The last few months have witnessed the beginnings of a major global credit crunch. Domestically, this has manifested itself in the recent Northern Rock crisis where thousands of people made a run on the bank. ION KERSHAW takes the pulse of the British economy. THE ORIGINS of the crisis lie in the United States housing market. As a result of financial deregulation the socalled 'sub-prime market was targeted by banks.
This was effectively for lowincome families who tradiDonaly Would not have qualified for morleases. Because they were seen as higher risks a premium rate of interest could be charged.
In 2006 it is estimated that some $600bn of sub-prime loans WCIC made Americans. The loans were parcelled into different packages and mixed with less risky debt.
This was then sold on to institutions like hedge funds, which found the prospect of earning high returns enticing. Inevitably, problems arose when people could not repay their loans - often as a result of losing their jobs.
When the crisis broke in US, banks became nervous about lending to one another. One analyst called it a 'crisis of information' as banks were unsure who held the debt that was owed.
Some estimates suggest up to $1 trillion of losses on subprime loans. It could take many months to untangle the legal mess.
All this will have an adverse effect the mortgage market; to recoup their losses banks will either raise rates or tighten lending. Already the US housing market is in crisis with a 12 year low in housing starts and a doubling of foreclosures unme last verd
In early September Northern Rock, the fifth largest mortgage lender in the UK, was forced to turn to the Bank of England for cash because no Citv institution was prepared to do so. As news spread, huge queues formed outside branches and as much as £lbn was taken out in one day.
The mall issue with Northern Rock is how it is raised its funds. Traditionally banks have relied on small savers to provide funds but Northern Rock relied a great deal on the wholesale money markets - it is estimated 75% of its funding comes from this source compared to half for most banks. The attraction of Lois source is that it Is conparatively cheap.
It enabled the bank to snap up 19% of the UK mortgage market in the past 6 months. However this source of funding dried up in the present crisis, when banks became very reluctant to lend funds to one anowner.
The Economist draws attention to the vulnerability in the UK financial system - the socalled 'funding gap' This refers The difference between loans and deposits. In December 2006 this was - from 80 to 160%. estimated to be about £530bn.
In normal circumstances this would not matter as loans becoming due would simply be rolled over or repaid with proceeds of tresh loans. However, in current times banks are noaraing their cash and unwilling to lend to other banks for more than a day.
A temporary glitch in the
an unfounded SYSICI Ol rumour could leave an otherwise solmo bank snor or casa. forcing it to go to the Bank of England to tide it over. This in fact did recently happen to Barclays.
The political fallout from this crisis is immense. There is a big debate going on in the ruling class about the way forward.
When the US crisis broke in August, both the Federal Reserve and European central banks poured billions into the markets in an attempt to get stability.
However the Bank of England refused to do so, on the basis that the banks which have been reckless in their lending would not be punished - the so-called 'moral hazard' problem.
No doubt due to massive political pressure in the wake of the Northern Rock debacle the Bank was forced to do a Uturn and pump funds into the market.
It offered to lend £10 billion to commercial banks in an emergency 3-month auction. AIne same time aSO widened the collateral that it was prepared to accept to include mortgage loans. The Consumer debt as a percentage of disposable income (after taxes) doubled in the UK over the last 15 years top up reserves they hold in central bank coffers, and can draw cash against, by £4.4bn. Commercial banks snapped up the offer - draining the fund in less than an hour.
The Chancellor also guaranteed all deposits with Northern Rock. On September 19 the US Federal Reserve cut its interest rate by half a per cent.
This prompted the biggest one-day gain in equities (2.51% on the Dow Jones) since April 2003, which marked the start of the Iraq invasion. The euphoria northern rock None of them wants to take Alistair Darling's word for it their money is safe... among traders who greeted the Fed cut prompted commentator to say that its as if a cure for cancer had been found'!
In the UK there is also a vigorous debate about regulatory failings that contributed to the crisis.
When New Labour came to power it split responsibilities between the newly created Financial Services Authority (FSA) and the Bank of England with the former
of banking laking charge supervision and the latter responsible for maintaining economic and financial stability.
It appears that the FSA did
the Northern Rock fiasco and has been heavily censured.
However this glosses over the fact that New Labour's complacent approach to the financial sector contributed to
situation which Northern Rock could operate. Bank also allowed banks to It is not the first time that socalled 'regulatory failings' are seen as a convenient scapegoat for fundamental flaws in the
Underlying the initial Bank of England stance is that all this does is just to delay the crisis when the housing bubble bursts.
Will Hutton argues that the finance sector should be ugnuy regulated so unis Is not repeated. He is quite alarmist about the whole affair.
"Make no mistake. Britain's financial system is in the most precarious position since the war."
Even 1974 banking crisis was caused by banks lending too much on speculative property deals, but these were at the periphery of the system.
The big question is what input this banking crisis will have on the wider economy -whether spending will be curtailed as a result. This is because when mortgage rates go up, consumer spending will inevitably suffer. One must remember that the socalled New Labour has been underwritten by credit - which in large part has been fuelled by the housing bubble.
Total consumer credit in the UK recently topped £1 trillion. To put it in perspective consumer debt as a percentage of disposable income (after taxes) doubled in the UK over the last 15 years - from 80 to 160%. The trend in the US is very similar.
Since Labour came to power exports have been crippled by an over-valued pound and as a result the balance of trade has CUL WULSC
Financial and business services now account for about 30% of GDP. The risks are huge if this trend continues:
financial markets face period of weak activity the problems will reverberate throughout the system.
In conclusion the period ahead is uncertain. Because the extent of the credit problem cannot be gauged accurately the impact on the wider economy is difficult to assess.
The Economist does sound a warning when "Combine the present discord in credit markets with the seeming vulnerability of housing markets and it is all too easy to imagine the rich world economies in trouble".