A bubble in the US housing market precipitated the financial crisis of 2008 and lead to
markets around the world being affected (Soros 2008 FT). There was excess money in the economy
as a result of an artificially low interest rate and when all the credit worthy borrowers no
longer demanded the money, financial institutions turned to ones who were able to repay
loans at the lowered interest rate (riskier borrowers). These sub-prime mortgages would
have only been the problem of the US if banks did not package the toxic assets with other
assets and sell them on to third parties around the world. The inability of these third party
institutions to verify what exactly made up these financial securities was a key factor in how
high the velocity of trade in these assets was. Returns were dependent on these borrowers
repaying their loans at the prevailing interest rates, which proved to be impossible due to the
lines of credit on individuals and firms being restricted leading to massive defaults.
Under FRFB, the artificially low interest rate attracts individuals who would otherwise be
unable to borrow; they are able to do so and pay the lower rates once borrowing continues
by other individuals in the future. This is the (X+r controversy); the banks provide X
amount of money and require X plus interest. This model is unsustainable unless individuals
continue borrowing and most of them repay debts. However, game theory tells us that what
is optimum for an individual is not always socially optimal. The moral hazard problem arises
when banks know that there is a bailout clause in the form of the government, should they get
into trouble because the economy and banking system are interconnected.
The crisis was similar to others that have occurred since world war two; however, it marked
the end of credit expansion based on the dollar as the international reserve currency (Soros
2008 FT). Soros (2008) states, “The boom bust process usually revolves around credit and
always involve a bias or misconception”; this is usually a failure to recognise a reflexive,
circular connection between willingness to lend and the value of the collateral, highlighting
the myopic nature of individuals.
The easy access to credit generated demand for houses that push the property values up,
leading to more availability of credit. The bubble was created when individuals attempted to
refinance their mortgages at a profit (Soros 2008 FT). Quantitative easing (QE) allowed the
process to continue whenever there was trouble in order to stimulate the economy.
Market fundamentalism became popular in the US in the 1980’s; fundamentalists believe that
markets always tend towards equilibrium. However, without government intervention they
would not survive, so it was the government, and not the markets themselves that prevented
the breakdowns.
It is argued that had the products (securities) not become too complicated to calculate the
risks associated with them, the financial system would not have crashed as it was the inability
for objective organizations (government and credit rating agencies) to rate them that lead
to banks being deceptive. The quantitative easing programme could have continued its
successful trend of economic stimulation.
The financial crisis affected the UK’s banking system as a whole. Many of the major
institutions found themselves in dire need of liquidity in the form of government loans
(bailouts). The government has a controlling stake in the Royal Bank of Scotland and a
minority stake in Lloyds banking group resulting from the bailouts provided.
Since 2008
The government has sold some of their stake in Lloyds at below market price and still managed to make a profit. This sale sparked a ‘feeding frenzy’ among investors, only somehow the government managed to prevent some of them from gaining access to what the were providing. So the UK government profited from this investment (bailout of the banks) and those institutional investors who purchased the shares sold by the government profited from this sale because of arbitrage (under arbitrage you are able to buy at a below market price and instantly make a profit by selling at market price to buyers, while taking on no risk).
The taxpayers who assisted in helping bail out these financial institutions received nothing from this initial sale of shares, however it is anticipated that within the next year more shares in Lloyds held by the government will be sold.
Some other stakeholders have feared off even worse than the investors and the government. These are the individuals who are in receipt of less now than before the crisis because of loss of jobs, inflation eating away at what wealth they do hold, falling house prices (outside London) and pensioners (those whose portfolios comprised of stocks and property).
1. How have you been impacted by this crisis if you have been living in the UK?
2. How much of your portfolio consisted of stocks (from financial institutions) and what was the capital loss or reduction in wealth faced by selling or holding on to these stocks?
3. Have the lower interest rates had a noticeable favourable impact on your mortgage repayment (if variable) and how long do you expect this to last?
