3. Collapse of the UK Economy in 2007/08
I came across an article I wrote a while ago about how the economy collapsed in 2007/08. Thought I would add it up here as it eventually was not used for the purposes that I originally wrote it for. It is unreferenced, so at some point I will go through and add in the references for it. I talk about this issue so many times, especially when Labour say that they were not at fault - they were - they allowed this to happen by purposefully being blind to the utter greed of the City.
Economy: What happened?
The world-wide economic crisis is a hotly debated topic. However, there are some things we do know and understand.
When considering what happened in 2007 to 2009 it is important to understand that on more than one occasion it actually looked as though the economies in the UK, the US and many or most European countries looked as though they had reached a cliff edge and were about to go into free-fall. What would happen if that happens? In simple terms, Greece, Ireland and Portugal should be considered. Their economies had no more cash left in them and they defaulted on their debts. They did not have enough money to continue. That causes an economic crisis with ripples going out in to the world, as when one economy crashes and defaults another country does not receive cash through debt payments, which leads to that country having a financial crisis. Writ-large this could have caused every bank in the world to collapse. It is not an under-estimate to say that by October 2008 this is largely what actually happened in the UK, US and in many (or most) European countries. Everyone ran out of cash. We are now eight years away from the collapses of 2007 yet most of the world is still struggling with low or negative interest rates (in an attempt to get people to spend money), low or negative inflation (meaning no one is spending money) and low or flat-lining growth.
The collapse of the British economy was fuelled by British banking models plus the effects of the US collapse, which was fuelled by its banking model, which had been adopted by a number of British banks. It is this model that fuelled how a small number of banks operated, but the fall-out of these few banks literally led to the fracturing of the entire world economy throughout 2007 which led directly to the economic collapse that occurred in October 2008.
Unknown to many people, it is rarely a central bank (the Bank of England, the Federal Reserve etc) that creates money in an economy. Central Banks create the bank notes and coins, but it is usually a private bank that will create money through extending credit lines. In short, the vast amount of money in an economy is simply a digital number in the banking industry computers.
The model for British banking was always one of reserve. A bank would take money in through deposits and would carefully lend that money to other customers. The borrowing customer pays interest plus a margin. The margin is the Bank’s profit. The interest is used to pay for the costs of the bank borrowing any money plus paying interest to its depositors.
This model worked very well. Economic crisis’ after the war was led by shortages in the economy, not shortages of cash at banks.
However, the US model created in the late 1990s and adopted by some of the UK banks at the end of the 1990s and early 2000’s was different. This economic model said that a bank can create huge profits by simply creating more debt. By offering customers more lending that is cheaper – far cheaper – then more customers will borrow money, thereby creating more cash in the economy and more profits for the banks.
This worked. Bank of Scotland Plc did this, as did the Royal Bank of Scotland and Northern Rock. As the back-drop for this was the vast London banking market. As it had been since the early 1980s this was a machine with one sole purpose: create and increase profit.
To create the credit lines the banks started offering more and more mortgages to retail customers (ordinary people) but also new commercial lending to businesses. This created a lot of mortgages, all of which had a net future value based upon the interest and margin that would be paid back to the banks.
What the City did (ie. The financiers and capital investment bankers in London) was to create even more money with this. They would take a group of mortgages (say 100,000) and bundle them up. The income from fixed rate mortgages (2, 5 and 7 year fixed rates) was a fully known and expected amount of money. Variable rates less so. The investment bankers would then sell the income from the mortgages as a bond. This is known as securitising the mortgage debts. This is not novel or new, securitising of assets, capital, debt and equity has been around a long time. The bonds would create an immediate cash profit for the future income profits from the mortgages that had been securitised. So, if I were to expect profit of £2 billion over the period of 7 years and I sold that offer of income to someone for £1.5 billion, I get an immediate cash settlement rather than having to wait 7 years and the investor who buys the bonds gets a known or expected income over the term of the bond with a profit.
Banks liked this because the immediate payment of (say) 75% of the expected future profit would allow me to immediately reinvest that cash. If I can create a profit of more than 25% from the cash over that 7 year period (and most investment bankers could) then I create yet more profit.
