUMPTION (Cd)?

FOP = Factors of ProductionY = National IncomeCd = Consumption of Domestically produced OutputO = Domestic OutputE = National ExpenditureJ = Injections: I – Investment, G- Government Spending, X- ExportsW = Withdrawals: S – Savings, T- Taxes, M - Imports

Borrowers Lenders Savers

Individuals Banks IndividualsFirms Build' Soc' Firms

Local Government Insurance firms Local GovernmentCentral Government Pension Funds Central Government

Unit TrustsInvestment TrustsVenture Capitalists

Merchant BanksLease/Credit Houses

Discount Houses

The financial sector’s purpose is to turn savings into lending and is known as the process of financial intermediation.

For example; an individual saves money in a bank, the bank then lends this money to borrowers who might use it to buy a car (i.e. Consumption) or, it could lend this money to firms - the firms then benefit by having access to this ‘spare’ cash (SAVINGS), which they will then use to INVEST in their business.

Financial institutions and financial intermediation Turning SAVINGS into INVESTMENT

Recall the TV show: The Dragon’s Den

Besides returning savings back into the circular flow of income financial intermediation has other advantages:

1) Maturity transformation (where short term saving plans can be turned in to long term loans)

2) Collating (recording who’s borrowed/lent what)

3) Risk assessment (evaluating the probability of a default on any loan)

Financial institutions & Financial intermediation

As we will see later, items 2 & 3 (Collating and Risk Assessment)have played a role in the present credit crunch

CLEARING MONEY MARKETS BANKS (DEBT MARKETS)

SHORT LOANS * Certificates of deposit TERM OVER DRAFT * LOCAL AUTH' BILLS

* COMMERCIAL BILLS * EURO CREDIT * TREASURY BILLS

(CAPITAL MARKETS) EQUITY MARKET ['GILTS']

LONG Bus’ LOANS * DEBENTURES (FIRMS) * RIGHTS ISSUE TERM MORTGAGES * EURO BONDS * NEW SHARES

* LOCAL AUTH' BONDS * PREFERENTIAL * GOVE' BONDS VENTURE

CAPITAL

CLEARING MONEY MARKETS BANKS (DEBT MARKETS)

SHORT LOANS * Certificates of deposit TERM OVER DRAFT * LOCAL AUTH' BILLS

* COMMERCIAL BILLS * EURO CREDIT * TREASURY BILLS

(CAPITAL MARKETS) EQUITY MARKET ['GILTS']

LONG Bus’ LOANS * DEBENTURES (FIRMS) * RIGHTS ISSUE TERM MORTGAGES * EURO BONDS * NEW SHARES

* LOCAL AUTH' BONDS * PREFERENTIAL * GOVE' BONDS VENTURE

CAPITAL

Money & Equity markets are sub-divided intoPrimary Markets (where new issues are offered)Secondary Markets (where existing financial instruments are offered for sale)

Other types of Financial institutions: money & debt markets

Our focus is on the banking sector & its relationship with the money markets

Items marked * are collectively known as ‘financial instruments’ and all can be sold in the secondary markets if holders require ready cash (i.e. liquidity)

Banking: How SAVINGS get tuned in to SPENDING

DEPOSITS:The Bank’s LIABILITIES

£500m

LENDING:The Bank’s ASSETTS

Ready Cash(Tills & ATMs)

Advances(Loans)

Investments

£5m

£200m

£295m

£500m £500m

To met the daily needs of depositorsNote: Ratio of Cash to other Assets is 1% (LIQUIDITY RATIO)

Overdrafts to mortgages

Treasury bills, Gove’ BondsDebentures& others

Liabilities must equal Assets

££

How do Banks make a profit? They charge borrowers a higher rate of interest than they offer to depositors (savers). They also hope that the return on their investments is higher than the rate of interest they pay to depositors.

£495mbackinto the economy!

THE AIMS OF BANKS

LIQUIDITY: If the liquidity ratio is too high there is less to lend, which means lower profit

PROFITABILITY Risky loans are given higher rates of interest rate - they are profitable. But risky borrowers often default.

