- LITERATURE REVIEW
2.1 Literature review on Credit Crisis
The dominant discourse over the last year has resulted in the inclusion of ‘credit crunch’, once considered an arcane economic term, into the latest edition of Oxford English dictionary. Bernanke and Lown (1991:206) define a credit crunch as “a decline in the supply of credit that is abnormally large for a given stage of the business cycle. Credit normally contracts during a recession, but an unusually large contraction could be seen as a credit crunch”. They identified that a stable financial system is the one which maintain the delicate balance between credit demand and supply and proposed that credit crunch is an abnormally large decline in the supply of credit and argued that the demand factor is mainly caused due to the reduction in lending. A second definition of credit crunch does not focus on the reduction of lending rather it emphasis on shortage’s microeconomic principle. It states that if the demand for a good at the current market price surpasses the supply, then there is a shortage (Stiglitz and Weiss 1981). A credit crunch can therefore be defined as a period of sharply increased non-price rationing (Owens and Schreft, 1992).
Research shows (Allen, 2001) that contrary to conventional financial theory, global financial systems that are subject to market forces are prone to periodic financial crises. Historic examples of these crises include Dutch Tulipmania of seventeenth century, the South Sea bubble of England, the 18th century Mississippi bubble in France and US great crash of 1929. Similar events occurred in Norway, Finland and Sweden in 1980s and in mid 90s most of East Asian countries started to see the melt down of their economies (ibid; Kaminsky and Reinhart, 1996; Kaminsky and Reinhart, 1999). Although initially many experts suggested that the market failure caused in South East Asia market was linked to the corruption and weak political systems in these states, however when many American countries started suffering from this financial meltdown it became clear that this crisis is rooted into global financial system and its policies.
Some of the early work is on financial crisis is done by Williams (1963), who aimed to understand the financial causes and effected of 1931 financial crisis on UK housing crisis and mortgage lending sectors. Similar study was done by Stone (1975), who wrote series of papers, studying USA housing sector and how two different economic approaches, capitalism and socialism impact the housing market and financial market. His research highlighted some major flaws in capitalist approach and he recommended that it is utmost important that USA should reconsider their existing housing and mortgage strategies. His research resulted to the formation of a transitional socialist housing program (Stone, 1978). In same era Rosen (1977) examined the magnitude of the USA housing crisis, its causes and effects on financial sector and outlined a proposal which could help alleviating the crisis.
Bernanke (1983) presented the case study of 1930s US financial crisis. His work was based on the Friedman-Schwartz work. He studied the background of 1930-1933 financial crises, its sources and its correspondence with aggregate output movements. He also explained how the runs on banks and the extensive defaults can reduce the efficiency of the financial sector. Bernanke (1983) presented a theoretical framework to understand 1930s financial crisis. Among other sector, he also studied the effects of financial crisis on the housing market. In 1985 Diaz Alejandro tried to analyse the financial liberalisation in Latin America. His study focused on the imperfections in financial markets. He suggested that instead of following USA model of liberalisation, Latin American countries should find their own ways which better suite their domestic market. The key focus of his study was on housing market.
Boddy (1989) also did research on financial deregulation and UK housing finance. His looked into the building societies act 1986 and its impact on housing market future in UK. In 1991 Clair and Tucker (1991) tried to identify the causes of a credit crunch. They propose a six dimensional model which highlighted the key reasons of financial crisis. Bernanke and Lown (1991) wrote a classic article on the credit crunch. It documents the decline in the supply of credit in 1990, 91 recessions and also studies the five previous rescissions, going back to 1960s. The research reveals that the reason which led to the bank cutting their loan supply in 1990s was the combine effect of the lack of financial capital and decline in the quality of borrowers financial health. later Clare and Tucker (1993) highlighted that in part the term credit crunch has been used, firstly the understand the decline in the values of bank capital, and to analyse the conditions imposed by bank supervisors, regulator or banks themselves which require banks to grasp more capital then they usually would have held.