This started in the early 2000s. By 2005 it became very large. In 2005 both Royal Bank of Scotland started offering crazy amounts of money to investors – principally property investors. Whilst these huge sums of money were being lent to investors banks were merrily creating more profits form the income generated. Northern Rock started offering 125% mortgages (ie. If the property is worth £100,000 the Bank would lend the customer £100,000 secured against the property plus an additional £25,000 that was an unsecured loan). Bank of Scotland, through its subsidiary Uberior, was lending hundreds of millions of pounds on equity that was almost non-existent. Royal Bank of Scotland did the same. The profits doubled.
All of this debt creation came at a cost. A bank is allowed to create lines of credit, but to do so they were required to hold liquid cash (ie money) in order to meet the cash being withdrawn by customers each day. They must also has sufficient (which transpired not to be sufficient) amounts to cover a run on the bank by its customers. Deposits were previously the preferred way of holding cash. The cash had to be a % of the total sums loaned. When the banks started pumping out debt at huge rates deposits were not sufficient to capitalise the bank (capitalise means holding the correct ratio of liquid cash to debt). In order to keep within the European rules the banks were required find cash. They did this by borrowing money.
There is a huge amount of cash known as the whole-sale markets. As with a food whole-sale, a grocer will go to the whole-sale market and buy his food. He will then sell that food at a higher amount in his store. The bankers do the same. They go to the whole-sale markets and borrow money (from other banks or capital invetsors) for an amount (usually based upon LIBOR). They will then use that money to lend to its customer, adding a percentage to it plus margin. The money is borrowed for period ranging from over-night to a one week. As banks lend for years, the interbank borrowing (which is very short term) is utilised with other methods of cash creation. Interest Rate Hedging Products is one (and there are many others). As such securitising the mortgage assets a bank has plus its interbank borrowing could create a position where the banks could maintain huge amounts of lending without any risk to liquidity. Or so they thought.
The Bank of Scotland simply lent too much. The Royal Bank of Scotland did the same, just not as significant as Bank of Scotland. Northern Rock grew at an incredible rate. Unfortunately for Northern Rock it was known for lending 125% of property prices to customers who transpired not to be as credit worthy as first expected.
Throughout 2007 there were problems. This started when one of the US’s biggest property companies, Freddie Mac, issued a press release saying it would no longer buy “risky” sub-prime mortgages and their securitised products. There was then the collapse of New Century Financial Corporation in April 2007 when it filed for Chapter 11 bankruptcy protection. Between July and August there was a chain reaction. Banks and investors started questioning the banking model. All of the securities that had been issued were built on the building blocks of ordinary people with mortgages. What if their property prices started falling – would the securities still hold strong? What was the default rate on mortgages? Would the mortgage default rate increase if property prices fell or the economy went into free fall?
More Chapter 11 bankruptcy applications were made, banks liquidated investment funds and credit agencies started down-grading mortgage backed security bonds. Banks worried that the bonds that they had acquired may have been sold to them as “prime” mortgages when they could actually be sub-prime. Sub-prime mortgages have a far greater default rate than prime mortgages. If the bonds (and therefore the income from them) were sub-prime then the holdings of the banks and institutions would need to be downgraded. This was acknowledged for the first time when BNP Paribas froze three funds on 9 August 2007, admitting that it could not properly value the assets (which ultimately turned out to be a mix of sub-prime and prime securitised mortgages). It was this event that led to every bank in the western world to reconsider its assets. Almost every single one had substantial investments in these securities. The securities, which appeared on the balance sheet with a value, had their notional values slashed dramatically. Banks that had “solid” balance sheets suddenly found that they had worthless bonds, and their balance sheets were impacted accordingly.
It is the sale of sub-prime mortgages as securitised bonds (usually sold as prime and usually having a mix of both) is ultimately what caused the start of the crash, which culminated in the collapses and bail-outs in September and October 2008. It is now known in 2015 that the securities were most definitely sub-prime mixed with prime mortgages. Prior to that the banks had only sold prime mortgages, but greed got in the way and more and more sub-prime mortgages were mixed in, which created what appeared to be a more attractive product to sell, creating more money for the banks and the investment bankers selling them. The bonds acquired also gave what appeared to be really generous fixed incomes, which was attractive to most financial institutions as an investment. Litigation is still (2015) on-going.