PRUDENCE Capital adequacy, the level of unsecured loans compared to secured loans. Alsobanks need to have enough of their own money (profit) on hand to cover any defaults on unsecured loans.

ALL THESE AIMS ARE IN CONFLICTAs will be shown later, it was the ‘sub-prime’ crisis of 2007/08 that led to problems with Prudence and Profitability, which ultimately resulted in problems with Liquidity and the resulting credit crunch.

Banking: How SAVINGS get tuned in to SPENDING

As ‘lender of last resort’DEPOSITS:The Bank’s LIABILITIES

£500m



Advances(Loans)

Investments

£5m

£200m

£295m

£500m £500m

££


£500m



Advances(Loans)

Investments

£5m

£200m

£295m

£500m £500m

££


£500m



Advances(Loans)

Investments

£5m

£200m

£295m

£500m £500m

££


£500m



Advances(Loans)

Investments

£5m

£200m

£295m

£500m £500m

££

Banking: Maintaining liquidity: Banks & the Money Markets

Money Markets

Bank of England

(Supplies £)

If a bank is short of ready cash (to meet its day today obligations to depositors) it can go to the MONEY MARKETS and enter into a “REPO” aggreement.‘Repos’ = A sale & repurchase agreement of a bank’s assets (e.g. a bundle of gilts or other INVESTMENTS). The bank that purchases this bundle of ‘instruments’ is making a short-term cash loan. The bank ‘selling’ the ‘repo’ agree to buy the ‘repo’ back on a certain date – usually within 2 weeks. They will be charged a rate of interest (LIBOR).

Other Banks(Supply £)

REPO

£

£

£

REPO

A bundle of paper assets

The ‘sub-prime’ crisis: a case study in banking failure

In the UK the ‘crisis broke in August 2007, when Northern Rock experienced a ‘run on the bank’ the first in the UK for 140 years!

A ‘run on a bank’ :- where large numbers of depositors present themselves at a bank and demand the return of all their savings – in cash at once !

Problem? The bank does not have the depositor’s money in cash – they have lent most of it to borrowers (advances) or used it to make investments.

To return the depositor's money would mean either:

a) Foreclosing on the loans they have made.

b) Selling some of their investments (assets) on the secondary money markets, in the sub-prime crisis, this is where part of the problem lay: the INVESTMENTS many UK banks (including Northern Rock) made turned out to be virtually worthless.


In the case of Northern Rock, their only (and immediate) solution was to approach the Bank of England as the lender of last resort for a straight loan.

It couldn’t use a ‘repo’ agreement simply because so many of its Financial Assets where made up of these worthless investments.

It was press ‘rumours’ that Northern Rock was approaching the Bank of England that then lead to the run on the bank.

So where did it all start to go wrong? And why were so many of these investments now worthless?

The ‘sub-prime’ crisis: a case study in banking failure. The seeds of the problem lay in the USA mortgage markets

It started with the creation of CDOs: “Collateralized Debt Obligations”

A consumer gets a mortgage, the lender (bank) then sells the debt (the loan) to an investment bank.

The investment bank ‘pools’ loans with similar risks of default into one financial instrument (a Bond). Which would be sold in the Money/Debt Markets (world wide)

Technically, these bonds would be rated as low risk (of default) to high risk (of default). The ‘return’ on the bond would come from the repayments on these mortgages and would reflect the level of risk associated with each ‘pool’ of mortgages.

A safe bet?These CDOs were considered safe ‘bets’ – after all if someone defaulted on their mortgage, the house could be reprocessed and sold (i.e. the were backed by collateral).

The ‘sub-prime’ crisis: a case study in banking failure.Building a CDO

$100,000

$100,000

$100,000

$100,000

$100,000

Loan

$500,000

As a rule of thumb you will pay back 3 times the value of the mortgage over the 20 years of the life of the loan.

$300,000

$300,000

$300,000

$300,000

$300,000

$1,500,000

Repayment

Combine into one CDO &sell for$750,00

Not a bad ‘return’!

However, if homeowners, startto default on their mortgages the CDOsreturn will fall e.g. If there are 3 defaults the CDOs returns would fall to$600,000

The market value of the CDO is nowvirtually worthless


Many US householders have defaulted on their mortgages - in large numbers.

