The Sub Prime Market - Case Study Example

Introduction International financial markets have been very volatile of late with effects from one country spreading to other parts of the world. A case in hand is the crunch in credit (sub prime loans) markets in November 2007 that all started from Cleveland in the USA that slowed down the US economy, forced banks to incur billions in losses, and latter spread to the UK causing near bankruptcy of Northern Rock in Newcastle that was finally nationalised in February 2008. In this paper, the effect on sub prime loans will be discussed and a closer look on its effects on the US Economy and the Northern Rock will also be looked at. 1. The sub prime market What happened was, banks are known to financed their mortgage lending using customer deposits which of course is a limit to the amount of mortgage lending they can do. But in recent years, banks in a bit to fund additional borrowing, moved to a new model where they sell mortgages on the bond markets which was widely seen as an easier means of funds. But this form of borrowing led to bank abusing that incentive to carefully check mortgages they issued.1 Banks saw the business to be extremely profitable since they could earn a fee for each mortgage they sold and went ahead to urge mortgage brokers to sell more and more of these mortgages. The market soon extended especially as the private sector dramatically expanded its role in the mortgage bond market that was previously dominated by government-sponsored agencies like Freddie Mac. Prices became so high to an extend that if the boom had to continue, many US populations would have been evicted from their homes since the US interest rates too were interestingly high. The fall in housing prices affected the wider economies. The Standard & Poor’s/Case-Schiller index in March 2008 showed that housing prices in the US had fell by 11,4% in January and 8,2% in February 2008.2 Cut in interest rates by the Fed and effects of the cut The slump in credit had caused the US economy enormous problems in 2008. These among others include, In a bit to cushion the US economy from the worst effects of the credit crunch and housing slump due to the sub prime loans, the Fed in January 2008 had to cut down interest rates from 3.5% to 3% for the fifth time since September 18 2007 and today at 2.25%. This was in a bit to encourage consumption among Americans. The economic growth rate had slowed to an annual rate of 0.6% between October and December, half the rate forecast and compared with a brisk 4.9% growth rate in the previous three months due to the credit slump and may further be cut to 1,5%.3 To ward off the pressure of slower economic growth, the Bush Administration and Congress moved ahead to agree on a temporary stimuli package of some $150 billion. Financial markets also felt the effect of the credit slump as many of them made losses. But the cut in interest rates helped the stock markets to make some gains. The US economy had witnessed a recession in January 2008 due to the effects of the credit crunch. Fed had to cut the interest rates so as to ward off the recession, even though the effects of such cuts is that, if the cuts should persists in the future, then there is that likelihood of may be creating another asset boom. The US economy had had to witness a large budget deficit in January 2008 all emanating from the credit slump. Coupled with the cut in interest rates, the value of the US dollar had fallen compared to the Euro. This means that investors will be discouraged especially as the value of their goods exported to the US will become expensive, thereby boosting the American inflation. With the cut in interest rates, the government is discouraging savings and investments. This is because, they will be no difference between saving money in the bank and consuming immediately. People will tend to consume more. The effect here is on the low wage earning group of people especially as they who were used to saving for rainy days will have to spend their hard earned money and in times of crisis, they will now tend to the banks to borrow to meet up with the cost of living. Nationalisation of the Northern Rock The effects of the credit slump did not only end in the USA. It spread abroad and an example of a financial institution that faced the worst effects was the Northern Rock of Newcastle England. Northern Rock all started as a building society on 1 July 1965 as a result of the merger of Northern Counties Permanent Building Society (which was established in 1850) and Rock Building Society (established in 1865), and a number of small local building societies that made an amalgamation of 53 societies went public as a limited company in October 1997. It was listed on the London Stock Exchange and authorised to operate as a financial institution under the Banking Act of 1987. The Northern Rock Foundation, an independent charitable body was also established with