With the fear created by the re-valuation of securitised mortgage bonds came a further fear. If the new business model for banks was based upon debt and more debt, what would happen if there was a collapse in the property market? Not only would existing securities be worth much less (or be worthless), the ability to sell future offerings (ie sell more) would stop. Without that income, could a bank continue in business?
There were some very serious concerns that Northern Rock had been lending money to what appeared to be anyone who wanted a mortgage. Unemployed people on benefits were given mortgages, low paid workers got 125% mortgages and the bank securitised almost all of the mortgages by selling them. There were therefore rumours in the banking & finance markets about how Northern Rock was supporting its debt obligations. These rumours caused its share-price to dip until mid-September when it plummeted.
Following BNP Paribas’s confirmation that it could no longer price securitised mortgages no financial institution wanted to buy them. As Northern Rock (under the US banking model) needed the income from selling securitised mortgages, it would struggle to repay the money it had borrowed in order to provide the substantial mortgages it had been lending. On top of this, the rumours about Northern Rock meant no bank on the interbank market was confident of lending Northern Rock money.
In addition to this, suddenly (September 2007 onwards) financiers and investors considered what would happen if property prices fell. Property market data confirmed that property prices had indeed started to fall and mortgage defaults had started to rise by mid September. This led to a lot of speculation in the markets. Despite that Northern Rock was actually quite solid in its accounts its share prices plummeted as stockbrokers spread rumours of its insolvency and sold as much of the Northern Rock stock as they could. The precise terms of what happened can be found in the Treasury Select Committee’s report “A Run on the Rock” [HM Government 28 January 2008] .
The bank had to ask the Government for on 13 September 2007. This was because the whole-sale markets (the interbank markets) would not lend it money whilst it was required to repay its debts. As it relied on whole-slae markets for 75% of its revenue it ultimately had no option but to ask HM Treasury, the FSA and the Bank of England for cash. On 14 September 2007 this became public knowledge. Brokers, traders and investors tried selling their Northern Rock shares and bank customers queued outside branches to take their money out of the bank. The last “run” on a bank had been in Victorian times. Customers withdrew £1 billion in cash in one day. The Bank was effectively dead. It had no income because no other bank would not lend it money because the banks could not trust its solvency, its share prices fell from a high of £12.00 in February 2007 to and the cash reserves it had were about to be withdrawn by customers queuing in the streets.
Despite what was happening at Northern Rock, arrogance and vanity in his self-view as a Titan of Bankers led Fred Goodwin, CEO of RBS, to complete on the £49 billion takeover of ABN Amro in October 2007. This ultimately was the nail in the coffin of RBS which collapsed a year later.
A huge chain reaction took place throughout the world. The US banking model, which favoured significant debt over cash reserves, led to an economic collapse. There was no confidence that Banks had been selling prime mortgages in their securitised products; Banks and funds (such as pension funds) that held the securities became aware that the rates or mortgage default was not low as it would be with prime mortgages, but was in fact much higher because the bonds acquired contained more sub-prime mortgages than understood. And in addition to this, the British Government allowed Northern Rock to collapse. This led to a position within which no bank would lend any money to another bank because the fear was that every bank secretly held too much debt, too many securitised products that were effectively worthless and no bank had enough money to repay the debts. Whilst this was not strictly true, it was true to a certain extent. And the Banks that had been pumping out huge amounts of debt since 2004 were well known. This led to the slowing and then closure of the interbank wholesale markets. The loss of revenue was serious, as banks who worked on the US banking model needed the wholesale money in order to fund the repayment of the significant cash needed to fund the large and extensive loan portfolios that had been amassed since 2004/05.
Northern Rock collapsed and was ultimately nationalised in February 2008 by the UK Government. It took until the 2015/16 budget for the UK Government to be in a position to start selling off the assets it acquired in Northern Rock, so serious were its failings.
On 24 January 2008 the US announced it had had the largest fall in residential property sales for a quarter of a century. Property prices were in free-fall, and banks could not lend consumers money through mortgages. In addition to this, more customers defaulted, with sub-prime mortgage default rates shooting up.
