Posted by Will Lewis

Posted 10 March, 2012 OBI BLOG

It was the ‘American Dream’ for citizens of the US to own their home. A dream that was to cause the biggest global economic disaster to date (French, 2010). Wiz-kid financiers fashioned financial instruments such as collateralised debt obligations (CDOs), which shall be touched upon later, that even they did not even understand and gave the belief that all American citizens could achieve this dream.

In the late 1990s and early twenty first century G-7 countries: Canada; France; Germany; Italy; United Kingdom; Japan and United States and also Australia (now G-8 including Russia) experienced a period referred to as the ‘Great Moderation’. This was an era which witnessed unusually low inflation rates, low short-term interest rates and economic growth. The result was macroeconomic stability. Whether this phenomenon was due to a stroke of economic good luck, better monetary policy, a change in management of the supply chain or a combination of these factors remains to be answered. It can be said that the relationship between China and America (Chimerca) was a significant contributing factor (Ferguson, 2009). The emergence of China as a super power entering the market economy after decades of communism created a global imbalance. China’s ability to save and America’s ability to spend created a flow of capital from East to West which kept US long-term interest rates low. Additionally China supplied cheap sources of manufactured goods which also kept down inflation. The resulting effect was fertile ground for the growth of the ‘credit bubble’.

At the same time the America’s financial sector was undergoing deregulation. In the aftermath of The Great Depression (1927 – 1933) banking regulations were imposed. However with the arrival of Ronald Regan in power in 1980, dismantling of the regulations began. This led to the birth of complex financial instruments which invaded the US financial sector and spread internationally through the process of globalisation. Globalisation has enabled worldwide economic integration. Whilst it has been held responsible for many woes, it has also been congratulated for the exceptional prosperity it has brought.

The longer macroeconomic stability was experienced, the more people believed it was here to stay resulting in risks being underestimated. No longer were banks carrying out traditional methods of banking i.e. transferring funds from lenders to borrowers, instead the macroeconomic stability comforted banks and encouraged them to increase their leverage. The glut of savings from China made borrowing so easy that credit standards were weakened (Ferguson, 2009). During the 1990’s and most of the twenty-first century borrowing in the form of loans, credit cards and mortgages was booming in America and the United Kingdom. The marked rise in the use of credit was accompanied by a rise in house prices. This relationship reinforced each other and instilled confidence in both the borrowers and lenders: borrowers were reassured by the fact that the value of the house they were purchasing was rising and lenders also assumed that house prices were guaranteed to rise thus generating a higher yield. Convinced the steady climate was here to stay lenders consideration of risk was eroded – in some cases they offered 100 per cent mortgages and the calibre of individuals they granted them to decreased. Sub-prime mortgages, first introduced in the 1990s, are given to those who have poor credit histories (CBRE, 2008). Such loans had higher upfront fees, higher insurance costs, higher interest rates and fines for late payment (Mizen, 2008). Sub-prime mortgages were bunched together into high-yielding residential mortgage-backed securities (RMBs) and bundled collectively with other asset backed securities (ABSs) such as consumer credit, student loans and business loans and repackaged as CDOs. CDOs were sold on to banks who then sold it onto investors. This process, which used these financial instruments to theoretically spread the risk, was known as securitisation. This benefited the financial system as it refashioned illiquid assets into liquid.

Investors who were on the ‘hunt for yield’ were happy to purchase these high yield, riskier financial instruments at a higher leverage because traditional investment opportunities no longer satisfied them. RMBs and CDOs were sold globally to those who lacked experience of America’s financial system thus spreading the impending crisis into international financial markets. Investors who purchased the CDOs were comforted with the knowledge that the CDOs had been given a AAA rating (the highest possible rating). One would presume that rating agencies were an independent body that had the investor’s best interests at heart. In actual fact these ratings agencies were underwritten by the banks who sold the RMBs thus having a conflict of interest (Bean, 2009). They also insured against the RMBs and CDOs via the financial derivative Credit Default Swap which later became apparent that they were unregulated causing significant implications for the global economy.

