Financial Markets Final Draft

Q: - “Why is British banking in crisis?” Provide reasons and suggest possible solutions? The report investigates of why the British banking sectors is faced with crisis and what are the reasons behind these crisis and where they originated from. The sub-prime mortgages crisis that started in summer 2007 were the creation of a long housing boom enjoyed by people, which were been fuelled by low interest rates and excess liquidity. During the boom period mortgages brokers enticed by big commission, let people with poor rating into accepting housing mortgages with little or no down payment and without proper tax documentation or credit checks. The groundwork was established for the coming mortgage meltdown. The mortgages were bought by banks and packaged together on Wall Street with other similar debts. That was then moved on to the Wall Street and where it then became “Structured Investment Vehicle”. Investors bought these mortgages and didn’t keep the loans for very long and sold them to investment, insurance firms etc world wide, who really looked at these mortgages as a way to make some serious money. The diagram below shows the difference between the two models of mortgages: -

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http://news.bbc.co.uk/nol/shared/spl/hi/uk/07/subprime_mortgage_market/img/s ubprime_tog1b_416.gif Many companies wanted in on this as they saw it as profitable so it became a big circus. The problem with this was that some investors weren’t aware of what was going on so they did not know who they owed money to and when they needed to pay anymore. It was made so attractive because the credit rating agencies, such as Standard & Poor's, Moody's, and Fitch, give ratings to every type of bond according to its risk.

Letter grades mark the safety of the investments like AAA is given to the safest ones, for example US government bonds. The problem with these high rating is that agencies used the wrong data to estimate the risk. Looking back historically, what they saw was a very low rate of defaulting, a very low foreclosure rate. However, the current situation was different - with new qualification requirements, new mortgages given to people who would never have been granted them before. This speculative housing was eventually going to burst. These mortgages were unlike the conventional mortgages that have a fixed-rate 15- or 30-year mortgages, but theses ARMs were offered at low interest rates that increased after a period of time. Once the interest rate is no longer fixed, it becomes variable, usually resetting once a year for the remaining life of the loan. Variable interest rates are connected to Federal Interest rates, which are adjusted by the Federal Reserve Board. As federal rates increase or decrease, homeowners' variable mortgage interest rates also increase or decrease. As the chart below shows that in 2004 interest rates were very low and in 2006 the rates reached 5%, that meant people payment went up as they mortgages were linked to Federal Interest rate. It resulted sub-prime mortgages began to re-set that lead to foreclosures. As these loans and CDO’s that had 100 of sub-prime mortgages, were distributed worldwide, it started to have a rifle effect on all financial system caused mayhem in the markets

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http://money.cnn.com/2007/09/18/news/economy/fed_rates/index.htm As the Andrew Capon, Editor-in-Chief, State Street Global Markets points out “Market participants don’t know whether to buy on the rumour and sell on the news, do the opposite, do both, or do nothing, depending on which way the wind is blowing”. The show’s the situation that was faced by investor and seller. Investors began to have doubts about the safety of their investment in the American sub-prime mortgage market and got worried that there is not a good chance that people will be able to pay the loans. This sent the world financial market down as investors started to refuse providing credit because they thought they will not get thee money back and from here the “Credit crunch” started. This had a direct affect on The Northern Rock Bank, which was the 5th largest mortgages lender in UK. The underlying mortgage started to perform poorly and

mortgages backed securities declined. That made investor twitchy when they were making credits available, credit that was been offered so readily before the sub-prime crisis started seized. When the credits markets froze Northern Rock was unable to borrow at rates that made sense, it could no longer fund new loans meaning shutting down the ability to write new business. This due to the fact the Northern Rock had been borrowing 60% on money markets. This is because Northern Rock operated very different unlike other UK institutions “ lending out the assets they hold for savers and earning a spread on the interest rate they pay savers versus the higher rate they charge borrowers for use of the assets”1. That is also the reason why Northern Rock Bank was first to go under because of their heavy reliance on borrowing. Even with the help of Bank of England “'lender of last resort' who provided emergency funding could not stop the inevitable. When the news hit about the northern rock problem’s depositary rushed to the Bank to get their money out in the fear of bank collapsing. “A statement from Northern Rock issued last week revealed that its treasury operations have a £275m exposure to US sub-prime mortgages. It also has a £325m position in structured investment vehicles, the controversial bank finance instruments that have become embroiled in the global liquidity crunch.”2 As the graphs below shows that the share price plumped, even after Bank of England provided Funds to Northern Rock and shows Northern rock borrowing compare to other UK financial institutions.

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http://news.bbc.co.uk/1/hi/business/6996136.stm#shares

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http://www.morningstar.co.uk/UK/funds/article.aspx?Site=UK&lang=enGB&articleID=53884&categoryID=13 2 http://www.telegraph.co.uk/finance/markets/2815865/Northern-Rock-appealsfor-white-knight-as-run-on-bank-continues.html

