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The Credit Crunch Uncovered

15 Sep 2011

The crisis escalates

When it became known that the massive American sub-prime loans were pretty much worthless, the fabric of global lending began to collapse in chaos as the inter-bank markets, the forum where banks lend to each other, became increasingly nervous about sub-prime lending. This caused credit markets to freeze over as banks with any signs of vulnerability could no longer access finance to plug the gaps. The European Central bank reacted quickly, and offered £69bn in short term loans with mortgage loans as security. The US Federal Reserve decided to follow the ECB and offered £15bn on day one of the meltdown, which helped to avoid a crash in the US. Mervyn King, Governor of the Bank of England, on the other hand, chose not to act as he believed the current systems in place would take care of the problem. In the UK, banks would have to pay penalties for lending, and would have to lend at high interest rates to get themselves out of trouble. This proved to exacerbate the problem.

Problems started to appear first at the UK’s most aggressive lenders, such as Northern Rock, which had grown from a periphery lender to eventually take 2% of the complete new mortgage market in June 2007. When markets felt the pinch, it was those that had been most aggressive, which would be first to find it hard to raise funding to get out of difficulty. Because of its strategy, Northern Rock was viewed with similar suspicion as the doomed sub-prime lenders in the US. Unfortunately, because of the tight controls on lending by the Bank of England, the UK Building Society could not attract low cost, short term bail-out funds like its European and US counterparts.

Instead, after attempts to find a buyer of long term funding, a last resort was chosen by the FSA, Treasury and the Bank of England: a government loan from the Bank of England. Unfortunately, even this didn’t go to plan, as the press got news of the plan and it hit the news headlines before the investors were informed. This caused turmoil with the smaller investors attempting to withdraw funds from the bank.  By September 14, this had become the first recognised ‘run’ on a British bank since the 1860’s. In the end, the only rescue solution for the beleaguered Northern Rock was nationalisation, with £55bn of taxpayers’ money tied up for at least three years. The problems subsequently got even worse for the British government, with more banks and building societies reporting major difficulties.

Another and even bigger shock came when, in March 2008, the US Federal Reserve with the aid of JP Morgan Chase took control of American giant, Bear Stearns. The Federal Reserve was left with no choice as Bear Stearns had $10trn of open trading positions, and closing the bank would have pushed the global banking industry over the edge and into an abyss.

Lessons for business

In an article in Management Today in May 2008, UK City Editor of the Daily Mail Alex Brummer highlights how the late leading economist JK Galbraith “observed that all financial crises are caused by excessive borrowing or leverage” (3). This is an important message for any business.

Other key lessons from the credit crunch revolve around regulation, crisis planning, speed of reaction, foresight, greed, and ignorance of risk. Unfortunately, the last two factors were allowed to run wild and play a disproportionately large role in the events that eventually lead to the credit crunch.

References

(1) David Budworth, “Credit crunch explained”, Times Online, 14 August 2008

(2) IMF, World Economic Outlook, 9 April 2008

(3) Alex Brummer, “Where the Credit Crash came from”, Management Today, May 2008. This Insight Article uses source material from Brummer's article.

 

 

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