The Governments around the G10 implemented a series of attempts to save the banks in 2008. Hundreds of billions of dollars in cash were made available to banks to plug the gap made by the closure of the interbank lending markets. This was not enough. The general public stopped spending money, terrified that they face the prospects of a recession and would need their money.
There is academic debate about when the recession started, but it clearly started between January and July 2008. No one could have ever predicted what would happen next, because it had never happened before.
RBS had a £12 billion hole in its balance sheet so issued a rights issue in April 2008 in order to raise the additional £12 billion from shareholders, which staved off collapse for a short time. Barclays had to raise £7 billion, which it did privately. Banks started a re-classification and re-calculation of their balance sheets. With no income from the London interbank market Bank of Scotland and Royal Bank of Scotland had huge debts due for repayment with no income from borrowing from the market or depositors.
Despite the billions being made available by central banks, including the Federal Reserve, the securitised mortgage bonds caused Bear Stearns to collapse. The Federal Reserve offered cash to JP Morgan to allow it to acquire Bear Stearns. The Federal Reserve approved facilities to start taking securitised assets from other banks – which nominally still had a value but could not be sold on the market – in exchange for cash. Countrywide Financial (another large US finance house) was acquired by Bank of America because Countrywide had also collapsed.
On 11 July 2008 IndyMac Bank is closed and cash is transferred out of it. On 13th the Federal Reserve agrees lending to Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), which owned significant US sub-prime mortgages. The fear that a large number of residential properties in the US were subject to lending by two insolvent companies created Armageddon in financial terms. Despite the attempts to save them, both companies were lost financially, so the Government effectively nationalised them (which it actually did in September 2008). The sums of money involved were truly staggering. The US Government rushed through emergency legislation.
Merill Lynch became insolvent and was acquired for $50 billion on 15 September 2008. Later that day the unthinkable happened. Lehman Brothers collapsed and filed for bankruptcy protection. These two events were truly colossal in terms of the world economy. The selling of mortgage payments through bonds known as securitised mortgaged and the naked greed that led to uncontrolled lending led to the collapse of banks that were seen as being incapable of economic collapse. The fear that every banker and economist felt throughout the world that day cannot truly be under-estimated. AIG got $85 billion bailout the next day.
The Bank of Scotland (part of the HBOS Group) had been lending substantial nine and ten figure sums of money to commercial property investors with minimal equity by the customer. It re-calculated its accounts and balance sheets based upon the drop in property prices and the sub-prime securities issue and found it had a £200 billion hole in its accounts. IN addition, the closure of the inter-bank markets meant its income dried up. It was insolvent. On 16 September 2008 the Lloyds-TSB Group (as it then was) agreed to acquire the bank and to make £20 billion available to it. The sale completed in January 2009.
Stockbrokers around the world were on the one hand losing millions on financial institutions but making millions on short-selling financial institutions, which led to the collapse of share prices around the world. The cumulative effect of a down-turn in the property prices around the world, a significant slow in the public spending money, significant failures in the banks, the collapse of bank lending to each other and to their customers (business and retail customers) added to which the publicly available data that banks were actively collapsing left the world economies in tatters. The failure or near failure of some of the biggest banks in the world plus the unbelievable sums of money countries were having to make available to stop banks collapsing was unprecedented.
The morning of 15 September 2008 to 7 October 2008 saw banks world-wide reassess their assets, and found that their balance sheets were depleted, massively. The money every bank in every western country had locked up in securitised mortgages meant that every bank was in danger of collapse if the issuer of those bonds folded. Merill Lynch and Lehman Brothers had issued bonds on behalf of Fannie Mae and Freddie Mac, amongst others. It is estimated that every bank in Europe and the US lost significant sums in the collapse of the two banks and the two property companies.
On 21st September 2008 the two oldest and largest US investment banks, Goldman Sachs and JP Morgan Chase change their status to banking holding companies, marking the end of the investment banking model dominant during the 2000s. That Goldman Sachs could be brought down shocked the world, and the impact of what was happening in September and October 2008 cannot be over-stated. Armageddon had occurred. The world’s banks just kept on being toppled and no commentator or academic – and certainly no politician – could know which banks or businesses would be toppled next.
