Why did the banks fail? An explanation here.

Tom_Kelly

What went wrong!

In a recent report by ‘The World Economic Forum’, on the ‘Soundness of Banks’, British banks came 44th with a score of 6.0. The maximum score was 7. (The nation with the highest scoring banks was Canada with 6.8. It is a sad indictment to see Britain come below Brazil, Barbados and Botswana. Mind you, Iceland came 36th!

So what is the problem? In a nutshell the banks have lent too much money and people have borrowed too much money (including people who couldn’t afford to borrow money). In the olden days when bankers were bankers you were lent a proportion of the asset that you wanted to acquire (never normally more than 70%) and it was never more than 3 times your salary. In recent years these figures have changed to 130% of the value and 7 times your salary. Clearly this would surely raise some queries from the banks bosses, but no, because we were in a golden era when asset values (especially property) only went one way upwards ………. ad infinitum! Reality has hit – big time!

The new regime is that each banking licence has a £50,000 per individual guarantee by the government (i.e. joint accounts have £100,000). If you have £50,000 with RBS and £50,000 with HBOS you are covered by both (although if you have £50,000 with Abbey an £50,000 with Alliance & Leicester you only have one cover as both are owned by Banco Santander). Having said that, to-date, the government have covered all deposit accounts including, against all logic, those investors who took the ridiculous high rates of Icesave; and it is questionable if they deserve to be bailed out by the rest of us tax payers who chose a lower rate of interest but higher protection.

The financial package put forward by the Government is one of the more intelligent responses so far and has provided the blueprint for co-ordinated European action with the anticipation of similar moves in the States. The offer to invest £50 billion into banks share capital essentially guarantees all the major banks. To put this figure into context the market value at the end of last week for HBOS, RBS, Lloyds TSB and Barclays combined was £57 billion.

In addition they have committed to guarantee £350 billion worth of loans between banks. It is this latter point that is so important for the mortgage market. If we take HBOS as an example, for every £1 of deposits they have lent out £1.70. The difference (i.e. 70p) they borrowed in “the market”. All was well until interest rates rose, then LIBOR (the inter bank lending rate) rose even more. This put pressure on margins then the short sellers appeared and started selling shares they didn’t even own. As the share price fell worries over HBOS grew and “the market” said that this implied more risk and HBOS would have to pay above LIBOR. This further deflated earnings and therefore the share price which then began to make depositors nervous – so they started withdrawing funds. £1.00 of money on deposit became 80p, and the cost of borrowing the extra new 90p (original 70p + new 20p) rose from 5½% to 9%. This happened not in the space of years, months, or weeks, but in days, if not hours. So the crisis became tangible. Confidence had gone, and banks would not lend to each other, let alone us.



NEXT STEP
This is a huge capital commitment by the Government representing up to 4% of GDP and the highest spend on nationalisation since the 1940’s. While this Government action has potentially saved the UK financial system it is going to be a little while before credit availability re-opens and one should be in no doubt that we are entering a significant downturn in the UK.

Dan_1976

Greed!!!

Why has nobody replied??

mic200202

So there we go 'the banks have lent too much money' and thats why they are in trouble.Nothing to do with global economics then? Nothing to do with overexposure to credit default swaps,over leveraging, and US mortgage bonds???!!
I refuse to believe that the UK banking crisis has been caused by over lending in the UK.The implication is that everyone has suddenly defaulted on their loans and credit cards to the tune of £50billion? If that was the situation then all the banks would be hit equally - and thats clearly not the case. Some banks have been taking lots of risks with in their attempts to get more and more profits.Those risks are involved in the international money markets and increasingly complicated investments.Triggered by the sub prime which started in the US, the downturn has spread through the system.Some banks are more exposed than others. Yes the big lenders have been hit by a downturn in the housing market, but not to the extent that they need a bail out of the type we have seen.This is part of a global economic problem.
Your point on 'in the olden days' when we had 3 x salary - where on earth does anyone make a correlation by pulling income multiples out of the air? The reason why the older system was there was simply that they didnt have the systems to cope with anything else.Today whether its 3x, 4x or more is based on affordability - ie you can lend more to someone who doesnt have lots of outgoings than to another who does whats the big difficulty with that? CML figures do not show that there is any massive increases in arrears than in previous years. I have never ever seen an individual take on on loan they knew they could not afford to pay back. Banks may have lent, but heck people borrowed too!!

