Presentation on theme: "The 2007 ‘Sub-Prime crisis’ and the current Credit Crunch"— Presentation transcript:
1 The 2007 ‘Sub-Prime crisis’ and the current Credit Crunch David AllenSenior Lecturer School of EconomicsBristol Business School, UWEThe purpose of this session is to explain:the background to current credit crunchthe short-term & long-term implications of this credit crunchthe possible impact it will have on your future employmentprospects
2 Credit Crunch = shortage of bank credit The implications are fairly obviousIf there is less lendingthere will be less spendingless spending means less outputless output means higher unemploymentHowever we need to know WHY it has happened, to thenunderstand whether this is a short-term problem or a long-termproblem and, to assess whether it will happen again.This in turn means we have to explain the workings of theFinancial Sector in a modern global economy.
3 The Financial Sector & the Circular flow of Income FOP = Factors of ProductionY = National IncomeCd = Consumption of Domestically produced OutputO = Domestic OutputE = National ExpenditureJ = Injections: I – Investment, G- Government Spending, X- ExportsW = Withdrawals: S – Savings, T- Taxes, M - ImportsThe question is:How do SAVINGS get turned into INVESTMENT (I) and CONSUMPTION (Cd)?
4 Turning SAVINGS into INVESTMENT Financial institutions and financial intermediationTurning SAVINGS into INVESTMENTRecall the TV show:The Dragon’s DenThe 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 intermediationBesides 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 marketsCLEARING MONEY MARKETSBANKS (DEBT MARKETS)SHORT LOANS * Certificates of depositTERM OVER DRAFT * LOCAL AUTH' BILLS* COMMERCIAL BILLS* EURO CREDIT* TREASURY BILLS(CAPITAL MARKETS) EQUITY MARKET['GILTS']LONG Bus’ LOANS * DEBENTURES (FIRMS) * RIGHTS ISSUETERM MORTGAGES * EURO BONDS * NEW SHARES* LOCAL AUTH' BONDS * PREFERENTIAL* GOVE' BONDS VENTURE CAPITALMoney & Equity marketsare sub-divided intoPrimary Markets (wherenew issues are offered)Secondary Markets (whereexisting financialinstruments are offeredfor 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 SPENDINGDEPOSITS:The Bank’sLIABILITIESLENDING:The Bank’sASSETTSTo met the dailyneeds of depositorsNote: Ratio of Cashto other Assets is 1%(LIQUIDITY RATIO)Ready Cash(Tills & ATMs)£5mAdvances(Loans)Overdrafts tomortgages£200m£500mTreasury bills,Gove’ BondsDebentures& othersInvestments£295m£495mbackinto theeconomy!£500m£500mLiabilities must equal AssetsHow 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 SPENDINGTHE AIMS OF BANKSLIQUIDITY: If the liquidity ratio is too high there is lessto lend, which means lower profitPROFITABILITY Risky loans are given higher rates of interest rate - they are profitable.But risky borrowers often default.PRUDENCE Capital adequacy, the level of unsecuredloans compared to secured loans. Alsobanks need to have enough of their ownmoney (profit) on hand to cover anydefaults on unsecured loans.ALL THESE AIMS ARE IN CONFLICTAs 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 ofEngland(Supplies £)As ‘lender of last resort’MoneyMarketsREPOREPOA bundleof paper assetsOther 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 NorthernRock experienced a ‘run on the bank’ the first in theUK for 140 years!A ‘run on a bank’ :- where large numbers ofdepositors present themselves at a bankand demand the return of all their savings– in cash at once !Problem? The bank does not have the depositor’smoney in cash – they have lent most of it toborrowers (advances) or used it to makeinvestments.To return the depositor's money would meaneither:a) Foreclosing on the loans they have made.b) Selling some of their investments (assets) on the secondary moneymarkets, in the sub-prime crisis, this is where part of the problem lay:the INVESTMENTS many UK banks (including Northern Rock) madeturned 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 becauseso many of its Financial Assets where made upof these worthless investments.It was press ‘rumours’ that Northern Rockwas approaching the Bank of England thatthen lead to the run on the bank.So where did it all start to go wrong?And why were so many of these investmentsnow worthless?
12 The ‘sub-prime’ crisis: a case study in banking failure. The seeds of the problem lay in the USA mortgage marketsIt 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’ loanswith similar risks of default into onefinancial instrument (a Bond). Which would be sold in the Money/Debt Markets (world wide)Technically, these bonds would berated as low risk (of default) to highrisk (of default). The ‘return’ on thebond 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 CDOAs a rule of thumb you will pay back 3 times the value ofthe mortgage over the 20 years of the life of the loan.LoanRepaymentHowever, ifhomeowners, startto default on theirmortgages the CDOsreturn will fall$100,000$300,000Combineinto oneCDO &sell for$750,00e.g.If there are 3 defaultsthe CDOs returnswould fall to$600,000The market valueof the CDO is nowvirtually worthlessNot abad‘return’!$500,000$1,500,000
14 As a result many CDOs became worthless – The ‘sub-prime’ crisis: a case study in banking failureMany 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 CDOsbecame worthless –
15 The mix of low and high risk mortgages The ‘sub-prime’ crisis: a case study in banking failureOther 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 mortgageswas incorrect, making any assessmentof a CDO’s value difficult and uncertain.Why did this happen?Risk assessment agencies(and mortgage lenders) were sloppy intheir work or, to say the least; they were‘over optimistic’ on peoples’ ability toservice their loans.
16 The ‘sub-prime’ crisis: a case study in banking failure For the FINANCIAL SECTORTwo major outcomes from the sup-prime crisis1) 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 markets2) The uncertainty over the mix of risk further reduced the value of CDO’s on the money marketsThe 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 – Termi) Central banks (e.g. the ‘Fed’, the Bank of England, and theEuropean Central Bank) have had to pump taxpayer’s moneyinto the banking system to maintain liquidity and to restoreconfidence in the banking system.ii) In the UK banks have had a ‘wake up call’ on the waythey 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 depositsMore Long term?In order to restore their balance sheets many of the US and UK bankshave approached ‘Sovereign Funds’ . Sovereign funds have beenaround for a while but they are a relatively new phenomena.Basically, these are investment trust that are owned by a nationalgovernment, 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 creditYou will have to start saving – NOWif you want to buy a home in the futureJob prospects in the financial markets less assuredLikewise job prospects in industries whose productsare 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.