Financial Institutions & Markets Events in the Banking System in 2008-2009 - Case Study Example

Financial s & Markets – a critical review of events in the Banking System in 2008-2009 Financial s cater to the needs of different types of customers by providing relevant financial services. Financial institutions worldwide have been affected by the adverse market environment created by the US sub prime fiasco. Trouble began when the financial companies started relying too much on the innovation in the blind faith that it will yield returns. As it is common knowledge that banking industry has suffered the most due to the current meltdown, the symptoms of the malaise started emerging in the US mortgage business first. The cracks appeared in the banking system three years back. Housing prices, according to Financial World (2008) started falling in the year 2005. Initial symptom appeared in the market for sub prime residential mortgage-supported securities as investment demand shrank in 2006. In February 2007, auctions to finalise rates on ARS instruments failed because of decreasing investor demand. The same time, HSBC declared write-downs of $10.6bn on bad debts in US business. Cracks in financial market became wide open in June 2007 with the failure to meet the lenders’ call on Collateralised Debt Obligations (CDOs) by two Bear Stearns hedge funds for subprime loans. Let’s try to comprehend what happened. The recessionary trends as per BBC News (2007) that the banking industry is bearing appeared with the sub prime lending to home borrowers. The mortgage brokers were inspired to sell loans in the sub prime sector as hectic activity was taking place in the economy. The sub prime crisis started from Cleveland where loans in huge amount were cleared without verifying income and documents by the mortgage brokers. Refinancing was permitted with the condition that new sub prime mortgage would start after two years at double the prevailing interest rates. The crisis deepened when the whole of America came in its hold as property prices skyrocketed because of increase in demand for owning property through mortgage brokers and refinancing. After a reset period of two years, interest rates went higher as Fed interest rates also touched a high level, on which sub prime mortgage interests were based. Housing prices started declining sharply after the boom period. A wave of repossessions was behind this trend. Banks started taking precautionary measures, cutting back on credit to cover risks to their investments. Being forced to dry up the whole sale bond market and their balance sheets from the adverse affects, banks started shrinking their portfolio. The Pension Funds have suffered the severe losses being the prime purchasers of sub prime mortgage bonds. As the banks have hidden their holdings of sub prime mortgages in off-balance sheet instruments such as “structured investment vehicles” or SIV’s, they are reluctant to bear the losses. Causes of crisis, according to the HSBC Holdings plc (2008) were complex and inter-related. A number of reasons include global financial imbalance that was created by speeding transfer of global economy towards emerging markets. It was the macro economic triangle of consumer nations, producing nations and resource providers that opened the doors of high growth rate. It resulted in financial imbalance in consumer markets like America where deficit of liquidity was immensely felt. Second reason of the US economy taking a wrong turn was that the producing and resource providing countries had plenty of cheap credit, which they invested in US dollar. It created a boom in consumer market and fuelled the housing market. As mortgage market didn’t follow stringent rules while sanctioning home loan in America and in some of the emerging markets, it deepened the crisis further. Another reason was complex structure of securitisation. Behaviour of securities as financial instruments got beyond the comprehension of investors as well as senior bankers. Another cause of crisis was over dependence on wholesale funding, which the banks assumed that would be ever available. Their assumption proved wrong because with the collapse of securitisation market, assets’ market value came down sharply, creating losses on the balance sheet’s asset side and funding became a liability. Pressure on the banking system according to Credit Action (2008) was further deepening the crack, which was visible on a number of financial products, as per the Bank of England’s October Financial Stability Report: “Pressures on the UK banking system have been arguably as severe as at any time since the beginning of the First World War”. Total expected losses from the crisis were $2.8 trillion (£1.8 trillion) – with $1.58 trillion lost in the US and £122.6 billion in the UK. By the end of October 2008, if we talk about total UK personal debt, credit card debt that included motor and retail finance deals, overdrafts and unsecured personal loans, had reached to £4,911 per average UK adult. Total credit card debt in October 2008 was £53.1bn. Otherwise the collective credit limit on credit cards is £158bn, which on an average comes to £5,129 per person. The level of credit card debt has risen to 19% since 2007 (Debt Facts & Figures 2008). Figures on average mortgage due for 11.7m households, stood at ~ £103,903. According to the November Inflation report of the Bank of England, recession in the economy started in the 2nd half of 2008. In the year 2008, GDP was down by 0.5% in comparison to the 2nd quarter; it was since 1992 the first quarter of falling output. It is estimated by the Bank of England that the negative growth is going to affect the economy of the UK the whole year of 2009. The International Monetary Fund has also predicted contraction in output by 0.3% in developed economies for the year 2009. It is a first such downfall since post-war time. As per IMF, the US economy will contract by 0.7% in 2009 and in the UK; GDP will take a dive of 1.3%, the highest ever estimated downfall in a developed economy. Changes in the UK base rate brought it to a low, registered 53 years back. On 6 November 2008, the official bank rate was minimized by 1.5% to 3.0%, which was the biggest fall since March 1981, over 27 years ago. Likewise downfall in housing, according to the Department for Communities & Local Government, has resulted to 208,583 (£215,342 in England) for an average house by September 2008. Thus, annual house price inflation has fallen by 5.1% in UK, overall a little lower than London, where it has been down by 5.0%. The sub prime crisis (Onado 2008) has affected bank losses to $500 billion and more in waiting. Earlier banks were under the wrong impression by August 2007 that risks being sold outside the banking system, there was no danger to their goodwill; it was proved wrong as first of all, they existed on their books and secondly, it necessitated to take more risks to avoid damages and on top of that, some hidden risks were lying under the carpet of “shadow banking system”, according to the Bank for International Settlements. The Credit boom seen in the last two decades was due to excessively hopeful valuations. Continuous shock waves created deficiency of capital to the limit of insolvency and illiquidity for all big banks. As a result the main central banks had to come to the rescue of Northern Rock, Bear Sterns and others by operating out of way to help them recuperate. Citygroup has published research analysis of the crisis faced by European banking system by figures, which stated two important drawbacks, underlining that total assets increased at a faster pace than risk-carrying assets for which capital hold was mandatory. The other drawback occurred due to decrease in tangible segment of equity. It meant a good part of capital was formed of intangible assets derived from the merger activity within the baking system as shown in the figures. Figure1. Total assets to risk-weighted assets ratio Figure 2. Tangible equity to reported assets ratio The research analysis made it clear that banks benefitted from the excessive credit in the last two decades, which can be seen in the boom in household sector and decision taken by the banking system on capital requirement. Both carriers of the boom suddenly found themselves in reverse gear. It resulted in losses in international banking system due to short supply of credit, which further enlarged the macroeconomic impact of the crisis. The number of personal bankruptcies (Gilmore 2009) had been ever increasing in UK. Borrowers were leaving homes as they were not in a position to repay mortgage instalments. In the year 2008, 40,000 borrowers were evacuated from their homes due to non-payment. In 2007, the number of evicted homes was 25,900, an increase of 54% in 2008 as per the figures of Council of Mortgage Lenders. According to a news release (2008) Northern Rock plc had been provided liquidity support by the Chancellor of the Exchequer, authorising Bank of England to provide liquidity support to Northern Rock against security and an interest rate premium. It was the result of a tripartite statement issued by HM Treasury, Bank of England, and Financial Services Authority on 14 September 2007. Northern Rock has been facing the problem of liquidity since the turmoil began in financial markets. The three organizations, Exchequer, the Bank of England, and the Financial Services Authority unanimously reached the conclusion that Northern Rock is solvent, crossed the regulatory capital needs and possesses a standard loan book. The decision was made to help it gain long tern funding and the mortgage securitization market, on which it highly depended. The UK banking market (Sen 2008) had deteriorated to the extent that government had to come forward to their help as three major banks, Barclays, Lloyds TSB Group and Royal Bank of Scotland Group, have requested capital injection by the government. As per BBC report, the chief executives of the above banks had a meeting with Chancellor of the Exchequer Alistair Darling and requested him to act fast. The meeting was also attended by Bank of England Gov. Mervyn King and Financial Services Authority Chairman Adair Turner as per Bloomberg News. Capital injection to