In mid 90s another financial crisis hit the East Asian markets. This resulted in significant exchange rate adjustments and, property and stock market reversals in Indonesia, Thailand, Philippines, and many other countries and raised concerns about the quality of the world financial system. In 1997 Claessens and Glaessner wrote a book which tried to highlight the flaws of global financial system. Their research focused on developing countries and it introduces a methodology for adjusting corporate financial statement for inflation effects. Ding et al (1997) also studied East Asian countries financial crunch and tried to explore its aftermath. Their work follows a systematic framework to assess the occurrence and the magnitude of the credit crunch in five counties including Indonesia, Korea, Malaysia, Philippines, and Thailand. Similarly Lauridsen (1998) studied the financial crisis in Thailand. He classed this crisis as ‘private sector failure’, and explained how the careless lending/borrowing, individual greed, political instability, indecisiveness and mismanagement at political and administrative level can lead economies to disastrous situations. Herring and Wachter (1999) used Mark Carey model and tried to understand the link between financial sector and real estate market. The authors looked into Asian financial crisis and noticed that the most affected countries first experienced a collapse in property prices which weakened their banking system before experiencing exchange rate crisis. The authors first discuss that how real estate prices are determined and why they are so vulnerable to deviation from long-run equilibrium prices, paying special attention to the role of banking system in determining prices. Increase in the price of real estate may increase the economic value of bank capital; however the opposite it also true. Other authors who studied the relationship between Asian financial crisis and housing market include Hahm and Mishkin (2000), Mera and Renaud (2000), Krugman (2000) and Sheng and Kirinpanu (2000).
In 2003 Hunter at al (2003) published a book in which he studied the 80s and 90s credit crunches for both industrialised and developing worlds. His research showed that both decades have seen prolonged build-ups and sharp collapses in asset markets such as housing, stock and exchange. His book examines asset price bubbles to further our understanding of the causes and implications of financial instability, focusing on the potential of central banks and regulatory agencies to prevent it (Hunter et al, 2003). In last half decade many researchers looked into the causes and effect of global credit crisis and how it is linked with the housing market. This include research of Allen (2001), Blankenship (2002), Edelsteina, and Lum (2004) and Buckley and Kalarickal (2005). Bordo (2005) did a very interesting study of USA housing marketing. He showed major concern about the housing prices of US and classified it as bubble. He studied US economic history feared that this bubble will soon bust with dire consequences for the real economy.
2.2 Global Economic Melt Down (2007- 2009 Financial Crisis)
Since the summer of 2007 the global economic prospects have deteriorated markedly. The credit crisis which began in July 2007, has caused credit conditions to worsen across advanced economies and global economic growth is slower then ever. The first incident took place in early May 2007, when the Swiss owned investment bank UBS closed its Dillon Reed hedge fund after they incurred $125 million loss in subprime mortgage. Initially it was perceived as an isolated incident, but same month Moody’s announced it will review the ratings of 62 asset groups. 21 of them were US Abased and were in subprime mortgage securitisations. In June two failing hedge funds were supported by Bear Stearns and in July US three ratings agencies including Standard & Poor’s, Fitch Ratings, and Moody’s all downgraded subprime related mortgage goods from their secure AAA status (Mizen, 2008). IMF (2009) figures indicate that compared to 4¾ percent expansion in 2007, globally growth have slowed to 3.7 per cent in 2008 and is expected to further drop by 2.2 percent in 2009. Governments around the globe have taken extraordinary actions to tackle this crisis however it is still to be controlled (Crown, 2008).