ABSs and CDOs were hugely profitable for Wall Street. Mortgage bankers who initially approved the mortgage had little care for the strength of the mortgage holder’s credit quality as they were soon to sell it on to Wall Street underwriters who would in turn trade them on through the process of securitisation. The risk for underwriters was short-lived and the incentives were hugely attractive. It became a process of quantity over quality. It would be expected that the role of brokers who brokered the deal for investors would focus on the long-term profit for them; however the incentive structure focuses on short-term profit and thus neglects long-term risk. This management failure is not confined to brokers. Top executives of banks, who should align their interests with their investors, designed remuneration schemes which benefited executives long before the investor incurred huge losses (Bean, 2009). Banks failed morally in their management structure.

The incentivised practice resulted in a steep rise of sub-prime mortgages sold between the years 2002 and 2006 where the sub-prime component of the mortgage originations rose from $160 billion in 2001 to $600 billion in 2006 comprising 20% of the total annual mortgage originations in America (Mizen, 2008). Provided interest rates remained low and house prices continued to soar the sub-prime business model worked beautifully and the ‘American Dream’ became reality for many American citizens. However this model was to be short lived.

A significant occurrence in the American economy happened in 2006 when the closure of a car manufacturer cost Detroit 20,000 jobs (Ferguson, 2009). To compensate for this America increased short-term interest rates. This consequently had a small but significant effect on mortgage rates. This, coupled with the end of the initial mortgage ‘teaser’ periods, saw a rise in defaults in 2007. The outcome was the beginning of a fall in house prices resulting in the burst of the real estate bubble. Suddenly ABSs were worth much less than expected. Banks and lending institutions were facing huge losses; however the extent of their losses could not be established readily. Whether this is because banks simply did not know their losses, or whether they were seemingly averse to show the true extent of their losses in order to still compete for business in the short-term remains unknown. Either way banks became suspicious of each other’s balance sheets which halted interbank lending.

The way in which banks had been practicing in the credit bubble i.e. becoming highly geared and having no consideration for long-term risk was not sustainable. It has since been argued that banks continued to practice in this manner because they thought they were ‘too big to fail’ (Bean, 2009). They were comforted by the fact that they would be bailed out by the Government as they knew that their failure would put a downward pressure on prices thus causing losses for other financial firms. Such a bailout was witnessed in the United States with Bear Sterns (March 2008). The economic downturn was also having repercussions worldwide. The Government of the United Kingdom similarly had to bail out Northern Rock in February 2008. The sheer size and scale of this crisis was brought to light in September 2008 with the bankruptcy of Lehman Brothers; the fourth largest American investment bank. The inability of the Federal Reserve to bail it out raised alarm bells in the mind of investors who believed that such a bank was too big to fail. The financial markets crumbled with the loss of confidence and trust. 25,000 jobs were lost overnight (The Guardian, 2008).

The only way for threatened banks to recover was to de-leverage and reduce risk. Consequently there was “a severe shortage of money or credit” available (Clair and Trucker, 1993). This scenario is known as a credit crunch. The reduced liquidity meant that interbank lending plummeted. The London Inter-Bank Offered Rate (LIBOR) measures the rate at which international banks lend to each other; it tends to set the rates on loans granted to businesses and consumers and mortgage rates. It additionally affects the bank’s lending capacity (This is Money, 2012). When confidence and liquidity are high between banks the LIBOR rate tends to be 10-20 basis point above the bank rate (interest rate). However when the credit bubble burst in 2007 the LIBOR rate jumped 100 basis points and it is yet to return to normal (Mizen, 2008). The current three-month sterling LIBOR rate is 1.08894% (This is Money, 2012).

The credit crunch has had a significant impact on financial markets and therefore economies worldwide. This paper will now focus on the United Kingdom and the consequences that the credit crunch has had to date. As the crisis intensified the Bank of England cut interest rates initially in December 2007 by 0.25% in order to make saving less attractive and borrowing more attractive thus encouraging spending. Interest rates have now been slashed to an all time low of 0.5% for the past 34 months.

