The Credit Crunch in the United Kingdom - Case Study Example

The Credit Crunch in the United Kingdom: The Good, the Bad, and the Ugly One fall day in 2008 it was if the world had stopped turning as economies around the world ground to a halt and the flowing taps of credit dried up faster than a beer at a NASCAR race. It was if suddenly, and with no warning, all of the liquidity in the worlds market has simply just vanished with no reasonable explanation. Treasury secretaries and finance ministers worked late into the night looking for a way to grease the wheels of commerce and get the credit flowing again. The greatest economic minds in the world were at a loss to explain the crisis to the public as they stood like a herd of deer staring into the headlights of deregulation. The US seemed to have the biggest problems, if only by the sheer magnitude of their economy and its impact on other nations around the world. Still, Great Britain felt the shock and their economy suffers many of the same ills as the system has stagnated with the same symptoms. Though the political leaders portrayed the problem as an emergency that suddenly erupted, it was actually the culmination of years of under-regulation, neglect, abuse, and corruption. The credit crisis in the United Kingdom has come about as a result of over-extended consumer credit and a banking system that has exploited the concept of free market economics. To understand the vulnerabilities in the global banking system it is helpful to understand some of the history that got it where it is today. Six hundred years ago the population of England was largely agrarian and lived as subsistence farmers. Wages earned came almost exclusively from farm labor and were very sensitive to the law of supply and demand. When times were good, the population rose and the labor supply increased. This drove down farm wages and the resulting poverty would decimate the population. As the labor supply fell, wages increased again and the cycle repeated. In fact, the real wages earned in 1740 were the same as the wages earned in 1400 (Khan 10). However, the Industrial Revolution created a larger demand for labor and created concentrated centers of capital. Technological advancements contributed to the growing economy and real wages have risen by approximately 2200 percent in the 200 years since the turn of the 19th century (Khan 10). The escalating wage scale and the concentrated capital resulted in an economy that was ever more dependent upon credit and increasingly demanding consumer goods. According to Khan, "in the 19th century, a steady rise in living standards began that has, in some sense, never ceased. As a result, people are now accustomed to economic growth" (9). This cultural attitude of consumerism led to the concepts of easy consumer credit, sub prime loans, and the complex system of banking instruments that were at the foundation of the UKs current credit crisis. The credit crisis that suddenly came to a head in the fall of 2008 was not as unexpected as it was portrayed. Warning signs had been apparent for years as bankers favored greed and not heed. In the Spring of 2004 Cohn reported that "Thanks to easier credit terms and rock-bottom interest rates, unsecured debt in Britain is soaring, refinancings of home mortgages are way up, and more piggy banks are being cracked as the savings rate falls". This easy credit and mortgage refinancing resulted in speculators entering the real estate market in record numbers. People were refinancing their primary residence to purchase a second home as an investment in light of the soaring real estate prices. A house purchased for 100,000 pounds in 2000 would have been worth 180,000 pounds in 2004 (Cohn). This scheme worked well as long as prices continued to rise. Mortgage debt rose by 30 percent from 2000 to 2003 and hit a record $1.3 trillion. The more profits that the speculators made, the more that was put back in the market and the cycle of demand and escalating prices continued. Along with the high mortgage credit, consumers were also running up record levels of unsecured credit card debt. According to Steve Rhode, president of Myvesta.org, a non-profit, debt-relief group, "The UK has adopted the American habit of credit with vigor, and consequently consumers are rapidly getting in over their heads" (qtd. in "Credit Card Debt"). By 2004, the debt to income ratio had more than doubled in the past 10 years, and some economists began to warn that, "the easy credit party could be called off if interest rates jump, if the housing market cools, or if personal income levels dip" (Cohn). During 2007 and 2008, the housing market did cool off significantly and the in many areas the bottom simply dropped out. The hardest hit areas were in the locations that were most favored by speculators. They had created an unrealistic demand for housing that did not exist when the prices began to fall. With no real demand from primary homeowners, houses were left vacant with mortgages that far exceeded the new, and lower value of the property. If falling real estate prices had been the only variable, the economy could have probably withstood it without much fanfare. In most cases, the speculators would have credit worthy enough to stand the loss and there would have been a minimal impact on the banking system. Shiller blames the crisis on the public that was too eager to make a profit and their "irrational public enthusiasm for housing investments" (4). However, along with the real estate bubble were the numerous banking instruments that had collateralized and marketed these loans. The banking industry likes to refer to these as creative financing instruments, but a better term might be Las Vegas style gambling or simply bank fraud. One of the creative financing methods that was introduced in the recent decades was the sub-prime loan. This was a loan that had an interest rate set according to the borrowers credit rating, and the greater the risk, the higher the interest rate. These loans have been roundly criticized as being "built on straw: cheap housing loans to the poor, funded not through the deposits of bank customers, but by reckless forays into the bond market" ("Foolish bankers, scared politicians" 4). These high-risk loans were moneymakers for the banks that originated them and there seemed to be no limit to their greed. Bankers would violate banking ethics, disregard banking policy, and abandon all good business sense to have the opportunity to make one more loan. As an example, David Bradbury, despite