The current credit crunch started in the US and is now a global phenomenon. Stock exchanges across the globe have suffered billions of dollars of losses, and the UK’s financial and housing markets have also been hit hard by the crisis. Figures show that, on average, house prices across the country have seen falls of approximately 15 percent to 25 percent and despite government efforts such as VAT cuts, bailout packages and reduction of the base rate, this chaos is yet to be over. The aim of this thesis is to enhance the understanding of this financial crisis, its causes and the effects on the UK housing and banking sector, and to recommend strategies which could be used to avoid such crises in the future. The research methodology used in this thesis is mainly qualitative and is from secondary resources.

Research shows that the major causes of global financial crisis include: greed of financial institutions, foreclosures in subprime mortgages, high level of leverage used by all financial institutions, closely linked market participants of the financial and housing industries and an increase in bankruptcies and global unemployment. Research also reveals that the most important reasons for deteriorating house prices are: a shortage of mortgage finance, first time buyers struggling to secure finance and mortgages, an unbalanced ratio of house prices to incomes, negative market sentiment in the housing market, market sensitivity to interest rates, and, last but not least, lack of consumer confidence, as people are no longer willing to trust financial institutions they perceive as greedy. Analysis of the financial performances of the UK’s two top banks, Barclays Plc and Lloyds Group Plc, exposes the banks financial losses in their investments in subprime mortgages and decline in revenue, profit and the shareholder returns. Analysis revealed that there is an obvious link between financial institutions and the housing industry. After studying the whole situation it is suggested that all financial institutes should improve their corporate governance, internal risk assessment strategies, finance strategies and staff incentive structure etc. Banks should enhance their transparency. The UK government needs to reconsider their long term financial strategies and to work with industry to make financial products, literature and language straightforward for consumers, so that they can plan ahead and make informed choices.

1 BACKGROUND

1.1 Introduction

The financial crisis which originated in the USA has now become a global phenomenon (Bergsten, 2009). To date, stock exchanges across the globe have crashed. It is estimated that by the end of 2008, collective losses of London, Frankfurt and Paris markets alone were more than 350 billion dollars (Time Online, 2008). Bartlett (2008) identified that this financial crisis originated with the downfall of US sub-prime mortgage industry. However, the intensity of this disaster is such that it has affected the whole world.

August 2007 is considered the prime time for the UK housing market. The housing industry was at its peak and the market was booming. However, early in 2008, the UK housing market started being affected by the global credit crisis. Since July 2008 the UK housing market began reporting substantial losses in sub-prime mortgages in which banks had invested significantly over the decade. It is estimated that between August 2007 and April 2009, the UK housing market declined by at least 15 percent, whereas the capital was worst hit by a 25 percent decline in the average house price (Walayat, 2009). A consensus among experts (ibid, Bartlett, 2008) is that serious lending to sub-prime borrowers with high risk of default, a history of loan delinquency, inadequate debt experience and recorded bankruptcy contributed to these losses. So, although the bank’s heavy and risky lending in the housing sector at first resulted in a boom in the UK housing market and a sustained jump in house prices, the succeeding financial losses suffered by the banking sector in turn resulted in bursting this artificial bubble in the housing market by reducing demand for house-buying due to low liquidity. This resulted in a swift reduction in prices as shown in graph 1.1

Graph 1.1: UK house price forecast Aug 2007- Aug 2009 (Source: Walayat, 2009).

Previous studied indicate that the global financial systems is exposed to market forces that lead to periodic financial crises. These include the recent the early 90s US great crash, the 1980s Scandinavian credit crunch, the mid 90s East Asian financial crisis etc (Kaminsky and Reinhart, 1999; Bartlett, 2008). Research shows that the US housing market saw its initial financial wobble in February 2007, when sub-prime mortgage holders started defaulting in great numbers; however, at the same time the UK housing market continued to rise. In August 2007, the UK housing market reached its maximum limits. Many provided reasons as to why the UK housing market would never fall. These included:

Immigration: every year thousands of immigrants enter the UK and it was expected that these 800,000 migrants would never let the UK housing market suffer, especially in such an overcrowded country.

Strong UK economy: the UK economy continued to outperform mainland Europe and the US. When the credit crunch hit the US, the UK market continued to grow at the same pace for more than a year. This gave a false impression to observers and they continued to predict the best for the UK housing industry and lenders continued investing in high-risk borrowers and buy-to-let landlords who assumed capital rises in their rental properties.

Lack of Home Building: Up till early 2007, the UK home building associations use to build traditional terraces, and semi-detached; however, the ongoing boom made them invest in trendy flats and apartments, many of which were bought by investors as buy-to-let properties. This new trend transformed many city centres. Most of these high rises were due to be completed during 2007 and 2008. This created a glut of overpriced city properties which, for a time, met the needs of buyers and investors (ibid).

It was summer 2007 when some began raising the possibility of a possible UK housing market property crash (Walayat, 2007). Global credit market conditions continued to deteriorate. Then there was the first run on a British financial institute for well over a century: Northern Rock. This incident spurred the deterioration of UK’s financial market. It was April 2008 when the fall of the UK housing market started. During the summer months, the UK house market witnessed an accelerated decrease in house prices. It is estimated that by the end of August 2008, the house prices in the country were, on average, already 10 percent lower than at the same time the previous year. In September 2008, to support the deteriorating UK housing market, Gordon Brown announced 5% VAT cuts. The UK Government banned short selling of financial stocks and nationalised Bradford and Bingley Building Society. These were followed by the panicky interest rate cut of October 2008, announced by Bank of England, and an unexpected £500 billion bank bailout package. However, all these measures could not support country’s financial and housing sector. In November 2008, the Bank of England further reduced the interest rate to 1.5%, but even this extreme measure could not bring the housing market back to its previous levels. Today, the UK is experiencing one of its worst recessions in modern times. Unemployment in the country has already risen above 2 million, and it is estimated that by 2010 it will reach 2.6 million (Seager and Wood, 2009), although it may be a consolation to realise that all other European countries are suffering in a similar way.

As discussed earlier, the financial crisis began in July 2007 when investors lost their confidence in the value of securitised mortgages in the US resulting in a liquidity crisis. The increase in oil prices prompted this financial crisis and it became a universal incident, a crisis which is perceived by some to be worse than the Great Depression.

