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Low interest, high loans…

Updated Thursday 6th November 2008

Following the Credit Crash Britain programme Chris Giles, Economics editor for the Financial Times explains how low interest rates and borrowing have affected our economy.

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HOW THE BANKS AND BUILDING SOCIEITES BECAME COMPETITIVE LENDERS

By the mid-late nineties the landscape for banks was much more competitive, they now had to make money by lending to people in the UK or abroad, they had to get money in from savings from here or from the rest of the world. As we’ve progressed into this decade we’ve heard more and more that they were trying to get money in from the rest of the world. They became more global players in the banking sector, in the financial sector, even some of the very small banks that 10 years earlier had been very provincial, building societies with very localised customer base.

HOW LOW INTEREST RATES ENCOURAGED THE HOUSING BOOM

Interest rates came down in 2003 to 3.5%, the lowest rates in the Bank of England’s history since the 1950s, and that of course was quite different for consumers. It meant that suddenly mortgages were much cheaper than they had been, and house prices appeared much more affordable than they had been before because you could get a mortgage at quite a high loan and still it wouldn’t appear too expensive within your income.

HOW RISK ENTERED THE BORROWING SYSTEM

For a long period everything seemed to be a virtuous circle. House prices would go up, so the burden of a mortgage would go down, the mortgages would appear more affordable, you wouldn’t worry even if you lost your job and you got kicked out of your house as you would still have a pot of money at the end of it.

Things looked OK. The same for the banks when they looked at their books they could say ‘well, even if something horrible went wrong we wouldn’t lose much money, our shareholders are very safe and secure, we can give them dividends’ everything looked fine.

And so for that period you keep on lending, you lend more and more and more, you take on more risky customers as your overall books still look perfectly fine. And it’s great for the more risky borrowers because suddenly they have access to credit which they never used to have access to. And slowly and gradually the whole system begins to develop risk, and house prices rise to a level, and debt rises to a level where if something goes wrong it’s no longer fine.

2005 INTEREST RATE CUTS LEADS TO MORE BORROWING

By summer 2005 there was real concern that something very nasty was happening to the economy, and just then in August 2005 the Bank of England cut interest rates. Which at the time most people thought was the right thing to do just to give a little extra demand in the economy, take off some of the pressure and let things pick up again.

What we didn’t realise with hindsight, is the bank would probably admit that cut was a mistake. Not to criticise the bank as very few people at the time thought it was a mistake. What was actually happening was underlying all of this, was the economy was really picking up on its own and with the back half of 2005 and into 2006 we really were back into boom times in the economy and housing market.

HOW THE REPACKING OF DEBT LED TO THE CREDIT CRUNCH

We’re certainly right in the middle of a the repercussions of what was happening in 2005 to 2007 where banks were suddenly finding a new source of financing from the global capital markets, where they would package up all their loans and sell them on, which they thought was incredibly safe because that meant that they weren’t taking the risk but other people were taking the risk.

But these other people are now finding out that they are losing money hand over fist, they can’t sell on these things. They thought these were bonds they could buy and sell just like Government bonds. But actually when push comes to shove they found that because they don’t really understand which mortgages are actually in them, no one quite knows who it is, you don’t know the customer, you don’t know who it is who will be paying the loan back. Most of them are going to be perfectly safe, but the information is so lacking no one is touching them with a bargepoll and so it’s causing havoc across the whole global financial system.

This video extra is part of Credit Crash Britain: Money for Nothing which was first broadcast on Thursday 6th November 2008 on BBC TWO.

 

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