objectives to tackle disadvantage people in the North East and Cumbria and to improve quality of life in the North East and Cumbria.4 Northern Rock had established itself not only as the fifth biggest British bank but also as the top securitisation bank in England making £6,1 billion in January 2007 and £10,7 billion in the first half of May 2007 on securitised loans and a pre-tax profit of £627 million in 2006. Northern Rock in actual sense had a policy of financing her loans with cheap wholesale market funds rather than from retail deposits.5 It should be noted here that cheap wholesale market funds are the most risky funds for funding mortgages especially as they are not legally backed by any government actions. When the bubble burst that all started all due to sub prime loans from the USA caused credit markets to slump, it became apparently clear that Northern Rock could no longer meet repayment of the loans she had taken. But there was great need to keep the bank afloat and protect private money saved in the bank. To do this, the bank of England on February 2008, took temporary public ownership of the Northern Rock using some £25 billion ($49billion) of public and taxpayers money guaranteeing The Northern Rock Foundation a minimum income of £15 million per year in 2008, 2009 and 2010.6 What went wrong with Northern Rock? The main problems with Northern Rock were just an all issue of management strategies and management itself. Strategies instituted by Northern Rock since 1997 Northern Rock as already stated had as her main strategy to borrow cheap funds when available on the wholesale market to fund loans made to her customer’s world wide at more attractive rates than her competitors. The problem with wholesale cheap market funds is that, the loans posses the most risky since they do not have any legal backing such as government backing. When credit markets get frozen, such as was the case with the credit slump, this means there will no more funds available on the market leaving the bank vulnerable as she is unable to generate the required money for repayments. Securitisation by all means is a good hedging method especially as the risk of funding is diversified. But pooling the loans from people to put everything in a single bundle to give lenders, may work well only in the market where there is enough money circulate on the market. But when the credit dries off, it becomes a taunting task to raise the money given out to investors especially as they too may have invested the money in other market assets. In this case therefore, it will be of great importance if not all loans are sold in form of securitised loans. Management had failed to take note of all market indicators such as the fall in share price and company profit which was cut from 17% to 15%. In such instances management should have understood that there should be something going on with the world economic system and should tighten credit. But instead management went ahead to issue more loans at lower rates than what it will pay to finance. Another factor that was ignored by the bank was the cut in interest rate by the Bank of England. When interest rates are cut, it instead discourages savings and increases consumption and investment. In such instances investors will obviously run to the market to buy more funds for their investment thereby pushing up the interest rate. Thus giving loans at rates higher than what was on the market was a bad strategy. Northern rock had failed to strictly implement stress tests and create avenues for lending from the Central Bank in case of illiquidity. The bank since it was mostly based in England failed to exploit her Irish outlet to get funds from the European Central Bank due to negligence from management since it thought that the wholesale market was to exist for ever. Stress tests that would have been used to test the faith of the bank in case where the credit market dries up were not strictly implemented. Therefore, it will be prudent for management now to exploit all relevant avenues to tap in cash into the bank should there be a credit crisis and at same time keep a close look at the functioning of her branches. Consequences on the economy and individuals The effects of the credit slump that went right away to affect Northern Rock was a case in hand to create serious problems to shareholders, the government, and the customers. These consequences that come with bank failures can be prevented thus: It had became an issue that either turn Northern Rock into a profit making institution and get the taxpayers money paid back, or fail completely and the assets of the bank be sold to reclaim any money pumped in the bank to save it from collapse. The question now is, will the bank be able to use their competitive advantage on the mortgage market and outplay the other British banks? The advantage here is that Northern Rock can use the fact that depositor’s accounts are backed by the government