Tom_Kelly

mic200202 wrote: »

Nothing to do with global economics then? Nothing to do with overexposure to credit default swaps,over leveraging, and US mortgage bonds???!!

Sorry that you don't get it but your points above are down to overlending worldwide. I referred to UK banks as that is what most people here can relate to.

In simple terms. The worldwide banking system increased it's lending capacity to fit the new lifestyle of borrowing rather than saving. A generalisation I know, but that is at the heart of it. They could make even more money by borrowing from other banks and institutions at say, 4.0% and lending at 5.0%. They then moved onto customers in a higher risk category which became known as the sub-prime market. Always chasing more and more profits and higher resulting executive bonuses. Don't be fooled into thinking that there was anything else behind it. Lenders such as Northern Rock started to take a further risk by lending in excess of the security value (Together mortgage) whilst other started to offer income multipliers of up to 7 times salary. When the bubble burst in USA the UK market realised that the lenders strategy was questionable which started the problem at NR. The domino effect that followed was a result of the actions I outlined originally.

Dan_1976

I agree with the pair of you.

It is over lending, over borrowing, bad management, bad mortgages being wrapped up and sold as good ones, general greed of the public (We have to take some blame) and risk taking by greedy fundmanagers and bankers with other peoples money! Over all its about going a step to far all on a global basis.

We have been hit hard as we base our economy so much on the house market and borrowing. Thing is the banks found a new way to make money and to actually lend more money than they had deposited, thats the big difference from now and the last dip!

lethal0r

good article, thanks for posting. helped me learn a little about how things work.

mic200202

Your basic inference is that overlending and bad debt has caused the downfall of NR to start and then I suppose the more recent firms. I again contest this as being grossly innacurate. Take NR for example - if bad debt caused its downfall then how come the arrears book show the following figures - As of August 2008 its arrears on residential mortgages was the massive figure of 1.18% - lower the average CML figure of 1.21%.On its togther mortgage book(a much smaller number) the arrears figure in June 2008 was 2.14%. Hardly the sort of bad debt to bring down the firm.The reason why NR failed was down to it being unable to source the money it needed because the supply had dried up on the wholesale markets.It didnt have enough savers to offset the amounts it needed.Thats really it - the wholesale markets stopped supplying due to lack of confidence as a result of the fall out on the US, not what was happening with UK lending per se.Once that pillar of its business model was knocked out there was nowhere left to go.The lending strategy was not the issue - as per the figures above demonstrate.

The US situation was caused by reckless lending on sub prime which is well documented elsewhere.The UK sub prime market is vastly different and much more stringently regulated.Northern Rock was not a sub prime lender.
Money supply is at the heart of all of this,not bad debt in the UK.

Tom_Kelly

mic200202 wrote: »

Your basic inference is that overlending and bad debt has caused the downfall of NR to start and then I suppose the more recent firms.

No it isn't. This isn't an opinion or an inference. I have condensed things as the full chain of events can get boring.

I have been asked many times for a simple explanation of what happened and I have recreated the answer in a couple of paragraphs. I am stating (not inferring) that the banking problem was caused by banks borrowing increasing amounts to fund a new breed of lending such as sub-prime, adverse, self certification, high income multipliers. This was for no other reason than increasing profits even further.

What seemed like a good idea at the time has proved to be a disaster for the decision makers.

