1. The 2007 ‘Sub-Prime crisis’ and the current Credit Crunch
David Allen
Senior Lecturer School of Economics
Bristol Business School, UWE
The purpose of this session is to explain:
the background to current credit crunch
the short-term & long-term implications of this credit crunch
the possible impact it will have on your future employment
prospects

2. Credit Crunch = shortage of bank credit
The implications are fairly obvious
If there is less lending
there will be less spending
less spending means less output
less output means higher unemployment
However we need to know WHY it has happened, to then
understand whether this is a short-term problem or a long-term
problem and, to assess whether it will happen again.
This in turn means we have to explain the workings of the
Financial Sector in a modern global economy.

3. The Financial Sector & the Circular flow of Income
FOP = Factors of Production
Y = National Income
Cd = Consumption of Domestically produced Output
O = Domestic Output
E = National Expenditure
J = Injections: I – Investment, G- Government Spending, X- Exports
W = Withdrawals: S – Savings, T- Taxes, M - Imports
The question is:
How do SAVINGS get turned into INVESTMENT (I) and CONSUMPTION (Cd)?

4. Turning SAVINGS into INVESTMENT
Financial institutions and financial intermediation
Turning SAVINGS into INVESTMENT
Recall the TV show:
The Dragon’s Den
The financial sector’s purpose is to turn savings into lending and is known as the process of financial intermediation.
For example; an individual saves money in a bank, the bank then lends this money to borrowers who might use it to buy a car (i.e. Consumption) or, it could lend this money to firms - the firms then benefit by having access to this ‘spare’ cash (SAVINGS), which they will then use to INVEST in their business.

5. 1) Maturity transformation
Financial institutions & Financial intermediation
Besides returning savings back into the circular flow of income financial intermediation has other advantages:
1) Maturity transformation
(where short term saving plans can be turned in to long term loans)
2) Collating
(recording who’s borrowed/lent what)
3) Risk assessment
(evaluating the probability of a default on any loan)
As we will see later, items 2 & 3 (Collating and Risk Assessment)
have played a role in the present credit crunch

6. Other types of Financial institutions: money & debt markets
Our focus is on the banking sector & its relationship with the money markets
CLEARING MONEY MARKETS
BANKS (DEBT MARKETS)
SHORT LOANS * Certificates of deposit
TERM OVER DRAFT * LOCAL AUTH' BILLS
* COMMERCIAL BILLS
* EURO CREDIT
* TREASURY BILLS
(CAPITAL MARKETS) EQUITY MARKET
['GILTS']
LONG Bus’ LOANS * DEBENTURES (FIRMS) * RIGHTS ISSUE
TERM MORTGAGES * EURO BONDS * NEW SHARES
* LOCAL AUTH' BONDS * PREFERENTIAL
* GOVE' BONDS VENTURE CAPITAL
Money & Equity markets
are sub-divided into
Primary Markets (where
new issues are offered)
Secondary Markets (where
existing financial
instruments are offered
for sale)
Items marked * are collectively known as ‘financial instruments’ and all can be sold in the secondary markets if holders require ready cash (i.e. liquidity)

7. Liabilities must equal Assets
Banking: How SAVINGS get tuned in to SPENDING
DEPOSITS:
The Bank’s
LIABILITIES
LENDING:
The Bank’s
ASSETTS
To met the daily
needs of depositors
Note: Ratio of Cash
to other Assets is 1%
(LIQUIDITY RATIO)
Ready Cash
(Tills & ATMs)
£5m
Advances
(Loans)
Overdrafts to
mortgages
£200m
£500m
Treasury bills,
Gove’ Bonds
Debentures
& others
Investments
£295m
£495m
back
into the
economy!
£500m
£500m
Liabilities must equal Assets
How do Banks make a profit?
They charge borrowers a higher rate of interest than they offer to depositors (savers). They also hope that the return on their investments is higher than the rate of interest they pay to depositors.