1.2 Research Objectives and Questions

These facts point towards important linkages between the housing sector, the financial industry and the credit crisis that are expected to affect not only these but other sectors of the economy as well, and may have – and may well already be having – dire consequences for the real economy. It is, therefore, imperative to study its ‘cause and effect’ mechanism to understand its true nature and thus contribute towards building theories and strategies to help avoid these situations in the future.

1.2.1 Research Objectives

The existing scholarly literature on the current financial crisis is limited as the phenomenon is still taking shape; however, along with being a major limitation, this provides a unique opportunity to understand first hand its causes and effects. Of course, financial crises are not new phenomena and literature exists on previous instances (e.g. Bernanke, 1983; Boddy, 1989; Claessens and Glaessner, 1997). For this very reason it is important to understand the similarities and differences between the causes and effects of the current crisis and those which happened in the past. In particular, this thesis focuses on the role of the UK housing sector and the mortgage banks in instigating this crisis. Specifically, the objectives of this research are as follows:

To understand the causes and effects of the UK financial crisis, especially with reference to the housing sector and mortgage

banks.

To compare the effect of the credit crisis on the housing sector with its effect on the financial sector (mortgage banks).
To evaluate the strategies adopted by the housing sector and the mortgage banks that led to the current financial crisis.
To analyse the similarities and differences between this crisis and those experienced earlier, along with unravelling the complex ‘cause and effect’ mechanism of the phenomenon.
To develop deeper understanding of the relationship between the credit crunch, the housing sector and the financial sector in UK.
To recommend processes that will help avoid such crises in the future. The study is expected to have key implications for regulators, financial institutions and the housing industry.

The main motive is to ‘fill the gap’ in available literature by extending the understanding of the relationship between the housing sector and the financial sector, and the cause and effect mechanism of the credit crunch. The focus of the study is the credit crunch in the UK market, more specifically the housing and finance sectors; however, the analysis will provide an overview of the global crisis as well.

1.2.2 Research Questions

Given the lack of existing literature to build upon, this study aims to explore the primary factors that caused the current financial crisis in the UK and its impact on the housing and finance sectors. The specific questions are:

How were the housing and finance sectors in the UK affected by the Global credit crisis?
How did the housing and financial sectors in the UK contribute to the recent financial crisis?
How is the current credit crunch different from the previous financial crisis?
How is the housing sector in the UK being affected by the ongoing credit crunch?
How can such crises be avoided in the future?

I expect to obtain valuable experience of conducting qualitative research from conducting the literature review, gathering primary data, analysing primary and secondary data, and presenting findings. It is also expected that this project will lead to in-depth understanding of how the financial and housing markets work, and that of research methodologies, along with firsthand experience of managing a research project.

2 LITERATURE REVIEW

2.1 Literature Review on Credit Crisis

The overriding discourse over the previous years has resulted in the inclusion of ‘credit crunch’, once considered an arcane economic term, to the latest edition of the 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 identify that a stable financial system is the one which maintains the delicate balance between credit demand and supply, and proposed that the credit crunch is defined as 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 emphasises the shortage’s microeconomic principle. It states that if the demand for goods 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 (Owen 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 the 17^th century, the 18^th South Sea bubble in England, the 18^th century Mississippi bubble in France and the US Great Crash of 1929. Similar events occurred in Norway, Finland and Sweden in the 1980s and in the mid 90s most East Asian countries started to see the meltdown of their economies (ibid; Kaminsky and Reinhart, 1996; Kaminsky and Reinhart, 1999).

Some of the early work is on financial crises is done Williams (1963), Stone (1975), Stone, (1978), Rosen (1977), Bernanke (1983), Alejandro (1985) and Boddy (1989).The main focus of their studies was the effect of financial crisis on the housing market. In 1991, Clair and Tucker (1991) tried to identify the causes of a credit crunch. They proposed a six dimensional model which highlighted the key reasons for financial crises. Bernanke and Lown (1991) did their classic work on the credit crunch which documents the decline in the supply of credit in the 1990-91 recessions and also analysed the five previous recessions, going back to the 1960s. The research reveals that the reasons that led to the bank cutting their loan supply in the 1990s was the joint effect of the shortage of financial capital and the 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 to understand the decrease in the values of bank capital, and secondly, to analyse the terms and conditions enforced by bank supervisors, regulators or banks themselves, which require banks to grasp more capital then they usually would have held.

In 1997 Claessens and Glaessner wrote a book which tried to highlight the flaws of the global financial system. Their research focused on developing countries and introduced a methodology for adjusting corporate financial statements for inflationary effects. Ding et al (1997) also studied the East Asian countries’ financial crunch and tried to explore its aftermath. Similarly, Lauridsen (1998) studied the financial crisis in Thailand. He tried to explain how 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 the Mark Carey model and tried to understand the link between the financial sector and the real estate market. Other authors who studied the relationship between the Asian financial crisis and the housing market include Hahm and Mishkin (2000), Mera and Renaud (2000), Krugman (2000) and Sheng and Kirinpanu (2000).

In 2003 Hunter at al published a book about the 80s and 90s credit crunches for both the industrialised and developing worlds. In the last half decade, many researchers have looked into the cause and effect of the global credit crisis and how it is linked with the housing market. This includes the research of Allen (2001), Blankenship (2002), Edelsteina and Lum (2004) and Buckley and Kalarickal (2005). Bordo (2005) studied the USA housing marketing in which he showed major concern about housing prices and classified it as a bubble. He studied US economic history and feared that this bubble would soon bust with dire consequences for the real economy.

2.2 Global Economic Melt Down (2007- 2009 Financial Crisis): where did it all begin?

Since the summer of 2007, 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 has slowed considerably. 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 a $125 million loss in subprime mortgages. Initially, it was perceived as an isolated incident, but in the same month Moody’s declared that it will review the ratings of 62 asset groups: 21 of them were US-based and were in subprime mortgage securitisations. In June, two failing hedge funds were supported by Bear Stearns, and in July, 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 4.75 percent expansion in 2007, globally growth slowed to 3.7 percent in 2008 and is expected to drop by 2.2 percent in 2009. Governments around the globe have taken extraordinary actions to tackle this crisis, but it is still to be controlled (Crown, 2008).

As highlighted by Reinhart and Rogoff (2008), and Baker (2008), the current financial crisis began when investors lost their confidence in the worth of securitised mortgages in the US, and this resulted in a liquidity disaster. 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 the most affected and it is estimated that by the end of 2008 around 4.5% of mortgage borrowers and 18% of US subprime borrowers are behind on their payments. The current increase in oil prices made this crisis even worse and it became a worldwide phenomenon. Some of the main contributions have been made by Feldstein (2007), Reinhart and Rogoff (2008), Muolo and Padilla (2008), Baker (2008) and Muellbauer and Murphy (2008). However, it is an ongoing phenomenon, and little academic literature exists on it.

