The UK Banking Crisis - Essay Example

Evaluate the role of “sub-prime” mortgages in the UK banking crisis of 2008. In addition, discuss what other factors contributed to the crisis. The banking crisis of 2008 in UK could be traced back to many factors such as low real interest rates, a lookout for yield, seemingly excess liquidity and a misconceived faith in financial innovation. All these culminated into an ambience of over-confidence, excessive optimism and suppression of opposing opinions. In the midst of this vulnerable set up, certain banks have invited their own destruction. The British banks’ culture was gradually becoming a risk taking one, progressing to the meltdown witnessed by the nation. The failure resulted not only from the short-sightedness of the banks but also that o the supervisory body which safeguards the public from risk. As on April 2, 2007, nine banks held positions in FTSE 100 all share index and total market capitalisation stood at £316.9 bn comprising the sole biggest part of the index. By April 7, 2008, Northern Rock and Bradford & Bingley had to move out of the index with a capitalization that stood at £245.1 bn and by April 6, 2009 it stood at £138.1 bn. Five out of these nine banks are nationalized at present partly or totally. Several jobs in this sector were lost and unemployment rose as a whole. The credit squeeze had taken toll on the industries and this damage is expected to have long run impacts (House of Commons, 2009).   The Great Moderation preceding the crisis The macroeconomic parameters like inflation and growth seemed to be attractive; the world economy was becoming vulnerable. Huge imbalances in capital were observed in developed countries and emerging nations showed large surpluses.  Attempts were made to intermediate these imbalances and Mervyn King, Governor, Bank of England, felt that the failures in IMF brought about the imbalances in flow of capital between nations which led to low interest rates and pro risk taking attitudes. As fast growing economies in Asia entered the world trading and financial systems, a new big flow of savings began to be generated. The later could be termed as ‘search for yield’. The imbalances grew as a result of some Asian countries’ (China and Japan) responses to the 1998 Asian financial crisis through a policy of pegging their exchange rates and acquiring foreign reserves at an unexpected high rate. As the surpluses increased, the industrial nations framed policies targeted at maintaining sufficient demand to keep inflation at stable rate and reach desired output and employment levels. This stimulated domestic demand, current account deficits and absorbed the surpluses of the Asian nations. This way huge level of savings entered the world economy and as the central banks managed to control inflation rates, nominal interest rates in industrial nations would be lowered. This further triggered the ‘search for yield’ through “a combination of a fall in risk-free returns, and large amount of capital looking for a home in western capital markets which then created a demand for assets offering higher returns”.  Many banks did not consider the fact that only higher risks would initiate higher returns. Hence money was lent on smoother conditions. The asset prices therefore increased further and financial sector’s expansion in size was almost explosive as new instruments were introduced. Banks also lent to other banks apart from extending housing loans to buy fascinating assets innovated by the system. As a result originally risky loans were replicated several times. Balance sheets of the largest banks almost doubled. Thus it may be concluded that the banking crisis of 2008 in UK was a culmination of several associated factors, the most prominent of which was the sub-prime mortgages (House of Commons, 2009).   Role of Sub-prime Mortgages The long boom in the housing market of the UK from 1996-2007 was because of the low level of real interest rates that stood at 2.1% in 2006. Comparing to the increasing demand, the supply of the houses was tight. This was similar for all the countries in the world at that time. The easy availability of loans was prominent at the start of the twenty first century. The early years of the twenty first century witnessed a rise in the activities related to the mortgaging and purchasing of the houses. This period was characterized by a huge increase in the activities related to purchasing, selling and development of houses. There was a huge rise in the valuation of the houses by the end of the twentieth century. This triggered excessive borrowing from banks and financial institutions for investments in the housing sector. At the zenith of the boom period, UK banks even lent “suicide loans” till 120 percent of the house’s value even against self certified income (MacWhirter, 2008). With the rise in demands, the banks offered loans at easier rate without inspecting the credibility of the customers. People with no credential in terms of the repayment were offered loans. There was a huge increase in demand in housing sector. The banks and the other financial institutions even had forwarded unregulated loans at subprime rates in exchange of the mortgage value of the houses. Home loans were extended to people with zero income and asset. These subprime loans were unguarded loans forwarded without verification of the repayment capacity of the individual or institutions. The major banks and insurance agencies even had invested in property market for providing subprime loans. These investments were considered as safe at that time as the prices of the housing sector were at a rapid rise.  