The Credit Crunch

This short chapter looks at the impact of the credit crunch on the UK and world economy. Just a few years ago the credit crunch rarely if ever figured in an economics dictionary. Now it gets mentioned in the media every day! A credit crunch is a liquidity crisis. It means that banks become nervous about lending money each other and to personal and business customers. Where they are prepared to lend, they charge higher rates of interest to cover their risk. The result is a big fall in the supply of credit and an increase in the cost of borrowing. During the boom years of 2003 to 2006, and the first half of 2007, credit all over the world was at its cheapest point in history. In 2003, the US policy base rate was 1%, and even after a series of rises over the next 3 years, peaked at 5.25%. Similarly, UK interest rates were between 4% and 5% during this period. This cheap credit boom spurred a rise in both UK and US house prices fuelled by sub-prime lending, this involved mortgage lending to NINJAs i.e. lending to those with No Income, No Job or Assets. They were unlikely to be able to repay the loan made to them, and would have been rejected by traditional bank managers, but as house prices were rising, this did not worry those making the loans. On default, the bank in question took possession of the house, which had risen in value, and they sold it on at a profit. This strategy was immensely profitable for banks, yet it relied on rising house prices and it came to an end in 2007, when the US housing market began to decline. When sub-prime mortgages were defaulted, the banks now took on a debt instead of a profit. This could have been an almost uniquely US crisis, except for the fact that US banks had not kept all these mortgages on their balance sheets. Securitisation The mortgage securitisation business took mortgage loans, and packaged them up as structured investment vehicles (SIV). These were then split both geographically and in terms of quality, so subprime loans from California could have been in the same tranche as a more traditional loan from Illinois. These SIVs took on many names, including Collateral Debt Obligations (CDO), and Mortgage Backed Securities (MBS). They were often given AAA ratings by credit agencies, as the historical models used to predict the probability of all the mortgages defaulting showed that this was extremely unlikely. This meant that sub-prime mortgages were thought to have the same likelihood of default as the US government! These SIVs were then sold globally, for millions of dollars, as safe investments that yielded multiples of US Treasury bills. This meant that investors from Switzerland, say UBS, could have had exposure to the US mortgages market, lending to debtors they had never met, who had little chance of paying. This put the global financial system dependent on the US housing market. When the price of US houses began to fall, it was not immediately clear to those who held MBSs that the value of their asset had fallen, as the market was illiquid and opaque. It was not until sub-prime defaults became more frequent that their value was written down. When investors came to sell them, realising that the sub-prime market had collapsed, no one wanted to buy them, as they could see the impending fall in the US housing market, so their value was suddenly drastically lower, which surprised large investment banks who were then forced to write down their assets and declare huge losses. The fall in US house prices meant that banks became unwilling to lend to NINJAs again, and credit became more difficult to obtain throughout the financial system, even in the wholesale markets, as banks were unsure about who had the ability to pay back loans. The first noticeable casualty of this credit freeze was Northern Rock, which in September 2007 was nationalised by the UK government. This was because its business model relied upon borrowing money in the wholesale markets, and

lending it on to consumers at a greater rate of interest. This strategy unwound when their stream of cheap credit dried up, and they were forced to ask the Bank of England for emergency funding, which caused a run on Northern Rock, from which it never recovered. Many UK banks had invested large sums in sub-prime backed investments and have had write off billions of pounds in losses. As the market for securitized loans seized up the credit crunch occurred. Good value mortgages have become more difficult to find as borrowing rates have soared. Lenders now demand much bigger deposits from people wanting a home loan. Fixed interest rates on mortgages have risen. Falling share prices in 2008-09 hit people with money invested in pension funds.

What is the Credit Crunch? A credit crunch happens when 1. Financial institutions such as banks and building societies cut the amount that they are prepared to lend to each other this is a decline in inter-bank lending in the wholesale money markets. In short there is a freezing of the supply of available credit. 2. The fall in the supply of credit leads to a rise in inter-bank interest rates e.g. in the UK we have seen the LIBOR rate remain well above the official UK bank base rate set by the Monetary Policy Committee. 3. This increase in wholesale interest rates feeds through to higher interest rates for mortgages and credit cards - making borrowing more expensive for ordinary people and for homeowners. It has become much harder for aspiring homebuyers to get a mortgage. The lenders are much more selective and cautious about whom they lend to most mortgages now require a sizeable deposit. 4. It can also make it more difficult for businesses to raise fresh capital through bond issues forcing many of them to look to the stock markets for streams of new capital e.g. by making use of rights issues. 5. The banks themselves look to improve the asset side of their balance sheets by seeking to raise fresh capital either by rights issues or by attracting extra savings from depositors. 6. On the liabilities side of the banks balance sheets, the lenders cut back on loans this is a process known as de-leveraging and makes it harder to get a loan. 7. The crunch involves a draining of liquidity in the financial system driven by worries among investor about where the bad debts are (e.g. bad loans linked to the sub-prime market).