29 September 2008 saw every major central bank in the G10 countries issue hundreds of billions of dollars of help for banks (including extending swap lines of credit). US and UK Governments provided further funds in return for assets that could not be sold by banks. On 30 Citi Group agreed to acquire another Bank involving $320 billion of loan portfolios. On the same day the US Treasury rushed through legislation allowing it to buy more assets from financial institutions in financial trouble. The Emergency Economic Stabilization Act of 2008 cleared congress on 3 October 2007 and established a $700 billion Troubled Asset Relief Program. The sums involved by the start of October 2008 was over one trillion dollars worldwide. The US Government’s entire Budget for 2008/09 was only $2.5 trillion, yet the collapse of the banks in the G10 countries could cause losses upwards of $5 trillion.
Iceland's three biggest commercial banks – Glitnir, Kaupthing, and Landsbanki – collapse on 7th and 8th October 2008. These banks had some of the most attractive interest rates in the world, so held deposits for local and central governments around the world, in addition to private retail customers’ deposits. To protect the deposits of their many British customers, Prime Minister Gordon Brown uses anti-terror legislation to freeze the assets of the banks' UK subsidiaries.
At 6:30pm on 7th October 2008 the chairman of RBS had to call the Chancellor of the Exchequer and confirm that the bank had run out of money and could not close their accounts without Government money. This saw the share prices collapse from £6.03 in March 2007 to 11.6p on 19 January 2009. This was followed shortly by Lloyds-TSB Group confirming that it needed a bail-out.
The Treasury ultimately agreed it would inject £37 billion ($64 billion, €47 billion, and equivalent to £617 per citizen of the UK) of new capital into Royal Bank of Scotland Group plc, Lloyds TSB and HBOS plc, to avert financial sector collapse. The government stressed, however, that it was not "standard public ownership" and that the banks would return to private investors "at the right time" . The Government took a stake of 58% in RBS. The Treasury had to inject further sums of money. It still owns a stake in RBS and has not announced when RBS shares might be sold. Lloyds shares have slowly been sold, with the remaining shares to be sold in 2015/16.
On 8th October 2008 AIG received $37.8 billion cash by selling securities and bonds to the Federal Reserve Bank of New York, showing the world that it was effectively bankrupt.
On 8th October 2008 many central banks reduced interest rates by 0.50%. This proved not to be enough, and rates were slashed to between 0.00% and 0.50% by March 2009 in an attempt to try and stimulate the public to start buying things and to get commerce to buy and sell. It did not work.
In November 2008 the asset purchasing form banks was found not to be working. The US Government instead tried quantitative easing, which is (in simple terms) pumping huge amounts of cash into the banking systems. This process was taken up in many G10 countries, including Britain. On 10th December 2008 British Prime Minister Gordon Brown accidently says he saved the world. Whilst sounding arrogant, it may not be too far from the truth.
In January 2009 the UK Government agreed to inject money into the UK banking sector to try and create new bank lending to businesses and individuals.
On 2nd April 2009 the G20 agrees a global stimulus plan of $5 trillion. Unfortunately, by this time the problem was no longer confined to banks. The collapse now meant that entire countries were bankrupt.
10th October 2009 to 27th April 2010 Greece is found to have huge debt and a massive hole in its finances. It has its credit rating reduced to “Junk”. It required a bail-out. Greece owed money to banks and investors around the world.
In November 2009 the Government had to increase its stake in RBS from 70% to 84% because the bank still was trading at a massive loss. Despite that RBS was bankrupt but for the bail-out funds, the board of RBS threatened to resign en-mass if the Government did not let it pay £1.5 billion in bonuses to its bankers in December 2009. There was public outrage that the very people who had brought economic collapse on the western world – the bankers – were being paid as though nothing had happened. How could RBS afford to pay £1.5 billion in bonuses if it needed tens of billions of Government injections? More than 100 senior bank executives at RBS were paid more than £1 million in late 2010 and total bonus payments reached nearly £1 billion – even though the bailed-out bank reported losses of £1.1 billion for 2010. 2008 saw a £24 billion loss at RBS and a £3.6 billion loss for 2009.