It was considered that the mortgage would bring in more profits even in the case of default. However the excess investment in the housing sector and the excess development of the houses led a fall in the valuation of the houses, this led to a series of defaults. The defaulting of the loans became cheaper as compared to the repayments. People had to pay more than the actual valuation of the houses in the market if they were to repay the loan. Therefore it was convenient for the people to choose the easier way that is to default the loans. This series of defaults were triggered in the USA and followed all over the western countries. These defaults led to huge losses for the financial institutions that had invested in the banks for providing loans to the public. This even triggered the bankruptcy of a number of large financial institutions.  When the credit crunch set in the UK, the financial institutions were the most affected. Northern Rock was the primary victim. The Northern Rock used to raise money by a residential mortgage backed securities. With the decrease in the prices of the real estate stock, Northern Rock could not raise any more money. In a sharp response the government nationalized it instantly. The ‘fear stage’ of the behavioral model was initiated in the UK economy with Northern Rock being nationalized. The experience of the Northern Rock underlined the fact that the economy of the UK was not regulated enough to prevent the situation. The banking sector increased the interest rates of the housing loans as a cautionary measure. This resulted in the decrease of the mortgage loans by 43% in 2008 as compared to 2007. (Ball, October, 2008) Suddenly, the banks and the financial institutions found themselves at a position where they were left with a large number of houses at their disposal. The buyers were less interested in them with the gradual decrease in the prices of the houses. The banks and the financial institutions worsened the situation with offering the loans in the package of financial instruments. The UK economy was considered to be a strong one and it was expected the economy would not be influenced by the credit crunch faced by the other nations of the world. “The UK housing market continued to rise despite rising interest rates that had been forecast in November 2006 to rise to a peak of 5.75% by September 2007 as the Bank of England would battle with inflation during 2007.” (Walayat, January 2009; Laperriere, April 2006). However the market behaved otherwise and the cash flows became erratic resulting in financial stringency. The traditional mortgage lenders decreased their interest payments to the savers. A financial downturn prevailed throughout the country with cost cuttings and credit crunch. Many homeowners faced negative equity as the price of their homes fell below the mortgage value. Northern Rock extended credit to around 200,000 of them before the bust period arrived and it had to be nationalised such that the government turned into the highest sub-prime mortgage holder. Hence, Bank of England bailed it out with £50bn and more thereafter. The housing demand kept on falling leading to the crash of the market. The housing prices decreased in an unusual manner both in nominal and real terms. The demand of the housing in the UK fell due to the institutional changes, which came along with the fiscal changes. “It was inevitable that the steady increase in interest rates which began last year would ultimately impact on levels of housing demand right across the market - a trend that has been exacerbated by the seasonal slowdown in activity over the summer.” (Lambert, July 2007). The investments in public housing and sales decreased. There were many microeconomic factors that added to the unsteadiness of the UK markets. These microeconomic factors were affordability and availability of the finances.  Also it was unwise of Bank of England to take the risky mortgage bonds from Northern Rock in exchange of Treasury bonds since the mortgage bonds were of little or no value, else the bank would have sorted them out independently. The main problem came up because of the overvaluation of the house prices by 30 percent and the delusion that prices would continue to rise. The housing bubble can be discussed with the psychological aspects of the market through the above graph, which is an adapted form of the behavioral finance model. The graph below depicts the different stages of the housing bubble and the subsequent crash. Source: Roberts, 2008: 112 The first stage of the bubble is of enthusiasm where the prices in the market are on the rise. There is cautious buying. The general customers take notice of the trend and flocks into the market. During this stage, the prices are always rising and the buying spree of the buyers is present because of the rising prices. The psychology of the buyers is that the prices will continue to rise. In this stage, the lenders in the market tend to lend money at a very low rate of interest. There is no fear on behalf of