Why so many defaults?Many of the provincial mortgage lenders where lending money irresponsibly (they were seduced by profits rather than being prudent ).

They were granting mortgages to people who could not afford to keep up the repayments (let alone pay off the principal sum). In some cases the repayments represented 80% of the householder’s monthly disposable income.

$100,000

£100,000

£100,000

£100,000

$100,000

Loan

$500,000

$300,000

£300,000

£300,000

£300,000

$300,000

$1,500,000

Repayment$100,000

£100,000

£100,000

£100,000

$100,000

Loan

$500,000

$300,000

£300,000

£300,000

£300,000

$300,000

$1,500,000

Repayment

As a result many CDOs became worthless –

$100,000

£100,000

£100,000

£100,000

$100,000

Loan

$500,000

$300,000

£300,000

£300,000

£300,000

$300,000

$1,500,000

Repayment$100,000

£100,000

£100,000

£100,000

$100,000

Loan

$500,000

$300,000

£300,000

£300,000

£300,000

$300,000

$1,500,000

Repayment

Other Problems?For the Investment Banks the problem was then of trying to track back and find out which CDOs included mortgages that had defaulted (i.e. the process of collating has turned out to be rather shoddy).

Another problem?The mix of low and high risk mortgages was incorrect, making any assessment of a CDO’s value difficult and uncertain.Why did this happen?Risk assessment agencies (and mortgage lenders) were sloppy in their work or, to say the least; they were ‘over optimistic’ on peoples’ ability to service their loans.



For the FINANCIAL SECTORTwo major outcomes from the sup-prime crisis1) The high level of defaults saw returns on these CDOs fall – greatly reducing the value (the price) an investor would offer if invited to buy the bond on the secondary money markets

2) The uncertainty over the mix of risk further reduced the value of CDO’s on the money markets

The Implications for the FINANCAL SECTOR?a) Bank balance sheets would not balance; their assets would be lower than their liabilities. As a result many banks have had to ‘write down’ their asset values and seek additional capital from existing shareholders or seek new investors to pump money into the bank to restore their balance sheets.

B) CDOs were of such indeterminate value they could not be used in any type of ‘repo’ / ’reverse repo’ arrangement with other - arrangements that could then assist the banks in maintaining their daily liquidity (there was a credit crunch!).


Banks ‘Taking a hit’ Dec 07 Share Prices of Banks since March 07

The ‘sub-prime’ crisis: a case study in banking failure The overall ‘fall out’ of the sub – prime crisis?

Short – Termi) Central banks (e.g. the ‘Fed’, the Bank of England, and the European Central Bank) have had to pump taxpayer’s money into the banking system to maintain liquidity and to restore confidence in the banking system.

ii) In the UK banks have had a ‘wake up call’ on the way they lend money, they are more ‘risk averse’ result: credit – crunch; - business are finding it harder to get loans - many consumers have seen their credit limits reduced significantly - home buyers are now having put down sizable depositsMore Long term?In order to restore their balance sheets many of the US and UK banks have approached ‘Sovereign Funds’ . Sovereign funds have been around for a while but they are a relatively new phenomena. Basically, these are investment trust that are owned by a national government, notably the state governments of many Arab nations (e.g. Kuwait, Oman), but include China, Russia, Norway, Singapore, Brunei

The ‘sub-prime’ crisis: a case study in banking failure The overall ‘fall out’ of the sub – prime crisis?

From your perspective?

Things have significantly changed – the impact is likely to be quite long term ( 5- 6 years) • You will find it harder to get a loan or credit

• You will have to start saving – NOW if you want to buy a home in the future

• Job prospects in the financial markets less assured

• Likewise job prospects in industries whose products are sold using a lot of credit will be less assured


The question is will it happen again? Probably, because banks know that the central banks will ALWAYS step in to restore confidence. Put another way, they know the taxpayer will always bail them out when they make the wrong lending decisions.

The 2007 Sub-Prime crisis and the current Credit Crunch David Allen Senior Lecturer School of...

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