As highlighted by Reinhart and Rogoff (2008), Baker (2008) the current financial crisis began when investors loss their confidence in the value of securitised mortgages in United States resulted in a liquidity crisis. As concerns grew over the implications for lending bodies, the effect on US financial markets spread quickly across the globe. To date the US housing market is most affected by the problems. It is estimated that by the end of 2008 around 4.5 percent of mortgage borrowers and 18 percent of US subprime borrowers are at the moment behind on their payments. Recent rise in oil prices triggered this crisis further and it became a global phenomenon, a crisis which is considered worst than Great Depression. As this is an ongoing phenomenon, not a lot of academic literature is present on it. Some key contributions are done by Feldstein (2007), Reinhart and Rogoff (2008), Baker (2008), Muolo and Padilla (2008) and Muellbauer and Murphy (2008). The central element of their work is the analysis of current financial crisis and how the housing bubble contributed and enhanced it. They all mainly look into the circumstances under which the bubble began to grow and discussed how financial institutions greed and the lack of proper regulatory structure allowed the bubble to grow to even more dangerous levels and eventually to bust in a way that has placed unprecedented strain on the global financial system (Murphy. 2008).
2.2.1 Causes of Global Financial Crises
The recent financial crisis has already affected millions of people across globe. It is one of the hottest topics and in last one year. We have witnessed the government bail outs for major financial institutions, and outright crash. This include major events such as nationalisation of northern rock, bankruptcy of Lehman Brothers , Merrill Lynch sale, nationalisation of major banks in Iceland, UK government taking control of Lloyds Banking Group’s interests etc(Prosser, 2008 ;Marketwatch, 2008; Merrill Lynch, 2009). Although from very beginning American housing sector has been citied as the major causes of this crisis, it is now revealed that the global financial system was vulnerable because of its highly leveraged and complex financial contracts and operations. According to the chief economics commentator and associate editor of the Financial Times, Mr Martin Wolf, the recent credit crisis has significance similarities to the previous financial crisis or turning points of economy, e.g. the emerging markets crises in 1997-98 or the dotcom boom-and-bust in 2000. Similar to previous crisis it involved the international investors and the asset backed securities consisted risky mortgages, investments, and pension funds globally (Wolf, 2007). However at this stage it is important to understand that this crisis is far more complex then others. Many authors have tried to identify the actual causes of this recent financial crisis (Patrick, 2008). Some of which include following:
Foreclosures in US Subprime Mortgages:
As compared to other financial crises, the 2007-09 credit crunch is far complex as it involves the financial innovation by banks which allowed new ways of bundling the assets. This crisis is closely linked with the growth of subprime mortgage market in the US. In the second half of 2007 US sub-prime mortgages foreclosures raised drastically. This activated global financial disruption and this trend in foreclosures has continued for last two years (as shown in Chart below)
Graph 2.1: US sub-prime mortgage foreclosure rates (Source: Crown, 2008)
The financial institutes in US offered nonstandard mortgages to individuals with nonstandard credit profile or income. It got even worst due to the mispricing of the risk of these financial products and as concerns grew over the implications for lending institutions, the effect on US financial markets spread swiftly around the Globe.
Bankruptcies and rise in global unemployment:
When the number of defaults increased it caused many small, medium and even large sized US and global companies to go bankrupt. These losses were not restricted to mortgage lenders; other institutes such as bank, car manufacturers, construction companies etc also lost billions of pounds and has raised global unemployment rate. Banks had to write off large losses and this made them very reluctant to make any further lending, especially in the subprime sector. As a result, all around the globe many markets has dried up and it has become very difficult to borrow money and to raise funds. The cost of interbank lending has risen considerably (Crown, 2008).
2.3 The Implications of credit crunch on the UK housing market
Growing tension and uncertainty in macro-economic stability of financial market is now being felt across the UK housing sector. It is estimated that only in the first quart of 2009, house prices in UK declined by 2.7%. Although this was the smallest quarterly fall since 2008 first Quarter. Figures indicate that since the peak in July 2007, UK house prices have fallen considerably (as sown in graph 2.1). On average the house prices in UK range from -1.5% in the North to -22.2% in Northern Ireland and are still declining. It is estimated that the UK average house price has returned to just below the level it was at in year 2004 Quarter three (Lloyds TSB, 2009). It is estimated that by the end of 2008 in the UK around 1.5 percent of mortgages borrowers were in long-term arrears whereas between 2000 and 2007, the total sum of outstanding of UK residential mortgage-backed securities and covered bonds rose from £13 billion to £257 billion. Only in 2006, the outstanding amount of RMBS raised by £78 billion (Crown, 2008).
