8.

Understanding the 2008 banking crisis and credit crunch

In 2008 there was global banking crisis which then led into a credit crunch
and, for some countries, recession. This section looks at the causes of the
banking crisis and the knock-on effects mentioned.

8.1 Contributory factors

Contributory factor 1: US sub-prime mortgage lending

In 2001 the US faced recession, due partly to the events of 9/11 and the Dot
com bubble burst, so the US government was keen to stimulate growth. As
part of this in 2003 the Federal Reserve responded by cutting interest rates
to 1°/o - their lowest level for a long time.
/-
winterest rates encouraged -- ---------
l.O . A h . people to buy h
price rise~. s. o~se prices began to ris a ouse, resulting in house
their Iendin~ cnter_1a and tried to capitalise, mortgage companies relaxed
jhiS boom in credit was also fuelled by U~ on the booming property market
to grant _mo~gages to people who, under n;overnme~t pressure on lender~
a very high nsk of default. These wer th rmal banking criteria, presented
with, many borrowers taking out ad· e e so called 'sub-prime mortgages'
affordable for the first two years. JUS!able rate mortgages that were '

ihis 'sub-pr_ime market' expanded ve .

rnortgages in the US ~ere sub-prim ryBquickly and by 2005, one in five
prices were continuing to rise so if e. anks felt protected because house
recover its loan. someone defaulted the bank would

In 2006 inflationary pressures in the US .

Normally 4% interest rates are n t . caused interest rates to rise to 4%.
O
taken out large mortgage pay tarti?u!arly high but, because many had
ayments unaffordable Al men s, this increase made the mortgage
P . so many homeowners w . tO th d f
their
. 'introductory
. . rt offers' an aced much higher payments. This led to an o
d f . ere coming e en
increase in mo gage defaults.

As mortgage _defaults increased the boom in house prices came to an end

and house prices started falling. In some areas the problem was even worse
as ~here had been a boom in building of new homes which occurred right up
until 2007. It meant that demand fell as supply was increasing causing
prices to collapse, meaning that banks were no longer able to recover loans
when borrowers defaulted. In many cases they were only ending up with a
fraction of the house value. ·

Contributory factor 2: 'CollateraHsed debt obligations' or CDOs.

Normally if a borrower defaults it is the lending bank or building society that

suffers the loss. As a result they are very diligent to verify the credit
worthiness of potential borrowers and whether they have the income and
security to repay loans. However, in the US mortgage lenders were able
effectively to sell on mortgage debt in the form of CDOs to other banks and
financial institutions. This was a kind of insurance for the mortgage
companies. It means that other banks and financial institutions shared the
risk of these sub-prime mortgages.

Using the income from their mortgage book as security, banks sold COO
bonds with a three-tier structure:

(1) Tier 1 was "senio~' or "investment grade" and supposed to be very low
risk but with a low return.
(2) Tier 2 was the "mezzanine tranche" and had medium risk and return
(3) Tier 3 was the "equity tranche" and had highest risk and return.
~r stem .:'. . _ _ _ _ _ _ __ __
·-
As money was received on mortgages, it was used to pay the Tier b
--
1
holders their inte~est fi rst, then Tier 2 and fi~ally Tier 3, so if borrowers oncJ
defaulted, then Tier 3 holders would suffer first and so on, like a waterfa/
effect. I

Unfortun ately losses were so great that Tier 3 and Tier 2 and in some
Tier 1 investors were affected. At the very least, the value of Tier 1 bon~ases
due to the perceived risks. s fell

Contributory factor 3: Debt rating organisations

The COO bonds were credit-rated for risk, just like any other bond issues
.Maybe because these sub-prime mortgage debts were bought by ·
'responsible' banks like Morgan Stanley and Lehman Brothers, or maybe
because they didn't fully understand the COO structures, risk agencies gave
risky Tier 1 debt bundles AAA safety ratings. Normally AAA would denote
extremely low risk investments.

This encouraged many banks and financial institutions to buy them, not
realising how risky their financial position was. The trillions of dollars of sub-
. prime mortgages issued in the US had thus become distributed across the
global markets ending up as CDOs on the balance sheets of many banks
around the world.

Many commentators have seen this factor as an example of a regulatory

failure within the financial system.

Contributory factor 4: Banks' financial structure

Unlike most other commercial enterprises, banks are very highly geared
with typically less than 10% of their asset value covered by equity. A.drastic
loss of asset value can soon wipe out a bank's equity account and it was
this ri°sk which led some banks to start selling their asset-backed securities
on to the market.

.However, the sellers in this restricted market could not find buyers; as a
result, the values at which these "toxic assets" could be sold plummeted and
many banks around the world found themselves in a position with negative
equity.

Contributory factor 5: Credit default swaps

As an alternative (or addition) to using COOs, the mortgage lenders could

buy insurance on sub-prime debt through credit default swaps or COSs.

F example AIG wrote $440bn and Lehman Brothers more than $700bn-
w~~h of CDSs. These were the first institutions to suffer when the level of
defaults started to increase.

Warren Buffett called them "financial weapons of mass destruction"

s.2 Implications and consequences

Implication 1: The collapse of major financial institutions

Some very large financial institutions went bust and oth t. t .

d ers go in o serious
d
trou bl e an nee ed to be rescued. For example,

• In September . 2008 Lehman Brothers went bust . Th'Is was th e b'Iggest

k
ban _ru~tcy in _co~porate hiStory. It was 10 times the size of Enron and
the tippin~ poin_t into the global crash, provoking panic in an already
battered financial system, freezing short-term lending and marking the
start of the liquidity crisis. '
• Also in September 2008 the US government put together a bail out
package for AIG. The initial loan was for $85bn but the total value of this
package has been estimated at between 150 and 182 billion dollars.
• In the UK the Bank of England lent Northern Rock £27 billion after its
collapse in 2007.