Macroeconomic Consequences of the Credit Crunch The whole world economy has been affected by the credit crunch and it is a great case study in how economic and financial developments in one country can affect the economy of other nations the world economy is highly inter-dependent.

USA House Prices - S&P Case-Shiller Index

Monthly house price index Jan 2000=100
220 210 200 190 180 170 220 210 200 190 180 170 160 150 140 130 120 110 100 00 01 02 03 04 05 06 07 08 09 10

Index

160 150 140 130 120 110 100

S&P Case-Shiller, Chicago

S&P Case-Shiller, New York

S&P Case-Shiller, San Francisco

Source: Reuters EcoWin

The fall out from the sub-prime crisis for the United States can be seen in this chart showing average house prices. Rising mortgage defaults has created a problem of repossessed housing and fire sales of properties, which has created excess supply in the housing market. Falling prices have reduced wealth and led to an increase in negative equity. Bad debts from toxic mortgages led to enormous write-offs and huge losses for many banks and hedge funds. As the credit crunch gathered momentum, in the autumn of 2008 the US investment banking industry all but collapsed. Lehman Bros went bust in September, Bear Stearns was sold at rock bottom price of $2 a share to JP Morgan; Merrill Lynch was bought by Bank of America and the US government nationalised mortgage lenders Freddie Mac and Fannie Mae as well as introducing an enormous bail out programme for the toxic securitised loans. The steep fall in housing demand has led to a sharp decline in construction output with hundreds of thousands of jobs lost in construction and other related industries. UK Household Sector The credit crunch has made it harder to get loans the supply of new mortgage finance has dried up and the number of new mortgage loan approvals collapsed in 2008 and into 2009 contributing to a steep decline in property demand and house prices. Many property owners found themselves having to cope with an increase in fixed-rate mortgages which hit their effective disposable income There has been a large negative wealth and confidence effect from falling property prices and a large fall in consumer spending on new durable products such as cars, furniture and household appliances.

Because consumption is such a high percentage of aggregate demand, the decline in household spending has been a key factor driving the UK economy into recession during 2009.

Base Rates and the London Interbank Lending Rate

Percentage, since May 1997 base rates have been set by the Bank of England

7.0 6.5 6.0 5.5 5.0 4.5

Percent
Bank of England Base Rate LIBOR 3-Month Interest Rate

7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Jan May Sep 05 Jan May Sep Jan May Sep Jan May Sep 06 07 08 Jan May Sep 09 Jan May Sep 10

Source: Bank of England

Policy rates and LIBOR The chart above tracks the official policy interest rate set by the Bank of England together with the London Interbank Offer Rate (LIBOR) which is the interest rate on inter-bank lending in the City of London. In normal times there is virtually no difference between the two perhaps 0.1 or 0.2% but during the financial crisis the gap between LIBOR was almost 2%, this reflected the unwillingness of banks to provide each other with loans because no one could be sure about the extent of bad loans and losses that each bank was having to deal with.

Case Study: The Rise and Fall of the Northern Rock

Northern Rock Ordinary Share Price

Daily closing price, s per share 13 12 11 10 9 8
GBP

13 12 11 10 9 8 7 6 5 4 3 2 1 0 97 98 99 00 01 02 03 04 05 06 07 08

7 6 5 4 3 2 1 0

Source: London Stock Exchange

Northern Rock was a former building society that, having de-mutualised to become a commercial bank in 1997, began to expand rapidly. The business was led by CEO Adam Applegarth whose ambitious plans for the bank but flawed business model ultimately led to its downfall. One of the key issues was that the Northern Rock relied heavily for its funding by borrowing money from the wholesale money markets rather than by attracting deposits from savers. Indeed around three-quarters of total funding came from borrowing whilst only a quarter of funding came from deposits. This was justified on grounds of cost - it was cheaper for the Rock to borrow from the money markets than it was to offer attractive rates of interest to savers. By 2006, Northern Rock had captured 7 percent of the U.K. mortgage market and in the first half of 2007 such was the pace of expansion that it accounted for almost 10 percent of gross mortgage lending in the U.K. Then came the credit crunch - beginning in August 2007 when growing concerns about exposure to US sub-prime mortgage assets led international wholesale markets including those in the UK to seize up. Northern Rock came under pressure, as suddenly the supply of loan finance on which it depended simply dried up. It applied to the Bank of England for emergency 'lender of last resort' help and news of the bank's financial difficulties led to a surge in depositors queuing outside Northern Rock branches asking for their money back the first run on a bank since the late 19th century. Northern Rock's share price halved within the space of a few days and continued to decline. The run was stopped only when the Chancellor Alistair Darling, on September 17, announced arrangements to guarantee all existing deposits in Northern Rock. On November 16, the chief executive resigned. There then followed several months whilst the Rock sought salvation from a private sector buyer but no agreement could be finalised. On February 17, 2008, the Chancellor announced that Northern Rock would be taken into temporary public ownership - the Northern Rock was to be nationalised. Source: Tutor2u Economics Blog