Day 13: The financial crisis (2008)
The 2008 financial crisis:
The financial crisis was the worst global economic slump since the Great Depression in 1929. The crisis stemmed from the USA, and happened due to the culmination of many economically negative events in a very short period of time(since 2006).
The federal reserve bank in the United States lowers the interest rate to just 1% and liberalised credit(financial deregulation). This encourages banks to borrow lots of money as they will pay only 1% interest. They continue to do great business and make lots of profit, and pay back the debt. The housing bubble was created as housing prices rapidly rose and then the banks start engaging in mortgages, and they borrow money from the federal reserve to buy mortgages from mortgage lenders or lend themselves. Then the investment bankers receive all the monthly payments, making huge profits. The profit is turned into the Collateralized Debt Obligation. Then the banker sell the CDO to investors, who have found a good investment. Everyone was benefiting from this; investors, mortgage lenders, investment bankers, banks, mortgage brokers etc.
However, when the banks want to make more money, there aren’t many consumers left who can qualify for mortgages. They then start with subprime mortgages(lending money to people who’ll have trouble repaying). These mortgages are very loose and risky. Now many people are defaulting their mortgages because they can’t keep up with repayments. Now the investment banker isn’t receiving monthly payments, he just has many houses on his hands. The bankers put the houses up for sale. Now because there are so many houses up for sale on the market, there is more supply than demand and housing prices fall.
The remaining home owners see the value of their house fall, so they don’t think its necessary to keep paying the mortgage, so they walk away. This further increases default rates and decreases house prices. The investment banker is in trouble as he has a bunch of worthless houses and the investors don’t want his Collateralized Debt Obligation anymore. Now the investment banker can’t pay back the debts he owes to the federal reserves. Since the investors aren’t buying from the investment banker, and the investment banker isn’t buying mortgages from the mortgage broker, the market is frozen. Many banks go bankrupt, Eg. On April 2nd 2007, New Century, an investment trust specialising in subprime lending, one of the trusts giving out lots of mortgages, went bankrupt. On August 7th, American Home Mortgages files for bankruptcy. On September 15th 2008, the Lehman Brothers bank goes bankrupt. Other banks like Fannie and Freddie Mac also filed for bankruptcy.
The effects of the crisis on the UK:
The UK had an economy very reliant on financial services, real estate and retail sales. The growth up until 2008 was based on the borrowing and lending bubble that blew up, causing the financial crisis. The UK therefore was one of the most heavily affected countries in the world.
The FTSE 100 fell by 31% in 2008 due to a reduction of consumerism. The unemployment level rose to 5% as many bankers and mortgage brokers lost their jobs and housing market sales fell by 20%. The economy moved into a recession as the GDP declined by 2.6% in 2008 and stayed low for a while. The country was put into a lot of debt as the government had to bail out certain banks and businesses. Major businesses and many small businesses which were crucial to the economy were put out of business. Over 700,000 businesses went bust in 2008 and 2009. Also, many firms were in a huge amount of debt, so economic activity slowed down. Lastly, the interest rates for inter-bank lending shot up and the costs for insuring credit rose, further slowing economic activity.
The strategies used to get us out of the crisis:
In an attempt to stimulate growth, the government cut the VAT rate in November 2008 to increase consumerism and pull the economy out of recession. The government helped multiple banks stay afloat, for example Lloyd’s bank, Northern Rock and Halifax. They also cut base interest rates from 5% to 0.5% to try to encourage investment and borrowing and consumption.
The government increased government spending and capital investment to stimulate growth, reduce costs, increase production, increase income, increase consumerism, increase GDP growth and animal spirits. The amount that each bank got was negotiated individually between that bank and the government. Some of the banks that participated were Barclays, Lloyds, Royal Bank of Scotland and HSBC. In total the government were willing to hand out 500 billion pounds in loans and guarantees to all kinds of businesses the rescue the UK economy and pull it out of recession. To be specific for the Bank Recapitalisation Fund, £25 billion for the first instance and another £25 billion to be called upon if needed. Finally,the government underwrote inter-bank lending, giving a loan guarantee of £250 billion.