Implication 2: The credit crunch

Banks usually rely on lending to each other to conduct every-day business.

But, after the first wave of credit losses, banks could no longer raise
sufficient finance. ·

For example, in the UK, the Northern Rock was particularly exposed to
money markets. It had relied on borrowing money on the money markets to
fund its daily business. In 2007, it simply couldn't raise enough money on the
financial markets and eventually had to be nationalised by the UK
government.

In addition to bad debts, the other problem was one of confidence. Because
many banks had lost money and had a deterioration in their balance sheets,
they couldn't afford to lend to other banks. Even banks that had stayed free
of the problem began to suspect the credit worthiness of other banks and,
as a result became reluctant to lend on the inter-bank market.
I

The knock on effect was that banks became reluctant to lend to anyone,
causing a shortage of liquidity in money markets. This made it difficult for
firms to borrow to finance expansion plans as well as hitting the housing
market.

Many companies use short-term finance rather than long-term. For example,
rather than borrowing for, say 10 years, a company might take out a two-
year loan, with a view to taking out another two-year loan to replace the first,
and so on. The main reason for using this system of "revolving credit" is that
it should be cheaper - shorter-term interest rates are generally lower than
longer-term. The credit crunch meant that these firms could not refinance
their loans causing major problems.
 Implication 3: Government intervention

~a~y ~overnments felt compelled to intervene, not just to prop up major

rnstitu~rons (e.g. Northern Rock and AIG mentioned above) but also to inject
funds rnto the money markets to boost and stimulate liquidity.

Efforts to save major institutions involved a mixture of loans, guarantees and

the purchase of equity. For example, in 2008/9 the UK government invested
£45.Sbn in the Royal Bank of Scotland, ending up with an 82% stake.

Usually, central banks try to raise the amount of lending and activity in the
economy indirectly, by cutting interest rates. Lower interest rates encourage
people to spend, not save. But when interest rates can go no lower, a central
bank's only option is to pump money into the economy directly. That is
quantitative easing (QE). The way the central bank does this is by buying
assets - usually financial assets such as government and corporate bonds -
using money it has simply created out of thin air. The institutions selling
those assets (either commercial banks or other financial businesses such
as insurance companies) will then have "new" money in their accounts,
, which then boosts the money supply.

By March 2012 the UK Government had injected £325bn into the financial
system through quantitative easing.

The end result was that many governments found themselves with huge
levels of debt with the corresponding need to repay high levels of interest as
well as repay the debt.

Implication 4: Recession and "austerity measures"

The events described above resulted in a recession in many countries.

Despite the falling tax revenues that accompany this, some governments
would normally try to increase government spending as one measure to
boost aggregate demand to stimulate the economy.

However, the high levels of national debt have resulted in governments

doing the opposite and making major cuts in public spending. This is partly
to be able to reduce the level of debt but also because of fears over credit
ratings. If the rating agencies fear that a country will default on its debt, then
its credit rating will be downgraded resulting in higher costs for future debt.
implication 5: Problems refinancing government debt

In 2010/2011 some countries tried to refinance national debt by issuing

bonds:

• A problem facing the Spanish government at the end of 2010/2011 was

the need to raise new borrowing as other government debt reached
maturity. Spain successfully sold new bonds totalling nearly €3bn on
12/1 /11 in what was seen as a major test of Europe's chances of
containing the debt crisis gripping parts of the region. This was in
addition to the Spanish government cutting spending by tens of billions
of euros, including cuts in public sector salaries, public investment and
social spending, along with tax hikes and a pension freeze.
• The problem of refinancing is more severe for countries whose national
debt has a short average redemption period (Greece is about 4yrs) but
much less of a problem where the debt is long dated (e.g. the UK where
the average maturity is about 14 years).

For others they needed help from other countries and the IMF.

• Greece received a €110bn rescue package in May 2010

• At the end of 2010 Ireland received a bailout from the EU, the_uK and
the IMF. The total cost is still being debated but could be as high as
€85bn.
• In May 2011 Portugal received a bailout of €78bn .

For many, th.Is was compounded by seeing their national debt downgraded
by credit rating agencies:

• For examp Ie, on 20 September 2011, Italy had its debt rating cut by
Standard & Poor's, to A from A+.

. . 6·• The Eurozone crisis and fears over "contagion"

Implication

. nments trying to boost their economies while

The above ,~sues of gohver been particularly visible within the Eurozone.
reducing national debt ave .
This is due to a number of factors.

. mana e their own economies, governments of

• As well as t~1~g Euro;one are committed (at least in theory) to
countries _w,_thm
staying w1th1n thet ru Ies of the Eurozone - for example, that debt should
not exceed 60% of GDP.
 • Concerns over the possibility of Greece defaulting on its loans have
resulted in Eurozone ministers insisting on even greater austerity
measures before they will release further funds . At one point
commentators wondered whether Greece would vote to stop being Par
of the Eurozone. The cost of Greece dropping out of the Eurozone was
estimated at over one trillion euros.
• Credit rating agencies have been concerned about "contagion" - i.e. the
possibility of problems in countries such as Greece spreading
throughout the Eurozone, possibly resulting in the collapse of the Euro
as a major currency. For example, on 13 January 2012, credit rating
agency Standard & Poor's downgraded France and eight other
Eurozone countries, blaming the failure of Eurozone leaders to deal with
the debt crisis.
• By February 2013 ongoing fears over a continuing recession led to the
credit rating agency Moody's downgrading the UK's rating from AM to
AA+.