Who burst the bubble on the financial crisis?

This was my article that was included in the Birmingham Law School Newspaper. 

The financial crisis is currently the most far-reaching issue in the western world. It affects all aspects of life, from international mergers and acquisitions to the weekly shop and daily commutes of families. It’s something we constantly see in the news, and commonly features in questions asked to assess commercial awareness, but what is it and where did it all begin?

The origins of the current crisis lie in the housing market bubble in the USA and UK. Years of low inflation and stable growth in the housing market had promoted risk-taking and made houses seem like a safe investment for those buying and lending. Banks aggressively competed to lend, incentivising their staff with large bonuses and commissions. This competition became so intense that Northern Rock were prepared to lend for up to 125% of the value of the house. In the US it was also common practice for banks to offer loans with initially low interest rates, and then pool and sell off the debts to other financial institutions as apparently safe ways to invest their money.

In September 2008, the housing bubble finally burst with the collapse of Lehman Brothers. This global bank, deemed ”too large to fail”, took multi-million dollar bail-outs to shore up the industry, resulting in the worst recession in 80 years. We are still feeling the backlash. But why did the bubble burst? With 5 years of hindsight we now know the main cause was the lenders themselves. Banks would lend to ”sub-prime borrowers”, who could not afford it. These high-risk loans were then passed on to the big banks, who would turn them into low-risk securities by pooling them back securities known as collateralised debt obligations (CDOs), which were sliced into tranches in relation to their exposure to default. The rating that agencies such as Standard & Poors assigned to these tranches were also too generously assessed, so they were sold on to investors as high-return investments.

When the house prices started to fall, the banks who lent the money found it difficult to get it back. They sought to avoid avoid repossession as house prices were falling. In deed, it was the banks, who had heavily borrowed themselves to make the loans originally, that caused this situation to escalate into a global economic crisis. Indeed, some major US banks had borrowed up to 30x their capital. The crisis then rapidly spread across the globe with many big financial names being saved by governments. It was when the Lehman Brothers was allowed to go bankrupt that the panic spread. Lending between banks stalled and interest rates on inter-bank lo ans began to rise. The capital began to be recollected and hoarded by those with debts.

The crisis then spread through the whole economy as the hoarding of capital by banks reduced the flow of capital from lenders to those needing money. Companies needing capital for daily activities found it increasingly difficult to borrow and many UK construction projects were stopped. For example, the UK government had to change the funding for the London Olympic Games from private to public just to keep it on track.

The cracks in the financial system had been exposed and a chain reaction began. Mortgage-backed securities slumped in value and all CDOs turned out to be worthless despite being rated highly. The ultimate lubricant of the financial system, trust, had been broken, and it therefore became difficult to trade any asset. The financial system was shown to have been built on banks allowing their balance sheets to bloat, without setting aside enough capital to absorb losses.

The regulators also played a large part in causing the economic crisis in which we currently find ourselves. Through letting the Lehman Brothers go bankrupt, the panic in the markets increased. The government’s decision to allow the bank to go bankrupt ultimately resulted in them having to intervene in many other companies once the economy froze up, with institutions hoarding capital after lending froze. However, the fault of the regulators is much more engrained than this. Through insufficient regulation on the banks they allowed the housing bubble, which the banks had helped inflate, become a problem in the first place.

George Osborne’s recently released Autumn Statement has seen the economic growth forecast rise from 0.6% to 1.4% in 2013, and from 1.8% to 2.4% growth in 2014. This is an encouraging sign that the UK growth is continuing to rise and we may see it gain momentum through 2014 as predicted and the end to the financial crisis. With the passing of the Banking Reform Bill through Parliament it is clear to see that the government is learning from its mistakes, but is it a matter of time to see whether this can stop anything like this happening again.