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http://news.bbc.co.uk/1/hi/business/7250498.stm On 17 September, the Chancellor of the Exchequer, Alistair Darling, pledged that the government would guarantee all deposits held by Northern Rock effectively nationalizing the bank. This is known as a “ Bailout” that refers “ where Government inject money and guarantee money to stop the business from collapsing to prevent larger calamity, as it believed to be justified”3. In the wake of Northern Rock bank collapse other UK financial banks were also starting to feel the pinch of credit crunch that had originated from the US and to over come the financial problem, banks started to strategise on how best to keep the Banks from getting into trouble. Banks like “Royal Bank of Scotland and Barclays who’s write off amounted to £2.1 billion, that seem hardly enough to justify the £28bn that has been wiped off their combined stock market value since the start of this year”4. The merger of HBOS and Lloyds was designed to shore up HBOS and protect the millions of savers who hold a combined total of £243bn in their accounts. This deal will be worth 12bn and will create a banking giant holding close to one-third of the UK's savings and mortgage market. Where as Barclays went off shore like Middle East who is oil rich and managed to “raise £7.3 billion from the state investment funds and royal families of Qatar and Abu Dhabi”5. As every had found the whole banking sector is in turmoil, which was by sub-prime mortgages in US. The governments have being pumping in trillion into markets to stimulate the economy and get the credits markets moving, but it is still not having that much affect. I think we should root out the problem that was caused by greedy mortgages lenders who sold loans to people who couldn’t pay the payments, for the commissions. Below are some solution that might solve the banking crisis: 3

http://www.wisegeek.com/in-economics-what-is-a-bailout.htm http://www.thisismoney.co.uk/investing-and-markets/article.html? in_article_id=426143&in_page_id=3&ct=5 5 http://news.bbc.co.uk/1/hi/business/7701405.stm 4

This brings me to the point the bank should go back old stick former rules of lending whereby loans were issued only to creditworthy customers with appropriate collateral or solid business plans. Another solution could be that banks should maintain an effective liquidity to counter situation they are in right know, where banks are refusing to lend to each other and have adequately capitalised withstand unforeseen losses without having to take quick decisions to shore up their capital. Banks must not only lend to one another but also to creditworthy individuals and companies. Economies can only flourish once cash is once again circulating through their veins. For instance, the US auto industry is said to be in trouble because people can't get loans to buy cars. Finally there has to oversight and regulation like FSA need to be more stringent and should devise clear-cut rules limiting the level of leverage an institution can achieve in relation to its capital. Auditors must be careful, while rating agencies and should pay a price for assigning misleadingly high ratings to suspect investments. As “Britain’s financial services regulator admitted Wednesday that it had done a poor job of supervising Northern Rock, the mortgage lender which became Britain’s most prominent victim of the sub prime mortgage crisis”6. UK banks started to hit trouble because they had invested in mortgages that were “toxic”, thinking that these were good investments on the advice given to them by credit rating companies. These mortgages were given AAA, which was completely wrong; as it was not correct value This caused investor’s to lose confidence in the market and banks stopped lending to the other banks and institutions causing a massive problem and extending the problem even further. This led to tightening of credit certainly causes many problems in the short term, but this too shall pass. Regulators also contributed to the problem, as they didn’t check on banks as it was relaxed and if it wasn’t, this problem might have been stopped in its tracks, as they would never have given permission to bank to go ahead with risk investment vehicles Markets I think will correct mistakes by destroying misallocated capital, and we're certainly witnessing that now. But it should at least shake out flaws in the regulatory and credit ratings systems, and five years hence, the City and their Wall Street counterparts will have something new to worry about.

Reference: http://uk.youtube.com/watch?v=mzJmTCYmo9g http://www.historyandpolicy.org/papers/policy-paper-64.html http://dealbook.blogs.nytimes.com/2008/03/26/uk-regulator-admits-fault-in-northernrock-collapse/ 6

http://dealbook.blogs.nytimes.com/2008/03/26/uk-regulator-admits-fault-innorthern-rock-collapse/

http://public.getlegal.com/articles/subprime-mortgage-lending http://www.thisismoney.co.uk/investing-and-markets/article.html? in_article_id=426143&in_page_id=3&ct=5 http://news.bbc.co.uk/1/hi/business/7701405.stm http://www.guardian.co.uk/money/2008/sep/18/savings.banks1 http://www.telegraph.co.uk/finance/markets/2815859/Why-Northern-Rock-wasdoomed-to-fail.html http://www.morningstar.co.uk/UK/funds/article.aspx?Site=UK&lang=enGB&articleID=53884&categoryID=13 http://www.foreclosuredataonline.com/blog/foreclosure-crisis/the-subprimemortgage-crisis-how-did-it-all-start/ http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/a rticle3628701.ece http://www.independent.co.uk/news/business/news/banking-crisis-the-fear-spreads402674.html http://news.bbc.co.uk/1/hi/business/6996136.stm http://www.sciencedaily.com/releases/2008/11/081114080931.htm http://www.thisismoney.co.uk/investing-and-markets/article.html? in_article_id=426267&in_page_id=3 http://www.workersliberty.org/story/2007/09/27/lessons-northern-rocks-collapse http://www.historyandpolicy.org/papers/policy-paper-64.html http://news.bbc.co.uk/1/hi/business/7007076.stm http://www.guardian.co.uk/commentisfree/2008/nov/07/mortgagelendingfiguresmortgages http://www.guardian.co.uk/commentisfree/2008/nov/07/mortgagelendingfiguresmortgages http://www.telegraph.co.uk/finance/markets/2816223/Northern-Rockeffectively-'nationalised'-by-state-guarantee.html http://news.bbc.co.uk/1/hi/business/7622180.stm http://money.cnn.com/2007/09/18/news/economy/fed_rates/index.htm Actual word text:-1642