On 2nd May 2010 Greece is given a €110 billion bail-out and a year later requested and received a further €130 billion. This is followed by an €85 billion bail-out for the Republic of Ireland on 28th November 2010 due to the loss of €100 billion by the Irish banks, which had been under-written by the Irish state. The Government received €85 billion (part of it from its own reserves in pensions etc). Portugal also collapsed and needed a bail-out, under the terms of which it has drawn €79.0 billion. Spain took €100 billion due it bailing out its banks. Finally, Cyprus required assistance and took €10 billion.
In an unthinkable move, on 5th August 2011 US Sovereign debt was also downgraded by a credit rating agency, which evidences how far the economic collapse had gone.
On 12th March 2012 the European unemployment rate reached its highest level, ever.
Banking Crisis: what Happened
The collapse of the world economies in 2008/09 as a result of the 2007/08 banking crisis was unthinkable and had never been seen in previous economic collapses. The figures involved are in the trillions of dollars. The world’s largest economies came very close – perilously close – to total collapse. A $5 trillion stimulus package was almost insufficient to stem the tide after it had started.
It would not be possible to outline in a short article what happened. We have therefore included on our website a more detailed explanation of what happened and what caused each event to happen.
The crisis can be explained in a relatively easy to understand manner.
In the Golden Age of Banking a bank would take money from its customers, and would lend that money out to other customers. The Bank would take a profit and pay over to the deposit customer some money also. In this way everyone was happy.
In the late 1990s the US banking giants changed how they did business. This was started in the free-for-all money making schemes of the 1980s that led to the 1988 and 1991 recessions. The centre of banking was London backed up by New York, Singapore and Chicago. This new model said that banks should inject significantly more cash into the system through expanded debt. This would lead to higher profits, which would lead to more money to lend, thereby creating even more profit. They could maintain this lending by creating more money, borrowing money on the interbank markets and by selling securities. The model seemed unbreakable. Property would ultimately always go up. Even if there is a short term wobble in property prices, the eventual price of property could be depended upon. Add this to aggressive cash creation through investment a bank should be looking to increase its size by 20%+ a year.
This seemed to work for the banks. Despite new rules in 2000 in the UK, banks were largely unregulated in this area. Not all banks took to the new model fully, but four did. Bank of Scotland (as part of HBOS), Royal Bank of Scotland, Northern Rock and (to a lesser degree) Lloyds-TSB all aggressively expanded their investment banks.
The collapse happened because property prices did not remain. A product known as mortgage backed securities had been sold, but the securities’ model had ultimately been broken because banks in the US and UK were selling sub-prime (less attractive) mortgages and allowing investors to think that they were prime mortgages. When this was made public banks did not trust that other banks had enough money to repay debts, so banks stopped lending to each other. As their new banking model needed large incomes from borrowing money from whole-sale markets plus the sale of securitised mortgage bonds (which no bank could now buy) the banking model fractured and then collapsed.
Northern Rock and Royal Bank of Scotland suffered then the Bank of Scotland suffered with a £200 billion hole in its accounts. Lloyds-TSB had been persuaded to buy HBOS (including Bank of Scotland). Northern Rock had to be nationalised, as it was hopelessly illiquid. RBS and Lloyds (including HBOS) needed bail-outs by the UK Government. Banks in the US collapsed and went into bankruptcy. The biggest mortgage providers in the US had to be effectively nationalised. This had an impact around the world.
The ultimate cost of the banking crisis is not known. It is at least $5 trillion, but is likely to be nearer $10 trillion. All because banks needed to make more money. This collapse then lead to the collapse of Greece, Portugal, Spain, Cyprus and the Republic of Ireland. The crisis is sill with us and is unlikely to be fixed before 2020.
 BBC Source graph:http://news.bbc.co.uk/1/hi/business/6994328.stm
This website is © Kalvin Chapman 2015 & 2016. This website is owned and operated by Kalvin Chapman, and is promoted by Kalvin Chapman on behalf of UKIP, UKIP Stretford & Urmston and UKIP Manchester