1.3.2 The build-up to the global financial crisis
No event in recent decades has had a more cataclysmic impact on the financial services industry than the 2007/08 global financial crisis. At the height of the crisis there was a material risk that the banking system would implode with banks refusing to lend to each other. Since confidence underpins banking and financial services generally, the collective collapse of confidence in these years posed a threat to the industry and the wider economy.
From the early 1990s through until the mid-2000s financial services experienced a boom – supported by factors like the housing market that you looked at earlier. Lending expanded rapidly and financial institutions saw growing balance sheets and profits. The underlying trend of falling interest rates helped to underpin the growth of lending business.
It is generally accepted that the immediate trigger for the problems was the collapse of the so-called sub-prime mortgage market in the USA.
What exactly is a sub-prime mortgage?
In simple terms, it is a loan for property purchase that is offered to a sub-prime borrower: one who is deemed to have a relatively poor level of creditworthiness. This of course begs the question of why anybody would want to lend money to someone who has a high chance of not being able to repay it. The rationale for undertaking such business is that the loans are made on terms which build in an expectation that a proportion of borrowers will default.
In 2007, the neat business model of sub-prime mortgage lending started to unravel, with global consequences. US interest rates, having fallen in the early years of the 2000s, rose sharply during the period 2004–2006. Inevitably, the sub-prime market suffered particularly badly, given the relatively poor credit standing – and, by inference, income levels – of the borrowers. Many experienced difficulties in meeting the resultant higher interest charges on their mortgages. Default rates – the proportion of mortgage holders unable to meet their repayments – rose sharply to levels much higher than anticipated by those firms that had originally made investments in the mortgage-backed securities that had been used to finance the sub-prime lending business.
As US homeowners defaulted, the investments that comprised the loans that had been made to them fell in value. The banks and the other investors that were exposed to these losses suddenly found themselves in difficulty. Several of these were banks in the UK. A US sub-prime problem had therefore hit the UK financial services industry.
The financial crisis that was about to befall the UK was also to extend beyond those firms directly exposed to the US market. The impact of the collapse of the sub-prime market meant that banks and other financial firms became reluctant to lend funds to each other in what are known as the wholesale money markets. This was because they had become concerned that they might be lending to those who had been caught up in the collapse of the sub-prime market and might therefore themselves face difficulties repaying borrowed money. The first UK casualty was Northern Rock bank, which had to be rescued in September 2007 and subsequently nationalised when it found itself unable to raise funds from the wholesale markets.
All around the world, a paralysis started to develop in the financial markets, as banks curtailed their lending activities and became more cautious about whom they would lend to. The availability of credit to financial and non-financial firms and households began to dry up. The ‘credit crunch’, as it quickly became known in the media, was taking hold of the global economy.