2.3 Causes of Global Financial Crises

The recent financial crisis has already affected millions of people across the globe. Governments worldwide have bailed out major financial institutions, and there have been outright crashes, such as the nationalisation of Northern Rock and RBS, the sale of Merrill Lynch, the bankruptcy of Lehman Brothers the near collapse and nationalisation of major banks in Iceland, the UK government taking control of Lloyds Banking Group’s interests etc (Prosser, 2008; Marketwatch, 2008; Merrill Lynch, 2009). Although from very beginning the American housing sector has been cited as the major cause of this crisis, it is now revealed that the world’s financial system was susceptible because of its highly leveraged and complex financial operations and contracts. According to the chief economics commentator and associate editor of the Financial Times, Martin Wolf, the recent credit crisis has significant similarities to the previous financial crises or turning points in the economy, e.g. the dotcom boom-and-bust in 2000. Similar to previous crises, it involved international investors and asset backed securities consisting of 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). These include:

2.3.1 Greed

In available literature, the greed of financial institutes, traders, lenders and other individuals is identified as one of the key reasons for the economic meltdown (Patrik, 2008; Moore, 2008). The global economy is built on credit, and it is a useful tool if used sensibly. However, in the last few decades credit went unchecked in economies such as the US and the UK, condition went out of control. Financial institutes across the globe issued risky loans and mortgages to companies and individuals. The greed of big bonuses and commissions made bank employees offer their clients unwanted, but attractive deals, and thus all took irresponsible risks. Millions of people took loans larger than they could actually afford. They hoped that they may either sell their home for profit or could refinance it later at a lower rate and with more equity in their house; they planned to purchase another ‘investment’ house, for example. Many individuals got rich quickly and they wanted more. However, few realised that this greed was leading them toward a great financial disaster which started in July 2007 and is worsening every day.

2.3.2 Foreclosures in Subprime Mortgages

As compared to other financial crises, the 2007-09 credit crunch is far more complex as it involves financial innovation by banks which allowed new ways of bundling their assets. This crisis is closely linked with the expansion of the subprime mortgage market in the US. In the second half of 2007, US sub-prime (UK: self-certified) mortgage foreclosures (UK: repossessions) rose drastically. This activated global financial disruption and this trend in foreclosures has continued for the last two years, as shown in the chart below:

Graph 2.1: US sub-prime mortgage foreclosure rates (Source: Crown, 2008)

The financial institutions in the US offered nonstandard mortgages to people with substandard credit profiles or low incomes. It got even worse 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.

2.3.3 High Level of Leverage used by Financial Institutions

In theory, high levels of leverage used by UK’s financial institutions is another important factor that caused this financial crisis. When credit was cheap and the financial market was booming, many investment banks used leverage to support their balance sheets. The amount used for this purpose was short-term, making these financial institutions reliant on functioning funding markets and the capability to roll over their responsibilities at maturity. As highlighted by O’Leary and Antony (2008), being leveraged, a small alteration in asset values can have huge effects in terms of equity and losses/gains. Large chunks of these balance sheets consisted of securitised mortgages, so as soon the values of these products declined, the borrowing of collateral evaporated.

2.3.4 Close Interconnections between Market Participants

Research shows that participants in financial and mortgage market are closely interconnected (as shown in figure below). This link is so close that any disturbance can affect the whole web. For this reason, when the UK’s financial market got disturbed it had a direct impact on the mortgage industry and all other affiliated bodies (Jacobsson and Nordenstrom, 2009).

Figure 2.1: Interconnections between financial and mortgage markets ( Source: Jacobsson and Nordenström, 2009: 69).

2.3.5 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 banks, car manufacturers, construction companies etc also lost billions of pounds and this has raised global unemployment rate. Banks had no other option but to write off big losses, which this made them very reluctant to lend any further, particularly in the subprime sector. As a result, throughout the world a great many markets have dried up and it has become very hard to borrow money and raise funds. The cost of interbank lending has risen considerably (Crown, 2008).

2.4 The Implications of the credit crunch on the UK housing market

Growing tension and uncertainty in the macro-economic stability of the financial market is now being felt across the UK housing sector. It is estimated that only in the first quarter of 2009, house prices in UK declined by 2.7%., although this was the smallest quarterly fall since the first quarter of 2008. Figures indicate that since their peak in July 2007, the UK house prices have fallen significantly (as shown in graph 2.1). On average, the fall in house prices in the UK ranged 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), and that by the end of 2008 in the UK around 1.5% of mortgage borrowers were in long-term arrears, whereas between 2000 and 2007, the total sum of outstanding UK housing mortgage-backed covered bonds and securities increased rose from £13 billion to £257 billion. In 2006, the outstanding amount of RMBS increased by £78 billion (Crown, 2008).

	Index	Standardised Average Price	Monthly Change percent	Annual Change percent	Price/ Earnings Ratio
Period
May 2008	594.5	183,694	-2.3	-3.8	5.21
Jun	583.9	180,417	-1.8	-6.1	5.10
July	574.2	177,421	-1.7	-8.8	5.00
Aug	564.1	174,293	-1.8	-10.9	4.90
Sep	556.8	172,027	-1.3	-12.4	4.82
Oct	543.5	167,934	-2.4	-13.7	4.70
Nov	529.0	163,458	-2.7	-14.9	4.59
Dec	520.6	160,861	-1.6	-16.2	4.54
Jan 2009	531.2	164,126	2.0	-17.2	4.68
Feb	519.1	160,390	-2.3	-17.7	4.57
Mar	509.2	157,320	-1.9	-17.5	4.34
Apr	500.0	154,490	-1.8	-17.7	4.26
May	513.2	158,565	2.6	-16.3	4.36

Table 2.1: UK House Prices; Historical Data (Source Table: Lloyds TSB, 2009)

Graph 2.1: UK house prices: year percentage change (Source: MortgageGuideUK, 2007)

In the available literature, the 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 a mortgage. A shortage of mortgage finance has been identified as one of the most important factors in the falling demand for house-buying in the United Kingdom. It is estimated by the UK’s Council of Mortgage Lenders that the average number of mortgage approvals in 2008 are as low as in 1991. Figures clearly indicate that till July 2007, mortgage providers were very aggressive in their marketing and eager to attract new customers. They were offering products such as 100% or 125% mortgages and for high income customers, multiple and buy-to-let mortgages. The lending process was so easy and straightforward that many customers with bad credit profiles also got these deals, and the result was bad credit which led, in part at least, to the credit crisis. Today banks across globe are finding it difficult to raise finance; they have therefore reduced their mortgage lending. Banks have also removed a great 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).