The problem with low interest rates is that it produces cheap money which risks inflation. The Bank of England’s Monetary Policy Committee (MPC) has been committed to reducing the current inflation rate to 2% (Joyce et al, 2011). In order to improve liquidity and reduce the inflation rate the MPC introduced Quantitative Easing. This involves the Government purchasing assets (mainly in the form of gilts) from commercial banks and other financial institutions using money created from nowhere i.e. the Government is simply ‘printing money’. The intended outcome is that sellers will receive money which will encourage them to purchase other assets; this has a knock on affect. Overall the wealth of asset holders increases which promotes spending. This generates movement within the financial markets which increases consumer confidence. A further intended benefit is that it will put money into banks. This should hopefully see a rise in their lending capacity. However due to the pressures imposed on banks to de-leverage it is unlikely that this will occur. To date £275billon worth of assets have been purchased. It is near impossible to assess the true extent that QE has had on the economy long-term, if any.

The United Kingdom has seen a major contraction of the economy since the onset of the crisis. For the first time since 1991 Britain announced on the 23rd January 2009 that it had entered a recession i.e. two consecutive quarters of negative economic growth (BBC News, 2009). The Gross Domestic Product (GDP), which is a measure of economic growth, sank to -2.3% in Q4 of 2008 (BBC News, 2009). Industrial production saw the biggest decline in growth due to the export markets slowing. Retail, manufacturing, service and construction industries were all negatively affected. Inevitably unemployment levels accelerated. Latest figures show that levels of unemployment have reached 2.64 million within the United Kingdom (BBC News, 2012). This has seen a rise in Job Seekers Allowance claimant figures which has put a further drain on the economy. Such figures are not set to fall within the foreseeable future due to the continued contraction of credit resulting in less business and investment opportunities and reduced consumer spending.

When discussing the credit crunch one cannot neglect the issue of property. There is a significant level of interconnectedness between the state of the economy and the state of the property market.  The boom in credit saw a rise in both residential and commercial property prices. Demand was high and investment thriving. Due to the exceptionally high liquidity made available within the financial markets between 2004 and the beginning of 2007 the UK witnessed very high levels of highly geared property investment. A booming economy and easy loan access saw increased business opportunities for both new and established businesses. Employment soared resulting in an increased demand for commercial property. This demand coupled with the eroded element of risk saw investors investing. The housing market also witnessed soaring prices and demand was great.

The property market was not shielded from the bursting of the credit bubble. House prices fell dramatically; they have since reached a plateau. House prices are determined by the ability to borrow rather than supply and demand (BBC News, 2011). Due to the continued pressure on banks to de-leverage, house prices look to remain the same for the foreseeable future.  Investment and demand within the commercial property sector also suffered. Even though the interest rates have been slashed, the reduced ability to borrow from banks has been significantly reduced. Loan to value ratios decreased thus limiting the type and amount of property that investors can purchase. This, coupled with the increase in unemployment which reduces demand, has seen property prices and rents fall resulting in development being halted. No longer is it a landlords market, it is a buyers and tenants market. Landlords need to maintain cash flows even if they are at a lower level. Banks are now very focused on their clients and seek to re-negotiate existing/prior loans at any opportunity.

2009 witnessed a slight increase in investment as purchasers believed that they were at the lowest point of the cycle and so thought it would be a good time to invest. This gave a small glimmer of hope that markets were becoming active once again. However, realistically landlords who are not pressurised to sell are less willing to do so as they would rather hold out until property prices increase causing stagnation within the property market and as with all markets if activity is slow then confidence is down. This said, the future for the property market still looks mildly optimistic. There is a thought process that due to the lack of prime Grade A development in recent years, current prime assets will be in demand. Prices could therefore rise and investment will once again be appealing. Such demand coupled with a squeeze in supply will hopefully stimulate development once again.