The future? This will prove to be a case of two steps back for the economy and then a leap forward again starting in two years or so (could be less).

mic200202

Tom_Kelly wrote: »

No it isn't. This isn't an opinion or an inference. I have condensed things as the full chain of events can get boring.

I have been asked many times for a simple explanation of what happened and I have recreated the answer in a couple of paragraphs. I am stating (not inferring) that the banking problem was caused by banks borrowing increasing amounts to fund a new breed of lending such as sub-prime, adverse, self certification, high income multipliers. This was for no other reason than increasing profits even further.

What seemed like a good idea at the time has proved to be a disaster for the decision makers.

The future? This will prove to be a case of two steps back for the economy and then a leap forward again starting in two years or so (could be less).

I can tell you again that over lending has not caused any UK bank to get into difficulties.The stats simply don't show this (as I have shown above) so what are you basing your explanation on? - its really just conjecture and hearsay as much of the popular press have been doing.To tell you where I am getting my information from yesterday I was at a meeting which was attended by the chief economist of Abbey,Chief Operating Officer of HBOS, Head of Sales for Nationwide, Snr Corporate A/c Manager for C&G and Head Of Sale for Nank of Ireland. The clear message is that the money supply is /has caused the problems for UK Banks.Most of that money, supplied via the wholesale markets, was provided by huge US pension funds.Because of what has happended in the US sub prime market these fund managers are not looking for mortgage backed securities of any type to invest in. Hence no money to fund the big UK lenders therefore problems with those firms that rely on the wholesale markets.UK mortgage lending lending is expected to fall from around £346 billion in 2007 to £220 or less in 2008/09.Thats a massive drop.This is not enough to supply demand so everyone will suffer from less competitive rates, and harder to get mortgages for at least the next 2 years. And this is what has put pressure on UK banks. This will cause real problems for everyone,the choice of different types of deals will not be there so people will be stuck with much higher loan payments than necessary.

Pewter_2

Well it started with the US sub-prime market, but the reason it spread is because the banks both in the US and the UK and elsewhere changed their methods of lending. They started selling on the rights to the mortgage debt to third-parties, investors and funds that saw the income from mortgage repayments as a long-term investment. However, as they sold on the debts, the banks became bolder in their lending strategy, handing out ever increasing amounts of money, and taking more risks with the repayments in pursuit of profits. By offloading a proportion of the risk on to other institutions, they took it as a green light to take more risks with their lending. By the time the level of defaults on loans started to increase, it was already too late to stop the rot. The high risk from the years of high lending had spread far beyond the banks themselves, but into funds, and their investers, and so on.

Then the whole house of cards started tumbling down.

mic200202

Pewter wrote: »

Well it started with the US sub-prime market, but the reason it spread is because the banks both in the US and the UK and elsewhere changed their methods of lending. They started selling on the rights to the mortgage debt to third-parties, investors and funds that saw the income from mortgage repayments as a long-term investment. However, as they sold on the debts, the banks became bolder in their lending strategy, handing out ever increasing amounts of money, and taking more risks with the repayments in pursuit of profits. By offloading a proportion of the risk on to other institutions, they took it as a green light to take more risks with their lending. By the time the level of defaults on loans started to increase, it was already too late to stop the rot. The high risk from the years of high lending had spread far beyond the banks themselves, but into funds, and their investers, and so on.

Then the whole house of cards started tumbling down.

Pewter, you were going well there to start with then about halfway it all went a bit off the rails.If you would care to read my posts above then you will clearly see that your 'level of defaults...' lines are untrue. I agree this was a trigger for events in the US, but does not explain the UK banks position. If you can show me the arrears stats for the UK (which you wont be able to) I would take on board what you are saying.The UK DOES NOT have an arrears situation with mortgage lending anything like what happened in the US. That applies to 100% ,self cert ,and ordinary residential lending. It just has not happened. Yes they took on risk, but with other areas of business - investment strategies in the US and asset management.Nothing to do with ordinary primary lending in the UK.