2.4.1 First time buyers struggle to buy a new house

For first time house buyers it is becoming very difficult to get on the ‘property ladder’. In the past banks offered generous deals such as interest-only mortgages, 100% or 125% mortgages, or self certification. The Abbey National allowed first time buyers to borrow five times the borrower’s salary. This irresponsible lending arguably ruined the whole mortgage market.

2.4.2 The ratio of incomes to house prices has increased to an all time high

In the UK’s housing market many potential buyers are finding it difficult to get a mortgage as the ratio of incomes to house prices is fifty percent higher than the long term average (1975-2005) (The Economist, 2008). It is estimated that by the end of May 2009 unemployment exceeded 9%. This is worst in the last 25 years and many buyers can no longer afford a new or existing mortgage. An important point to remember is that house prices can fall even if there is limited supply e.g. in Japan in the 1980s the house prices were at their peak. Since the 1990s, they started falling and have fallen for 14 consecutive years (MortgageGuideUK, 2007).

2.4.3 Negative Market Sentiment in the Housing Market

Traditionally in British society, a house was not considered as just an asset, but it was a place to live. However, in the last few years, demand for UK housing has risen significantly and many investors have started investing in the housing market. 2007 figures indicate that in the UK letting of property accounted for 7.9 percent of total GDP or nearly £100 billion annually (Hamilton, 2008). However, as soon as the US housing market went bust and house prices started falling, investors stopped investing in it. According to Hamilton (2008), the state of the UK’s housing market could be determined by herding behaviour. It means that most of the increase in demand is rooted in market sentiment instead of economic fundamentals. This is the reason that when the market attitude towards the housing market changed, individuals become less confident about buying. OECD (2009) figures indicate that 15% of UK house prices were never represented in economic fundamentals, instead they were ‘speculation’. As soon the house prices fell, the buyers saw no incentive to buy.

2.4.4 Market Sensitivity to Interest Rates

Figures indicate that in last decade there was a record increase in the level of consumer borrowing in the UK, in 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). UK consumers are therefore very sensitive to increases in interest rates. Even a modest rise can significantly impact customers’ confidence and spending. The housing market is especially susceptible to any rise in interest rates. Although in the last quarter of 2008 the Bank of England reduced interest rates, it was arguably too little too late, and many banks have still not passed these cuts to the homeowners.

2.4.5 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 consumer confidence in the UK mortgage industry (MortgageGuideUK, 2007)

3. RESEARCH PLAN

3.1 Introduction

Various methodological choices were studied and considered for this thesis. These include the use of interviews, surveys, case studies, literature review, and primary and secondary data collection. The underlying assumptions and the philosophical roots of each method were studied and their relevance to this thesis analysed. A mix of qualitative and quantitative methods were studied and evaluated along with the survey of a large number of academic research articles on the topic (identified in the literature review) in accordance with the aims and objectives of this project. Qualitative methods, such as literature review, were finally selected based on the resource limitations of the thesis to be the main data gathering method, complemented by some quantitative studies (obtained from secondary sources and discussed in the literature review). Thus the study achieves triangulation by using some quantitative (secondary) data gathered through the literature review and a number of recent and classic studies on financial crises. In this part of the thesis the author will look into various research philosophies, methodologies, data collection methods etc. The author will highlight the key strengths and weaknesses of each approach and will derive a research plan for this thesis.

3.2 Research Paradigm

Hussey and Hussey (1997) mentioned two main research paradigms or philosophies for conducting research i.e. positivistic paradigm and phenomenological paradigm or interpretivist.

3.2.2 Positivistic paradigm

Positivistic paradigm can be regarded as quantitative, objectivist, scientific, experimentalist or traditionalist. In such paradigm it is highly desirable that the researcher ensures that the concepts used in the study can be operationalised, i.e. they may be described in such a way that they can be evaluated (Hussey & Hussey, 1997). The underlying assumption in this paradigm is that the researcher is independent of, and neither influences or is influenced by, the subject of the research (Remenyi et al., 1998). It tends to use highly precise and specific quantitative data from large samples. Different methodologies that can be categorised under positivistic paradigm include cross-section research, experiments, longitudinal research, and surveys (Saunders et al., 2003; Remenyi et al., 1998; Hussey & Hussey, 1997).

3.2.3 Phenomenological paradigm

Cohen and Manion (1987) defined the phenomenological approach as:

“Phenomenology is a theoretical point of view that advocates the study of direct experience taken at face value; and one which sees behaviour as determined by the phenomena of experience rather that by external, objective and physically described reality.” (Cohen and Manion, 1987)

Remenyi et al (1998) argued that in phenomenological approach each situation is considered as unique and therefore it gives meaning according to the situation and the individual involved, and the researcher is an intrinsic part of it. Therefore, considering the above literature, the positivistic paradigm can be considered as more appropriate to conduct this thesis.

3.3 Type of Research Methodology

There a number of types of research methods that may be employed for this thesis. These include longitudinal studies, case studies (single and multiple), survey, discourse analysis etc. However, the main focus in this thesis is on the case study approach.

3.3.1 Case Study

The research methodology chosen for this dissertation is the case study. Case study research is the most commonly used strategy in management and social science research. Yin (1993) defines the case study research method as “an empirical inquiry that investigates a contemporary phenomenon within its real-life context; when the boundaries between phenomenon and context are not clearly evident; and in which multiple sources of evidence are used”. The advantage of case study is its applicability to real-life, contemporary human situations and its public accessibility through written reports.

Case study research is one of the most common qualitative methods used in organisational studies and is well suited to understand the interactions between the financial and other markets, especially in organisational contexts (Orlikowski & Baroudi, 1991; Myers, 1999). Moreover, Benbasat et al. (1987) suggest that the case study strategy is well suited to organisational research because this field is relatively new and focus has now shifted to economic and social, rather than technical, issues. Benbasat et al. (1987) further argues that changes take place at rapid pace in the financial industry and businesses need to adapt quickly; and therefore suggest three reasons for the suitability of case research to organisational studies:

Researcher gets the opportunity to study the organisational settings in a natural setting, learn about various issues that it is dealing with, and develop theories from practice.
Case method helps in answering ‘how’ and ‘why’ questions, which enable the researcher to understand the nature and complexity of the processes.
Case approach is highly appropriate for an area where few previous studies have been carried out.