the lenders as the prices are rising continuously. There is bullish psychology in the market. In the case of the UK, the initial stages of growth in the market were because of the presence of enthusiasm in the market. The bank rates were lower and the customers flocked to get credit from the banks. The mortgage availability from the banks was easier. (Roberts, 2008, p.112) The Greed stage is the extension of the enthusiasm stage. During this period, the prices are on the rise and this attracts more buyers in the market. The prices began to rise and the buyers began to purchase the assets. During this time of the rise of the prices, purchasing the property is termed as a good investment. This inflicts a positive influence on the rise of the purchase of the houses in the market. In the case of the UK market, the period between 2003 and 2007 has been the greed stage. The price of the houses was on the rise during this period. Buyers flocked to the market and this helped in the growth of the market. The prices of the houses have been constantly increasing because of the greed. The Denial stage is the first phase where a breakdown of the economy is expected. In this stage, the market does not accept that the prices of the assets are going down. They are under the view that the prices will rise forever. This stage takes place when most of the prospective customers have been approached and the market has been saturated. The buyers do not want to sell their houses at lower prices and the customers do not want to buy the houses at existing prices. The denial stage gives rise to the fear stage for the customers. The customers have a negative feeling and suspicion about the valuation of the assets. It is during this stage that the customers begin to look for loans in banks with the help of the mortgage of the buildings or other assets. In addition to the down mood of the market, the banks increase the rates of interests on loans. This worsens the fear in the minds of the customers and they become more averse of the property market. (Roberts, 2008, pp.113-114) In the last stage of catapult, the prices of the houses begin to fall. There is a general sentiment among the people that the prices will further dip down in the future. This influences the holders of the properties to sell their houses. This results in a downward spiraling price in the case of houses. (Roberts, 2008, p. 116) The credit crunch, which affected the entire world badly, affected the housing market in UK mainly because “housing is a long-lasting asset that represents a major proportion of the nation’s capital stock and total wealth” (Ball, October 2008, p.28). Huge amounts of loans are taken in order to fund the assets. Reports show that “Dwellings, excluding land, represent 43% of the UK’s net capital stock and 60% of the UK’s asset wealth (which includes land)” (Ball, October 2008, p.28). Most of the major financial institutions in the UK and across the world suffered as a result of the crisis in banking but the level of suffering differed largely. For instance, the balance sheet of Bradford Bingley showed that they funded much of the growth in retail deposits and loans through acquisitions like those of Mortgage Express in 1997, John Charcol Holding Ltd. in 2000 and Aitchison & Colegrave in 2003. Again Royal Bank of Scotland (RBS) has overestimated the economic situation ignoring all warnings from other institutions. RBS’ poor risk management system is also responsible for this exposure to bankruptcy. Thus it has been a combination of internal factors along with external economic factors which contributed to the banking crisis of 2008 in UK. However the period had stirred strong lessons for the banking sector in the world and still comes under the scanner at times. References Ball, M. (October, 2008). The Modern UK Housing Market: Origins and Prospects. National Federation of Property Professionals. Available at: http://docs.google.com/viewer?a=v&q=cache:W__AxxY_bJcJ:www.naea.co.uk/modernukhousing/+modern+housing+market+in+UK&hl=en&gl=in&pid=bl&srcid=ADGEEShDJKNMDxrqk7wte2yRgpNviNHvrfGhbqjdspO5L_hpMqe5ZDs3BYvF441VstlnEWRLzWQt0G1nqNMQV2bZLVmBgDYCyZZb7ykl4qEb2CBpDfFMxpOMhKhfwE9KiTzPdnLGnAnK&sig=AHIEtbSfrgdSFDIfAnGdWlHw7JWaucEP5w (Accessed on June 23, 2010) House of Commons, (2009), Banking Crisis: Dealing with the failure of the UK Banks, available at: http://www.publications.parliament.uk/pa/cm200809/cmselect/cmtreasy/416/416.pdf (accessed on March 7, 2014) Laperriere A. (April 10, 2006). Housing bubble trouble. The Weekly standard .11(28). Available at: http://www.weeklystandard.com/Content/Public/Articles/000/000/012/053ajgwr.asp (Accessed on June 23, 2010) Lambert S. (July 27, 2007). House prices shudder to a halt. Available at: http://www.thisismoney.co.uk/mortgages-and-homes/house-prices/article.html?in_article_id=422798&in_page_id=57 (Accessed on June 22, 2010). MacWhirter, I. (5th June, 2008). Crash: the housing crisis is just beginning. New Statesman. Available at: http://www.newstatesman.com/economy/2008/06/house-prices-housing-british (Accessed on June 23, 2010) Roberts, L. (2008). The Great Housing Bubble. Monterey Cypress LLC. Walayat, N. (2010). UK Interest Rate Forecast 2010 and 2011. The Market Oracle, available at: http://www.marketoracle.co.uk/Article16450.html (accessed on June 29, 2010) Read More