and attract more deposits from where they can give out loans at more attractive rates than other mortgage institutions on the mortgage market. Given this advantage, the ban can use retail market funds such as deposits and savings from their customers to fund any loans. This is the only way through private individuals who have savings within the bank are sure of getting their funds. Failure to meet this target, will means failure on the part of the bank and many people obviously will loose money. But what happens in case the bank fails to pay back taxpayers money used to bail the bank? This will mean a total failure of Gordon Brown (Prime Minister of Britain), through whom he backed the nationalisation of the bank, especially as elections are already around the corner. This will also mean that, other banks that may find themselves in similar circumstances in the future will not be bailed out by the Bank of England. This will lead to the bank collapsing and individuals loose businesses. This will also lead to a total mistrust of the whole British financial system as people will now try to leave British banks, causing a fall in the value of the Sterling and the whole economy will flop. Conclusion The effects of the sub prime loans are not just an issue that affects one sector of the economy. Its effects are not only in the country in which it all started, but it often spreads from the stronger economies and the hardest felt in most instances are the weak economies. But with the intervention of the central banks pumping more money into the credit sector, stability within the economic system can be achieved. Summary of business and financial activities - During the week, Microsoft made an offered to buy Yahoo for $44.6bn (£22.6bn) which was turned down by Yahoo. But on Thursday April 10th 2008, in a bit to frustrate or get more from Microsoft, Yahoo and Google have announced a two week experimental period in which Google will be able to place ads alongside 3% of search results on Yahoos website. (http://news.bbc.co.uk/2/hi/business/7339864.stm, retrieved on 10-04-2008, at 18,30pm) - April 2nd 2008, Maurizio Prato, Alitalia’s Chairman steps down as the intended Air France-KLM take over bid collapsed. The airline company has been in trouble and risks bankruptcy except they bailed it out. In this move, the government has been trying to sell her 49,9% stake in the airline and saw that the only possible bid that was good for the airline was Air France-KLM bid. The government refused that they hadn’t the 300m euro ($470m; £236m) needed would be an impossibility for the government. The whole deal flawed when on March 31st 2008, major union representing all Alitalia workers refused the offer of 0.10 euros a share from Air France-KLM and walked out. (http://news.bbc.co.uk/2/hi/business/7323064.stm, retrieved on 10-04-2008 at 18,47pm) - March 26th 2008, Tata, Indias biggest vehicle maker, paid $2.3bn (£1.15bn) (about half the amount Ford originally paid for the marques) for Ford’s UK based Jaguar brand and Land Rover after months of negotiations over price and supply relationships. - At a time when the financial market is facing serious turmoil and globalization linking world economies, two world major central banks (the Fed and the European Central Bank) are thinking differently. While the Fed is cutting interest rates to boost the credit markets and consumption, the European Central bank is fighting to stabilise but their inflation rate. But the questions that has to be answered are; is the Fed risking an inflationary spiral in the US to sow seeds of the next bubble in financial markets? Is the ECB underestimating the impact of the crisis and risking killing off a eurozone recovery that could have helped balance a US recession? Or are they both acting judiciously in response to a different mix of economic risks? The simple fact here is that, if both central banks continue thinking differently, the immediate risk is that the competing strategies of the two central banks may result in a currency shock, with a further sharp rise in the euro against the dollar delivering a “knock-out blow to the European economy” and fuelling inflation in the US.7 - Japan’s Financial Group, Mizuho, on Friday April 11th 2008 cut its earnings estimates for the year just end by some $3,9 billion losses in trading made by her brokerage unit (Reuters). References Ralph A. and Krishna G. (2008): Focal distance – why two top central banks are taking different views. Financial Times of 9th April, 2008 The Economists, February 21, 2008 The Economists, October 18, 2007 http://companyinfo.northernrock.co.uk/investorRelations/corporateProfile/, retrieved on 10-04-2008 at 15,55pm http://news.bbc.co.uk/2/hi/business/7312797.stm, retrieved on 10-04-2008 at 14,55pm http://news.bbc.co.uk/2/hi/business/7218055.stm, retrieved on 10-04-2008 at 15,00pm http://news.bbc.co.uk/2/hi/business/7073131.stm, retrieved on 10-04-2008at 14.50pm Read More