This study requires a holistic interpretation of the evidence because the focus is based on learning about the organisational processes (Yin, 2003 and Remenyi, et al, 1998) such as the financial crises that have hit the global markets in relation to the current credit crunch. Case study methodology is considered as a preferred strategy when ‘how’ or ‘why’ questions are being analysed and the investigator has less or no control on the existing events (Yin, 2003). Case studies help to provide an explanation of the observed phenomena that allows the researcher to establish links between different parts of the problem and develop a better understanding of the research topic in its real life context and environment (Yin, 2003 and Remenyi, et al, 1998).

Case study methodology helps to provide a rich and multi-dimensional picture of the situation that is being analysed (Remenyi et al, 1998). As my aim is to create a broader understanding of the factors responsible for the current financial crisis and the role various stakeholders (e.g. the major US and UK banks) have played, I propose to use case study methodology. It will be a descriptive case study approach in which I will also evaluate the role of two major global banks in contributing to cause the global financial crisis. The study will also explain how these institutions were themselves affected by the crisis and the link between the financial industry, the housing sector and the financial crises.

3.4 Data

The method of research helps to identify the specific research techniques utilised to collect and analyse data that can be quantitative or qualitative (Hussey & Hussey, 1997 and Easterby-Smith et al, 2002). Saunders et al (2003) highlighted some differences between qualitative and quantitative data which are listed in table 1.1 below:

Quantitative data	Qualitative data
Based on meanings derived from numbers	Based on meanings expressed through words
Collection result in numerical and standardised data	Collection results in non-standardised data requiring classification into categories
Analysis conducted through the use of diagrams and statistics	Analysis conducted through the use of conceptualisation

Table 3.1: Difference between Quantitative and Qualitative Data

Source: Saunders et al (2003)

In this case study, triangulation is typically employed; as each research methodology varies within the depth of the research it provides (Benbasat et al., 1987). Data collection includes a variety of techniques, such as semi-structured interviews, company documents, published information, email correspondence and telephone discussions. It is evident from the above discussion that data collection would involve combination of qualitative and quantitative approaches.

The study mainly uses the qualitative secondary sources to obtain data on the recent and historic financial crises and various stakeholders involved in the process. Due to time limitations and sensitivity of the issue (and the protective behaviour of the banks) it was not possible to conduct interviews. Also the nature of the study did not permit a large scale survey or the use of other primary quantitative methods. The study therefore exclusively relies on the secondary sources and key data elements are obtained from organisational reports and documents, in particular annual reports. All efforts have been made to ensure that data collected from these documents is relevant to the aims and objectives of this thesis and provide a good measure of the phenomenon under study. Some basic financial information about the current fiscal conditions was obtained from newspapers and other trade publications. The author has taken care that these are carefully chosen, so that only reliable information is used for this thesis. The newspaper used for example, have a proven reputation for accuracy and maintenance of high standards in journalism. Due care was also taken while collecting data that the views and opinions of the author are not included in the analysis to minimise bias and make the research as independent as possible. The sources of information used were also impartial and neutral as much as possible.

The first step in conducting the research was to identify the cases to be analysed. These were chosen based on availability of information required and the convenience of the author. Keeping in view the research question and its aims and objectives, this was decided to be the two giants in the financial industry i.e. Barclays Plc and Lloyds Bank Plc. These institutions play a key role in global financial industry and operate both in the UK and US. This proved helpful in understanding the sources of the financial crisis and its impact which spilt over in the UK and then global financial sectors. The annual statements of both organisations were available online and that made the process of obtaining information relatively easier. The figures on various indicators, however, still need to be gathered, analysed and presented in an appropriate manner. The data was obtained mainly from annual reports for a number of years and then combined and converted into percentages for analysis. The results are displayed in the form of tables and pie charts.

Another key data gathering method used is literature review. Literature review is considered essential for most research projects as it allows the researcher to grasp the research to date on the topic concerned and also helps identify any lacunae in the available literature. A comprehensive literature review was therefore conducted on the financial crisis and related issues. Since literature review provides the processed secondary data, it is subjective in nature and may be biased due to the affiliation of authors with a particular school of thought. Practitioners’ literature was therefore excluded from the literature review and only the scholarly, academic papers published in reputable journals and independently reviewed by academic peers were used for this study. The library was used extensively in this regard, and selected sections from various books on the topic studied. A variety of academic journals was also accessed either in printed form in the library or using electronic resources. The research also made use of electronic databases to search relevant articles to conduct the literature review e.g. ABI Inform, Web of Science etc. using the Athens login facility. The data thus gathered were read and synthesised systematically and the relevant information obtained, paraphrased and added to the literature review in a structured way. The reference lists of important articles were also extensively used to move forwards and backwards to identify key literature on the topic and access it through the library and/or electronically. The findings of the literature review were important in deciding the scale and scope of the project, in understanding key issues related to the topic, finalising the aims and objectives of the study and identifying any gaps in available literature.

In summary, this study attempts to collect qualitative data through organisational documents, semi-structured interviews, journal articles, published reports and personal experience.

3. 5 Conclusion

The research will follow a phenomenological point of view. The logic of reasoning used in this study is Retroductive. The research is explanatory in nature, as it aims to understand phenomena which took place in a natural setting. This thesis is based on case study method, and the researcher will be analysing the single case study of the UK financial crisis. Data collected is all from secondary resources and is qualitative in nature. The project provided a valuable opportunity to design and implement a viable research plan and learn various research skills along with providing first-hand experience of conducting primary and secondary research to the author. The preliminary study narrowed the focus of the study to an appropriate level, the literature review helped identify any gaps in available literature and key issues to focus on, and study of methodologies provided the understanding of their underlying assumptions and appreciation of their advantages and disadvantages, and conducting the research helped mastering qualitative techniques and analysing data. The application of research methodology devised for this project thus developed in researchers the skills required to conduct academic research and may well shape their future research assignments.

4 ANALYSIS OF UK FINANCIAL SECTOR (BEFORE AND DURING FINANCIAL CRISIS)

4.1 Introduction

This chapter analyses the cases of two major retail and mortgage banks in the United Kingdom: Barclays Plc and the Lloyds Group Plc, two retail banks which are among top 10 mortgage banks in the country (as shown in table 4.1) . The focus is on the performance of both financial institutions prior to and after the credit crunch. Various indicators of the performance are used to establish this: for example, revenue, profit, shareholder return, share value and the dividend paid to share holders. The analysis helps understand how the credit crunch affected financial institutions in the UK and also sheds light on some of the causes of the crisis.