The economic downturn sparked by the collapse of the United States sub-prime mortgages market has not been restricted to America and the United Kingdom, it is being experienced globally. Governments which once bailed out banks have now fallen into debt and are now having to rescue each other; this has created a tense situation within the Eurozone which has never been experienced before. Greece requires a further bailout or a cancellation of its debts otherwise it will default within the Eurozone. Unfortunately Greece is not alone in its situation; France and Spain are facing similar problems. This has unnerved financial markets globally and threatens to send the United Kingdom into a double-dip recession. Although interest rates are at an all time low, they are not having their desired effect. People are worried about their debts and are committed to paying them off. 2011 Q2 figures show that on a net basis, £5.8 billion worth of mortgages were paid off (Lawry, 2011). This illustrates the lack of confidence that people have about the future. Standard monetary policies imposed in normal business cycles are having very little impact indicating that this is not a typical cycle. We have entered unknown territory and a lack of leadership within the Eurozone does not instil confidence worldwide thus impacting negatively on European trade.

In order to prevent this worldwide phenomenon occurring again the question needs to be asked, who is to blame? Is it the deregulation of financial markets that allowed financial instruments which are at the centre of the sub-prime mortgages to be created? Is it rating agencies who classified them as a AAA-rating? Is it the banks for creating an immoral incentivised structure which did not take long-term risk into consideration? Is it eastern countries such as China who allowed us to borrow extensively and allow us to sustain our credit bubble? Further questions need to be asked in response to the crisis; should the Governments have bailed out the Banks? In doing so are we not setting the tone for the future that it is acceptable to take highly incentivised risks as we know the Government will once again step up and bail out the banks?

No one knows how this financial catastrophe will end. We do know that it has changed our world forever and the effects of the ‘American Dream’ will be felt for generations to come. Whether we learn from it remains to be answered. There are signs that we are with new protective measures are being imposed which separate retail banking from riskier investment banking. However, history dictates that human behaviour and the short-term greed for money could mean that we relive this worldwide phenomenon once again.

Emma Powell is an Assistant Surveyor at OBI Property LLP and is studying a Masters in Real Estate and Property Management at the University of Salford.

References

BBC News (2009). UK in recession is economy slides. Accessed 11th January 2012  http://news.bbc.co.uk/1/hi/business/7846266.stm

BBC News (2012). Economy Tracker. Jobs. Accessed 11th January 2012  http://www.bbc.co.uk/news/10604117

BBC News (2011). Economy Tracker. House Prices. Accessed 10th January 2012 http://www.bbc.co.uk/news/10620450

Bean, B (2009) The Great Moderation, the Great Panic and the Great Contraction. Annual Congress of the European Economic Association. Barcelona 25 August 2009

CBRE (2008) Credit Crunch and the Property Market. Accessed 10th January 2012

http://www.london.gov.uk/mayor/economic_unit/docs/credit-crunch.pdf

Clair, R and Trucker, P (1993). Six causes of the Credit Crunch (or why is it so hard to get a loan?). Federal Reserve of Dallas Economic Review. Q3 pp. 1-19

Ferguson, N (2009) The Ascent of Money: a financial history of the world. pp.331 -450) Penguin Books

French, N (2010). Implications of the change in user preferences in the economic downturn on investment strategies. Journal of Property Investment & Finance. 28(6) pp. 466-474.

Joyce, M. Tong, M. & Woods. (2011) The United Kingdom’s quantitative easing policy: design, operation and impact. The Bank of England’s Quarterly Bulletin Q3

Lawry, P (2011). This time is very different, very different. The Roberts Partnership Investment Conference 2011. Downloaded 11th January 2012 http://i.robparnews.co.uk/CmpDoc/2009/5455/57716_investing-in-uncertain-times-2011.pdf?dm_i=47J,LLYY,4K49IY,1R3A0,1

Mizen, P (2008). The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses. Federal Reserve Bank of St. Louis Review, 90(5), pp. 531-567.

The Guardian (2008). Jobs cull begins in London and New York as Lehman Brothers goes to the wall. Accessed 9th January 2012 http://www.guardian.co.uk/business/2008/sep/16/lehmanbrothers.marketturmoil

This is Money (2012). Latest on LIBOR- the bank borrowing rate that affects mortgages. Accessed 10th January 2012 http://www.thisismoney.co.uk/money/markets/article-1645325/LIBOR-Latest-inter-bank-lending-rate-charts.html