Table 2.1: UK House Prices: Historical Data
All Houses, All Buyers (Seasonally Adjusted)
Source Table: Lloyds TSB, 2009
UK house prices: year percentage change (Source: MortgageGuideUK, 2007)
In literature following has been identified as the main reason for falling house prices. Shortage of Mortgage Finance:
Due to the credit crunch it is difficult to get the mortgage. In literature shortage of Mortgage finance is identified as one of the most important factor in falling demand for housing in United Kingdom. It is estimated by the UK’s Council of Mortgage Lenders, that the average mortgage approvals in 2008 is as low as in year 1991. Figures clearly indicate that till July 2007, mortgage providers were very competitive and were eager to pull new customers. They were offering products such as 100% mortgages and for high income customers, multiple mortgages. The lending process was so easy and straight forward that many customers with bad credit profile or those who were not able to commit also got these deals and the result was bad credits which led to the credit crisis. Today banks across globe are struggling to raise finance. They have therefore reduced their mortgage lending. Banks have also removed many mortgage products such as ‘subprime’ products, and are now asking for large deposits. Therefore the lending process for first time buyers is very difficult (MortgageGuideUK, 2007).
First time buyer struggle to buy a new house:
For the first time buyers it is becoming increasingly difficult to get on the property ladder. In the past banks offered generous deals such as interest only mortgages, 100% mortgages, or self certification. The Abbey National allowed first time buyer to have five times a borrower’s salary. This irresponsible lending possibly fuelled by greed ruined the whole mortgage market.
The ratio of house prices to incomes has risen to an all time high:
In UK’s housing market many potential buyers are struggling to get the mortgage as the ratio of house prices to incomes is 50 percent higher than the long term average (1975-2005) (The Economist, 2008). It is estimated that by the end of May 2009 the unemployment has exceeded 9 percent. This is worst in last 25 years and many buyers can no longer afford a new or existing mortagage. An important point to remember is that the house prices can fall even if there is limited supply e.g. in Japan in the 1980s the house prices were at their peek. Since 1991 they started falling and have fallen for 14 consecutive years (MortgageGuideUK, 2007).
Negative Market Sentiment in Housing Market:
Traditionally in UK society house was not considered as just an asset, but it was a place to live. However in last few years demand of UK housing significantly rose and many investors started investing into the housing market. 2007 figures indicate that in the UK letting of property was the largest business and it accounted for 7.9% of total GDP or nearly £100 billion annually (Hamilton, 2008). However as soon the US housing market went bust and the house prices started falling, the investors stopped investing in it. According to Hamilton (2008), the UK’s housing market is dominated by herding behaviour. This means that most of the rise in demand is rooted into market sentiment rather than economic fundamentals. Therefore when the market sentiment changed, people became less confident about buying. OECD (2009) figures indicate that 15% of UK house prices were never reflected in economic fundamental, instead they were ‘speculation’. As soon the house prices fell, the buyers see no incentive to buy.
Market Sensitivity to Interest Rates:
Figures indicate that in last decade there was record increase in the level of consumer borrowing in the UK. It combines both personal debt such as credit cards and mortgage borrowing. It is estimated that by the end of 2008 the total level of debt was approximately £1.168 trillion (BBC, 2009). The UK consumers are therefore very sensitive to increase in interest. Even a modest rise can significantly impact the consumers’ confidence and spending. The housing market is more vulnerable to any rise in interest rates. Although in the last quarter of 2008 the Bank of England reduced the interest rates, it was too late and many banks have still not passed these cuts to the homeowners.
Northern Rock and other financial institutions effect on consumer confidence: Research shows that the failure of Northern Rock and problems of HBOS, Lloyds TSB and other financial institutes have severely dented consumers’ confidence in the UK mortgage industry (MortgageGuideUK, 2007)