Ranking	Name of Financial Institute
1	Halifax Building Society
2	Abbey National
3	Nationwide
4	Northern Rock
	Woolwich Building Society (Barclays Plc)
6	Bradford and Bingley
7	HSBC
8	Royal Bank of Scotland
9	Lloyds TSB
10	Alliance & Leicester

Table 4.1: The top 10 mortgage banks in UK; ranked into order with their market share (author illustration, data gathered from various sources)

4.2 Barclays Plc

Barclays Plc is one of the leading global financial services provider listed on the London, New York and Tokyo stock exchanges (Barclays, 2009a). The firm operates in various regions of the world including North America, North America, Europe, Australia, Middle East, Asia and Africa. Barclays is included in the FTSE 100 index and is also raked the 25^th largest company in the world according to Forbes Global 2000 (2008 list). It is also recognised as the fourth largest financial services provider in the world according to Tier 1 Capital and the second largest bank in the United Kingdom (with respect to asset size). The firm’s assets are estimated to be worth $32.5 bn. It employs over 148,000 people globally and generated revenue of £23.3 billion in 2008 with net profit of £5.2 billion (Barclays, 2009b).

Barclays Plc’s headquarters are located at 1 Churchill Place in Canary Wharf, in London’s Docklands. It can trace its roots to 1690 when entrepreneurs John Freame and Thomas Gould started business as Goldsmith bankers in London. Over the years the ownership structure of the firm has kept on changing. The name Barclays was however added when James Barclays, son-in-law of John Freame, became partner in 1736. It has since also gone through a number of acquisitions and mergers over the centuries to get to where it is today (Barclays, 2009a).

Barclays Plc experienced rapid growth until 2006 (Barclays, 2009b). All of the key performance indicators remained positive and the market perception was highly favourable (as summarised in table 1). This is evident from the increase in revenue from £15.3 billion in 2004 to almost £18 billion in 2005 and subsequently to £22 billion in 2006. Similarly, profit (pre tax) also increased from £4.5 billion in 2004 to £5.2 billion in 2005 and then to £7 billion in 2006. Shareholders also benefited from the performance and gained returns of 21% during 2004 and 2005 and almost that of 25% in 2006. Therefore, it can be said that the company was growing rapidly and all key performance indicators were positive. However, during 2007, primarily due to the losses suffered as a result of the credit crunch (as will be discussed later in detail), the company’s growth, revenue, profit and the shareholders returns suffered (table 1). The revenue only increased marginally to £23.4 billion in 2007 and slightly reduced to £23.3 billion in 2008. Profit reduced from £7.12 billion in 2006 to £7.07 billion in 2007.

	2008	2007	2006	2005	2004
Revenue	23.3 bn	23.4 bn	22.1 bn	17.9 bn	15.3 bn
Profit before tax	6.07 bn	7.07 bn	7.13 bn	5.2 bn	4.5 bn
Share Value	59.3p	68.9p	71.9p	54.4p	51.0p
Shareholder Returns	16.5 percent	20.3 percent	24.7 percent	21.1 percent	21.7 percent
Total dividend for the year	£906m	£768m	666m	£582m	£528m

Table 4.2: Key Performance Indicators of Barclays Plc (author illustration; data gathered from Barclays Plc annual reports for the last five years)

Profit further reduced to £6.07 billion in 2008. The shareholder value was worst hit, which reduced from almost 25% in 2006 to 20% in 2007 and then further to 16.5% in 2008. Following sections provides further details of how and why this happened (Barclays, 2009b).

Graph 4.1: Barclays Plc Revenue from 2004 to 2008

Graph 4.2: Barclays Plc Profit before tax from 2004 to 2008

Graph 4.3: Barclays Plc Share Value from 2004 to 2008

Graph 4.4: Barclays Plc Shareholder return from 2004 to 2008

Graph 4.5: Barclays Plc total dividend from 2004 to 2008

The first indication of adverse affects of the credit crunch on Barclays was in November 2007 when the bank revealed that it had to write down £1.3bn of assets due to losses in the mortgage and credit markets (Costello, 2007). The firm’s investment arm, Barclays Capital made a £800m write-down in October 2007 and then another write down of £500m in the third quarter of the same year. The bank also admitted that some of its securities backed by US mortgages were worthless because mortgage holders are expected to default on their loans. Despite these setbacks, Barclays expected a profit of £1.9bn which was an increase on last year but below analysts’ expectations; also there were rumours that the bank may be forced to write off as much as £10bn due to losses in mortgage business. It soon became clear that the US sub-prime mortgage sector faced a large number of defaults and caused massive losses to financial institutions including Barclays. The president of Barclays Capital, Bob Diamond, admitted publically that the Barclays Group was affected by the defaults in the sub-prime market where loans were made to people with poor credit histories and who now could not replay their debts (Costello, 2007).

The firm however, reassured, shareholders that it did not expect any further write downs and has taken a ‘consciously conservative’ position following the turn down in the US mortgage market. However, still the shares of the bank that had risen by 5% in early trading later shed all gains and recorded a fall of 1.5% from the previous day. In the month of November 2007, Barclays’ stock saw a steady downwards drive, losing 12% of its value amid speculation about huge losses suffered by Barclays Capital through its involvement in structured investment vehicles (SIVs) and other complicated financial tools in which various mortgage-backed securities are bundled together and sold on. It did emerge that the firm had to write off £190m from its £7.3bn worth of unsold underwritten leveraged loans, but Diamond blamed these on the slowed demand for leveraged loans in the overall market conditions and expressed hope that the market would pick up in early 2008. Despite these losses, some analyst argued that the Barclays write downs were ahead of industry average and yet they were under 2bn which should reassure investors. The losses, however, were enough to slow down the business’s growth and reduce profits in the second half of the fiscal year as compared to the first half (Costello, 2007).