the tune of 45 to 50 billion pounds ($70 billion to $89 billion) was discussed at the meeting. As a result of financial market turbulence (HSBC 2008) it had become difficult to follow prices for structured credit risk as market lacked liquidity. Asset market further deteriorated as financial institutions’ reach to wholesale markets to fund such assets was constrained due to extra load on asset prices. It resulted in decrease in the fair values of asset-supported securities and transactions in sub prime mortgages as well as in other asset classes. Financial institutions took steps to save the market from further deterioration of widening illiquidity and capital write downs by minimising leveraged exposures, create liquidity and arrange extra capital. But results didn’t come as expected because by the 2nd half of the year, economic scenario had aggravated further, increasing unemployment, putting pressure on global financial market. Stock market also felt the jerks throughout the 2nd half, creating wider interest spreads and hindering markets for securitised and structural financial assets. Downfall in the measured fair value of assets backed by sub prime mortgages became recurrent in 2008. All primary market issues showed weakness except US government backed issues. Spreads went on widening and delinquencies rising on underlying mortgages above the levels priced into securitisations issued lately. The deterioration not only flooded the sub prime assets but also measured fair value of securities supported by Alt-a collateral. Governments, central banks and regulators took a number of measures in the year 2008 to stabilise the financial market and generate faith in the working of the system. Through emergency funding, a big amount of money was employed to increase liquidity. Guarantees of the financial assets were extended. Economic engines were put on ‘save’ mode. Financial instruments most affected of the market turmoil were exposures to direct lending held at fair value, mortgage supported securities, collateralised debt securities and possible recovery from monoline insurers for structured credit activities and meant to be distributed leveraged financial deals. Financial institutions raised the transparency levels for investors and stakeholders and provided information beyond the accounting standards, regulatory needs and listing rules. Recommendations of the reports issued by a number of forums, committees and panels like the Financial Stability Forum on ‘Enhancing Market and Institutional Resilience’ (April and October 2008), the Committee of European Banking Supervisors on ‘Banks’ Transparency on Activities and Products Affected by the Recent Market Turmoil’ (June and October 2008) and the International Accounting Standards Board Expert Advisory Panel on ‘Measuring and disclosing the fair value of financial instruments in markets that are no longer active’ (October 2008), were followed by banks. Important information in the interest of investors coming from regulators and stakeholders on the disclosures was taken and considered for the investor’s benefit (pp. 146). One cannot expect instant results in finance market. Derailing of the economy, being worldwide, will take some good time to get back on the track if regulators take precautions and don’t let loose their reins and mistakes are not repeated. References: BBC News. 2007. The downturn in facts and figures: US sub-prime, [Internet] 21 November. Available at: http://news.bbc.co.uk/2/hi/business/7073131.stm [Accessed 13 April 2009]. Creditaction. 2008 Debt Facts and Figures – compiled 1st December 2008, [Internet] 1 December 2008. Available at: http://www.creditaction.org.uk/assets/PDF/statistics/2008/december-2008.pdf [Accessed 13 April 2009]. Financial World. 2008 From bust to boom and back again, [Internet] December 2008. Available at: https://www.financialworld.co.uk/Archive/2008/2008_12dec/Features/timeline/15705-print.cfm [Accessed 13 April 2009]. Gilmore, G. 2009. Personal bankruptcies on increase and borrowers walk away from homes. Times online, [Internet] 21 February. Available at: http://business.timesonline.co.uk/tol/business/economics/article5776483.ece [Accessed 13 April 2009]. HSBC Holdings Plc., 2008. Annual report and accounts ’Strength, diversity and resilience’. [Internet]. HSBC Holdings plc Available at: http://www.hsbc.com/1/PA_1_1_S5/content/assets/investor_relations/hsbc2008ara0.pdf [Accessed 13 April 2009]. News Release. 2007. Liquidity support facility for Northern Rock plc -- tripartite statement by HM Treasury, Bank of England and Financial Services Authority. [Online] 14 September. Available at: http://www.bankofengland.co.uk/publications/news/2007/090.htm [Accessed 13 April 2009]. . Onado, Marco. 2008. Banks’ losses and capital: The new version of the paradox of Achilles and the tortoise [Internet] 19 August. Available at: http://www.voxeu.org/index.php?q=node/1555 [Accessed 13 April 2009]. Sen, Neil. 2008. Report: U.K. banks seek capital injection. The Deal [Internet] 8 October. Available at: http://www.law.com/jsp/article.jsp?id=1202425103498 [Accessed 13 April 2009]. Read More