living on benefits and being in poor health, was given a 25-year, 55,000 pound mortgage to buy a home (Wallop). This case was multiplied by thousands as loan originators falsified documents, inflated incomes, and used fake collateral with the belief that prices would just keep rising, or the hope that they would get out before they fell. However, by 2005 the number of people filing for bankruptcy in England and Wales had increased almost 50 percent over the previous year ("Credit Card Debt"). By 2007, the market was in disarray and the rumblings of the coming crash could be heard. During a 3-month period in 2007, almost 5,000 sub-prime loans defaulted in the UK, and accounted for 70 percent of all property repossessions (Wallop). Houses that were worth less than their mortgage, were under-collateralized, and in bankruptcy were left abandoned by the thousands, with the banking system left holding hundreds of billions of dollars in bad loans. The risky sub-prime loans had been packaged with other and more conventional loans and found their way into the banking system around the world. Isolating these loans and attempting some form of pre-emptive damage control was as complex as trying to get the color out of the kool-aid. They spread like a virus and infected banks all around the world, from the US to Iceland. Companies that had insured these high-risk loans began to feel the pressure as prices fell further and they were left with nearly worthless collateral. To combat this problem, the banking industry had one more creative financing instrument. Known as the Credit Default Swap, it is as close to Las Vegas as a banker can get with the customers money. Credit swaps are a form of insurance that acts as a bet that the house will go into default. As a means of protection, banks holding these bad loans would purchase a credit swap. If the house went into default, the Credit Default Note holder would pay them. In essence, it was like making a bet that the house would go into default. However, these could be purchased by anyone and speculators began to bet that houses would go into default. If a loan failed, they would win. In fact, this added even more uncertainty and instability to the market as "doubts form about a companys soundness; creditors want more protection, so they try to buy credit default swaps; sellers of swaps engage in short-selling to hedge their own exposure; the companys stock and bond prices lose value; creditors get even more worried" (Kling). The banking system had reached the bottom of the trick bag and the house of cards began to cave in. The impact on the UK has been severe, as the government has moved to confront the situation in the face of worsening conditions. The UK has a banking system that is similar to the US and as a result has suffered many of the same problems. The UK has experienced several bank failures and the cost of maintaining their financial credibility has been enormous. To stem the rising tide of money needed to bail out the banking system, the UK has taken the historical step of semi-nationalizing eight of their largest and most prestigious banking institutions (Dodge). Individuals and organizations that have deposits held in international banks are left in a world of uncertainty that borders on panic. Over 100 local governments and municipalities in the UK have invested their tax base in Icelandic banks that have suddenly come into a shortage of liquidity, and their combined losses could top $1 billion (Dodge). The domino effect has reached around the globe and the mismanagement of the banking system has become a cancer on the international ability to conduct trade and business. The political reaction to the crisis has been at best uncertainty and at the worst indifference. While the US is instrumental in providing a solution for the global problem, Bush has been almost non-existent on the international stage. George Bush has promised to maintain the same free market, and non-regulating policies, that created the lack of oversight in the banking industry and allowed the problem to worsen ("The President’s News Conference" 530). Meanwhile, the growth rate in the UK is slowing and "Britain may avoid recession but the economy will not expand speedily enough to prevent the unemployment rate – which is at unthreatening levels – edging upwards" (Brummer 25). In any event, all indications are that the problem will continue to worsen in 2009 before the economy begins to turn around. In conclusion, our modern society is dependent on a central banking system and a credit based economy. Mass consumerism fuels our economy and relies on credit to keep it flowing. However, under-regulation and a lack of responsible oversight of the banking industry have allowed greed and corruption to impair the proper function of the banking system. Creative instruments, in many cases, are simply new ways for bankers to make more money by taking higher risks. However, it is not their money at risk. In the end it is the consumer and the taxpayer that foots the bill for someone elses bad decision. As the economy begins to turnaround, the government of both the UK and the US need to take a firm look at the banking industry and restore it to the role that it traditionally played in making the two economies some of the most vital on earth. Works Cited Brummer, Alex. "Is This the Return of Stagflation?" New Statesman 137.4903 (2008): 25. Academic Search Premier. 9 Dec. 2008. Cohn, Laura. "Getting Into the Swing of Plastic." Business Week 2 Feb. 2004. Academic Search Premier. 9 Dec. 2008. "Credit Card Debt Catches up With Britons." USA Today 22 Dec. 2005. Academic Search Premier. 9 Dec. 2008. Dodge, Andrew I. "Financial Crisis Has Odd Effects in UK." Pajamas Media. 22 Oct. 2008. Pajamas Media. 9 Dec. 2008 . "Foolish bankers, scared politicians and a crisis of their making." New Statesman 137.4881 (2008): 4. Academic Search Premier. 9 Dec. 2008. Khan, Aubhik. "The Industrial Revolution and the Demographic Transition." Review (Federal Reserve Bank of Philadelphia) Q1 (2008): 9-15. Academic Search Premier. 8 Dec. 2008. Kling, Arnold. Credit Default Swaps. 3 Oct. 2008. Liberty Fund. 9 Dec. 2008 . Shiller, R J. The Subprime Solution. Princeton, NJ: Princeton University Press, 2008. "The President’s News Conference With Prime Minister Gordon Brown of the United Kingdom." Weekly Compilation of Presidential Documents 44.15 (2008): 529-36. Wallop, Harry. "Sub-prime Loans Blamed for 7,000 Lost Homes." The Telegraph 8 Oct. 2007 [London]. 9 Dec. 2008 . Read More