The credit crunch, however, continued to take its toll on the firm, especially affecting profits. In August 2008, Barclays revealed that its pre-tax profit has reduced by 33% in the first half of the year (Rafiq, 2008). The bank was forced to write off another $5.5bn related to bad debts. The CEO of the firm, John Varley, described the bank’s performance as acutely disappointing and apologised for the decline in the company’s share price over the previous year. He admitted that the company’s shareholders had to endure a lot and suffer losses in many instances. Bad debts, however, continued to rise sharply. The company experienced an increase of 155% in bad debts during the six months ending in June 2008. They accumulated the figure of $4.7bn, primarily fuelled by the losses from subprime mortgages and other credit-related investments. This resulted in Barclays Capital posting total losses of $4bn for the year and raising fears among the experts of a collapse. Despite the bad news, the company was nevertheless in better shape than some of its competitors such as UBS or Merrill Lynch. Although the company’s profits fell by over 70% in the first half of the year, the unit remained profitable with earnings of more than $1bn. The rest of the company’s divisions, from credit cards to retail banking remained profitable and did well considering the circumstances (with the exception of Barclays Global Investors, the fund management arm that posted a 32% drop in profit). Overall, therefore, the company did not perform as badly as expected by some analysts. As it emerged that after all, Barclays has not taken the same massive write offs on devastated US subprime mortgages as many of its rivals on both sides of the Atlantic, its image stayed intact. In May 2008, the company wrote off another $3.3bn on the value of complex debt securities, but that was also a fraction of that of many of its competitors. Merrill Lynch, for example, was forced to sell $6.7bn worth of collateralised debt obligations. Some analysts therefore believed that Barclays was much better positioned and has been more successful with hedging (Rafiq, 2008).

In total, the Barclays group suffered credit crunch losses of £8bn in the year 2008 (Wearden, 2009). However, the management insisted that the company was still profitable and did not require a government bailout. In an open letter to shareholders, the company attempted to quash widespread speculation that it was close to collapse by disclosing its scale of losses in January 2009. It had a positive effect and the bank’s shares rose by 25%. It also brought the release of its 2008 results forwards by a week (to 9 February 2009) in another unusual move to gain the trust of investors. The company also projected a profit of over £5.3bn and described current trading as healthy. The Barclays share price, though, suffered as a result of rumours about the bank’s health: in the first six months of 2009 alone, it dropped from 150p to just 50p. Confidence was also battered by speculation that the bank may have to be nationalised soon. The company’s management however, including the chairman Aigus and the CEO Varley, defended the position of the bank by reiterating that it was performing well and did not need a capital injection from the government or anyone else. In another letter to the shareholders, they claimed:

“Our starting point is that Barclays has £36bn of committed equity capital and reserves; we are well funded, and we are profitable. However, we know that our stakeholders want to see the detailed figures for 2008 as quickly as possible,” (Wearden, 2009;np)

The figures reported by the bank include the total credit crunch related losses of £8bn for last year. The bank had previously only disclosed the losses of £3.3bn in the first six months, but the spokesperson claimed that the added losses came from the nonstop ‘market dislocation’.

The Chairman and the CEO further argued:

“Although we have been heavily impacted by the credit crunch, our income generation was at a record level in 2008 and has enabled us to withstand this impact and still produce strong profits…” (Wearden, 2009;np)

Some positive impacts of the share prices were seen as a result of active communication, with investors reducing some of their apprehensions, and the share price in late June increased by 12.8p to touch 64p. The company also indicated that it will consider talking to the UK treasury about participating in its asset protection scheme, announced by the government in June 2009. The scheme would allow these financial institutions to insure themselves against losses and thus encourage them to start lending again (Wearden, 2009).

4.3 Lloyds TSB

Lloyds TSB is a UK banking brand and part of Lloyds Banking Group, which is one of the UK’s biggest financial institutions. Lloyds TSB brand was formed in 1995 when Lloyds Bank and Trustee Saving Bank (TSB) merged and created (at that time) the second largest bank in the country (NYT, 1995). The Lloyds Banking Group was formed in 2009 when Lloyds TSB acquired HBOS. Through UK Financial Investment Limited, HM Treasury holds 43% of Lloyds Group shares. Lloyds TSB mainly operates in retail banking and provides services such as current and saving accounts, and mortgages etc. The Lloyds Banking Group, on the other hand, is involved in wide range of services; their main activities include wholesale, insurance, wealth and international as well as retail banking, and as it stands Lloyds Banking Group is UK’s largest provider of mortgages and offers a range of services from repayments to interest only. Lloyds’ widespread operations span the world, including Europe, US, Middle East and Asia (Lloyds TSB, 2009).

Before the 2007–2009 credit crunch, Lloyds TSB was the fifth largest bank in the UK and was rated sixth safest bank in the world. Since the formation of the Lloyds TSB brand, the bank performed very well and has been involved in many ventures including the following:

In 2000, the group acquired Scottish Widows. The deal was worth £7 billion, and it became one of the largest forces in the domestic financial market (BBC, 1999).
On September 2000, Lloyds TSB bought Standard Chartered Trust from the Standard Chartered Bank. The deal was worth £627 million. The Trust was converted into Lloyds TSB Asset Finance Division. The services provided by this division include personal finance, motor and retail. In the UK it operates under the trade name of Black Horse (The Independent , 2000)
In 2001, Lloyds TSB took part in the takeover bid of the Abbey National; however, it got rejected by the Competition Commission (The Telegraph, 2001).
In 2003, Lloyds TSB Group sold its subsidiary, NBNZ Holdings Limited (NZ Herald, 2003).
In 2004, Lloyds TSB sold its business in Argentina and Colombia (Banco Hiptecari, 2004).
In December 2005, Lloyds TSB released a statement that they have sold their credit-card business Goldfish to Morgan Stanley Bank International Limited. The deal was worth £175 million (BBC News, 2005).
In 2007, Lloyds TSB sold its Abbey Life insurance division to Deutsche Bank. In this deal, the bank generated revenue of £977 million (Financial Times, 2007).
In 2007 Lloyds TSB became the first high street bank to launch an Islamic Business and Corporate account. The bank has been very successful in this venture (The Guardian, 2007) though many have objected to this new scheme.