8. ALL THESE AIMS ARE IN CONFLICT
Banking: How SAVINGS get tuned in to SPENDING
THE AIMS OF BANKS
LIQUIDITY: If the liquidity ratio is too high there is less
to lend, which means lower profit
PROFITABILITY Risky loans are given higher rates of interest rate - they are profitable.
But risky borrowers often default.
PRUDENCE Capital adequacy, the level of unsecured
loans compared to secured loans. Also
banks need to have enough of their own
money (profit) on hand to cover any
defaults on unsecured loans.
ALL THESE AIMS ARE IN CONFLICT
As will be shown later, it was the ‘sub-prime’ crisis of 2007/08 that led to problems with Prudence and Profitability, which ultimately resulted in problems with Liquidity and the resulting credit crunch.

9. Banking: Maintaining liquidity: Banks & the Money Markets
Bank of
England
(Supplies £)
As ‘lender of last resort’
Money
Markets
REPO
REPO
A bundle
of paper assets
Other Banks
(Supply £)
If a bank is short of ready cash (to meet its day today obligations to depositors) it can go to the MONEY MARKETS and enter into a “REPO” aggreement.
‘Repos’ = A sale & repurchase agreement of a bank’s assets (e.g. a bundle of gilts or other INVESTMENTS). The bank that purchases this bundle of ‘instruments’ is making a short-term cash loan. The bank ‘selling’ the ‘repo’ agree to buy the ‘repo’ back on a certain date – usually within 2 weeks. They will be charged a rate of interest (LIBOR).

10. The ‘sub-prime’ crisis: a case study in banking failure
In the UK the ‘crisis broke in August 2007, when Northern
Rock experienced a ‘run on the bank’ the first in the
UK for 140 years!
A ‘run on a bank’ :- where large numbers of
depositors present themselves at a bank
and demand the return of all their savings
– in cash at once !
Problem? The bank does not have the depositor’s
money in cash – they have lent most of it to
borrowers (advances) or used it to make
investments.
To return the depositor's money would mean
either:
a) Foreclosing on the loans they have made.
b) Selling some of their investments (assets) on the secondary money
markets, in the sub-prime crisis, this is where part of the problem lay:
the INVESTMENTS many UK banks (including Northern Rock) made
turned out to be virtually worthless.

11. The ‘sub-prime’ crisis: a case study in banking failure
In the case of Northern Rock, their only (and immediate) solution was to approach the Bank of England as the lender of last resort for a straight loan.
It couldn’t use a ‘repo’ agreement simply because
so many of its Financial Assets where made up
of these worthless investments.
It was press ‘rumours’ that Northern Rock
was approaching the Bank of England that
then lead to the run on the bank.
So where did it all start to go wrong?
And why were so many of these investments
now worthless?

12. The ‘sub-prime’ crisis: a case study in banking failure.
The seeds of the problem lay in the USA mortgage markets
It started with the creation of CDOs:
“Collateralized Debt Obligations”
A consumer gets a mortgage,
the lender (bank) then sells the debt
(the loan) to an investment bank.
The investment bank ‘pools’ loans
with similar risks of default into one
financial instrument (a Bond). Which would be sold in the Money/Debt Markets (world wide)
Technically, these bonds would be
rated as low risk (of default) to high
risk (of default). The ‘return’ on the
bond would come from the repayments on these mortgages and would reflect the level of risk associated with each ‘pool’ of mortgages.
A safe bet?
These CDOs were considered safe ‘bets’ – after all if someone defaulted on their mortgage, the house could be reprocessed and sold (i.e. the were backed by collateral).

