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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.

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Presentation on theme: "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."— Presentation transcript:

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 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 Credit Crunch = shortage of bank credit 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 The question is: How do SAVINGS get turned into INVESTMENT (I) and CONSUMPTION (Cd)? 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

4 The financial sectors 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. Financial institutions and financial intermediation Turning SAVINGS into INVESTMENT Recall the TV show: The Dragons Den

5 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 whos borrowed/lent what) 3) Risk assessment (evaluating the probability of a default on any loan) Financial institutions & Financial intermediation As we will see later, items 2 & 3 (Collating and Risk Assessment) have played a role in the present credit crunch

6 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 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) Other types of Financial institutions: money & debt markets Our focus is on the banking sector & its relationship with the money markets 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 Banking: How SAVINGS get tuned in to SPENDING DEPOSITS: The Banks LIABILITIES £500m LENDING: The Banks ASSETTS Ready Cash (Tills & ATMs) Advances (Loans) Investments £5m £200m £295m £500m To met the daily needs of depositors Note: Ratio of Cash to other Assets is 1% (LIQUIDITY RATIO) Overdrafts to mortgages Treasury bills, Gove Bonds Debentures & others 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. £495m back into the economy!

8 THE AIMS OF BANKS LIQUIDITY:If the liquidity ratio is too high there is less to lend, which means lower profit PROFITABILITYRisky loans are given higher rates of interest rate - they are profitable. But risky borrowers often default. PRUDENCECapital 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. Banking: How SAVINGS get tuned in to SPENDING

9 As lender of last resort Banking: Maintaining liquidity: Banks & the Money Markets Money Markets Bank of England (Supplies £) 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 banks 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). Other Banks (Supply £) REPO £ £ £ A bundle of paper assets

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 depositors 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 couldnt 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 $100,000 Loan $500,000 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. $300,000 $1,500,000 Repayment Combine into one CDO & sell for $750,00 Not a bad return! However, if homeowners, start to default on their mortgages the CDOs return will fall 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

14 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 householders monthly disposable income. As a result many CDOs became worthless –

15 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 CDOs 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. The sub-prime crisis: a case study in banking failure

16 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 CDOson 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 07Share 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 taxpayers 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.


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