13. The ‘sub-prime’ crisis: a case study in banking failure.
Building a CDO
As a rule of thumb you will pay back 3 times the value of
the mortgage over the 20 years of the life of the loan.
Loan
Repayment
However, if
homeowners, start
to default on their
mortgages the CDOs
return will fall
$100,000
$300,000
Combine
into one
CDO &
sell for
$750,00
e.g.
If there are 3 defaults
the CDOs returns
would fall to
$600,000
The market value
of the CDO is now
virtually worthless
Not a
bad
‘return’!
$500,000
$1,500,000

14. As a result many CDOs became worthless –
The ‘sub-prime’ crisis: a case study in banking failure
Many US householders have defaulted on their mortgages - in large numbers.
Why so many defaults?
Many of the provincial mortgage lenders where lending money irresponsibly (they were seduced by profits rather than being prudent ).
They were granting mortgages to people who could not afford to keep up the repayments (let alone pay off the principal sum). In some cases the repayments represented 80% of the householder’s monthly disposable income.
As a result many CDOs
became worthless –

15. The mix of low and high risk mortgages
The ‘sub-prime’ crisis: a case study in banking failure
Other Problems?
For the Investment Banks the problem was then of trying to track back and find out which CDOs included mortgages that had defaulted (i.e. the process of collating has turned out to be rather shoddy).
Another problem?
The mix of low and high risk mortgages
was incorrect, making any assessment
of a CDO’s value difficult and uncertain.
Why did this happen?
Risk assessment agencies
(and mortgage lenders) were sloppy in
their work or, to say the least; they were
‘over optimistic’ on peoples’ ability to
service their loans.

16. The ‘sub-prime’ crisis: a case study in banking failure
For the FINANCIAL SECTOR
Two major outcomes from the sup-prime crisis
1) The high level of defaults saw returns on these CDOs fall – greatly reducing the value (the price) an investor would offer if invited to buy the bond on the secondary money markets
2) The uncertainty over the mix of risk further reduced the value of CDO’s on the money markets
The Implications for the FINANCAL SECTOR?
a) Bank balance sheets would not balance; their assets would be lower than their liabilities. As a result many banks have had to ‘write down’ their asset values and seek additional capital from existing shareholders or seek new investors to pump money into the bank to restore their balance sheets.
B) CDOs were of such indeterminate value they could not be used in any type of ‘repo’ / ’reverse repo’ arrangement with other - arrangements that could then assist the banks in maintaining their daily liquidity (there was a credit crunch!).

17. The ‘sub-prime’ crisis: a case study in banking failure
Banks ‘Taking a hit’ Dec 07
Share Prices of Banks since March 07

18. The ‘sub-prime’ crisis: a case study in banking failure
The overall ‘fall out’ of the sub – prime crisis?
Short – Term
i) Central banks (e.g. the ‘Fed’, the Bank of England, and the
European Central Bank) have had to pump taxpayer’s money
into the banking system to maintain liquidity and to restore
confidence in the banking system.
ii) In the UK banks have had a ‘wake up call’ on the way
they lend money, they are more ‘risk averse’ result:
credit – crunch;
- business are finding it harder to get loans
- many consumers have seen their credit limits reduced significantly
- home buyers are now having put down sizable deposits
More Long term?
In order to restore their balance sheets many of the US and UK banks
have approached ‘Sovereign Funds’ . Sovereign funds have been
around for a while but they are a relatively new phenomena.
Basically, these are investment trust that are owned by a national
government, notably the state governments of many Arab nations
(e.g. Kuwait, Oman), but include China, Russia, Norway, Singapore, Brunei

19. The ‘sub-prime’ crisis: a case study in banking failure
The overall ‘fall out’ of the sub – prime crisis?
From your perspective?
Things have significantly changed –
the impact is likely to be quite long term ( 5- 6 years)
You will find it harder to get a loan or credit
You will have to start saving – NOW
if you want to buy a home in the future
Job prospects in the financial markets less assured
Likewise job prospects in industries whose products
are sold using a lot of credit will be less assured

20. The ‘sub-prime’ crisis: a case study in banking failure
The question is will it happen again?
Probably, because banks know that the central banks will ALWAYS step in to restore confidence. Put another way, they know the taxpayer will always bail them out when they make the wrong lending decisions.