During the crisis, Lloyds TSB has gone through many ups and downs. The first incident took place on 17^th Sep 2008, when Lloyds TSB made a sudden decision to take over HBOS. It was a response to the tremendous drop in HBOS’s share prices, but perhaps rather unwise in retrospect. In the following month, Gordon Brown announced the UK government bailout plan and proposed that the Treasury would invest £37 billion into many major UK banks, including HBOS and Lloyds TSB. In November and December 2008, the new acquisition was agreed by both Lloyds TSB shareholders and HBOS shareholders (BBC, 2008). On 19^th Jan 2009 the takeover was completed and a new group named Lloyds Banking Group was formed. The UK government holds 43% stake in Lloyds Banking Group ordinary shares, and £4 billion of preference shares (IML, 2009). In March 2009, when it became clear that this recession was much worse than anticipated, Lloyds made another deal with the government. It consisted of two parts: firstly, it allowed Lloyds to avoid the payment of £480 million annual interest to the Treasury on preference shares, and also allowed Lloyds to resume the payment of dividends; in the case of ordinary shares, Lloyds had become the first EU to repay government ‘credit-crunch’ investment. Secondly, Lloyds agreed to go into the government’s Asset Protection Scheme to cover itself against possible future losses on previous loans, mainly on its HBOS account (Croft and Eaglesham, 2009).

In February 2009 the Group announced their losses for the HBOS account. Results showed that these were greater than the initial estimate of approximately £10 billion. On the London Stock Exchange the share price of the Group dropped by 32%, and most recently, in June 2009, Moody’s Investors Service downgraded the financial potency rating of Lloyds bank and placed it on a negative outlook. Lloyds TSB now stands at C, one notch from C+. This has impacted the rating of parent company Lloyds Banking Group and its subsidiaries HBOS and Bank of Scotland. Moody’s suggests that Lloyds TSB’s financial power has deteriorated as a result of the bank’s integration with HBOS; other reasons include the risk exposure to assets, which are not yet protected by the government’s Asset Protection Scheme (Holt, 2009).

4.3.1 Financial Situation of Lloyds TSB before and after crisis

The key performance indicators of the Lloyds Group indicate that it is severely affected by the credit crunch. The years before the credit crunch show much promise and growth, whereas those during the financial crisis indicate massive losses and a fall in income. The revenue of the Group, for example, continue to grow from £9.6bn in 2006 to £10.5bn in 2005.

Years	2008	2007	2006	2005	2004

Total Revenue	9,872	10,706	11,104	10,540	9,661
Profit for the year	845	3,321	2,907	2,555	2,459
Share Value	14.3p	58.3p	49.9p	44.6p	42.8p
Shareholders return	7.40 percent	28.20 percent	26.60 percent	25.60 percent	22.80 percent
Total dividend for the year	648	2,026	1,927	1,915	1,914

Table 4.3: Key Performance Indicators of Lloyds TSB (author illustration data gathered from Lloyds TSB annual reports for last five year)

This increased to £11.1bn in 2006. However, due to losses suffered during 2007, it was reduced to £10.7bn and then further dropped to £9.8bn in the year 2008. The drop of revenue clearly indicates recession in the market and losses suffered by the business. This has had a devastating effect on the profitability of the business. Profit has stayed around the £2.5bn mark during 2004 and 2005 and some increase was seen in 2006 when it touched almost £3bn and further increased to £3.3bn in 2007; however, a dramatic drop in profit was experienced in 2008 when it slumped to just £845 million.

Graph 4.6: Lloyds TSB Revenue from 2004 to 2008

Graph 4.7: Lloyds TSB Profit from 2004 to 2008

Graph 4.8: Lloyds TSB share value from 2004 to 2008

Graph 4.9: Lloyds TSB shareholder return

Graph 4.10: Lloyds TSB dividend for the year

The share prices also exhibited a similar trend. From 42.8p in 2004, the share price of Lloyds Group has constantly increased to 44.6p in 2005, then to 49.9p in 2006 and 58.3p in 2007. However, negative market sentiment since then and the news of the losses suffered by the Group resulted in a reduction of share value to just 14.3p at the end of 2008. Similarly, shareholder return increased from 22.8 % in 2004 to 28.2 % in 2007, but slipped to just 7.4 % in 2008. The decline in the KPI and gloomy fiscal situation ensured that the dividend paid out to shareholders was reduced to just 648 million in 2008 as compared to a total sum of over 2 billion paid in 2007.

4.4 Conclusion

It is clear from analysis that both financial institutions, Barclays Plc and Lloyds Group Plc, have been – and are being – badly affected by the credit crisis. Both institutions show similar trends in almost all performance indicators and there is marked decline in revenue, profit and shareholder returns. The analysis also revealed the link between financial institutions and the housing industry. It emerged that, starting from 2007 onwards, banks suffered major losses in their investments in subprime mortgage sectors where a large number of customers were given loans despite poor credit ratings. As more and more of these customers started to default, banks had no choice but to write off millions and eventually billions of pounds as bad debts. This reduced their further investment in the mortgage sector and the housing sector, stripped of any liquidity, crashed. Thus, property prices fell and started a vicious cycle that encompassed many other firms and industries as well. The global linkages of these financial institutions meant that the crisis quickly crossed borders and reached from the USA to the UK and spread all over Europe and beyond. Important lessons can be learnt from this episode, especially with regards to how ambitious investment in a particular market segment (e.g. sub-prime mortgages) may cause a global financial crisis. The next chapter will further discuss the issues that emerged from the analysis and conclude the thesis.

5. DISCUSSION, CONCLUSION AND RECOMMENDATIONS

The objective of this thesis is to understand the causes and effects of the UK financial 2007-2009 turmoil that hit financial markets, especially mortgage banks and the housing sector; to understand the relationship between the credit crunch, the housing sector and the financial sector; to analyse the differences and similarities between this credit crunch and the ones which took place earlier; to analyse the effect of this crisis on the UK’s financial institutions; and, finally, to recommend a strategic direction that can help avoid such crises in the future. Through a review of previous papers on this topic, combined with comprehensive investigations of many other sources such as news articles, annual reports and research reports, the author has offered a view of the essential institutions, instruments and events related to the crisis. They have been put in relation to each other, so that their relative importance and interconnectedness can be determined. The analysis provides in-depth review of two financial institutions who have suffered in this turmoil. By analyzing the compiled information, the author has identified the following factors that can be said to have played the important role in the credit crisis. These four factors are as followed:

The foreclosures in subprime mortgage have played a central role. Research shows that in the years before the crisis, mortgage interest rates were comparatively low, and financial institutions were willing to offer mortgages that were unsafe and were very attractive for the borrower in the short term. Thus the number of subprime mortgages increased significantly, as well as their share in all financial institutions’ revenues. Many mortgage lenders such as HBOS, Abbey National, Northern Rock, and Barclays etc started offering their customers products that were unsafe. In the greed of bonuses, a few banking staff even targeted borrowers with poor credit ratings. The increase in mortgages followed large increases in UK property prices. Many financial institutes designed mortgages with the assumption that real estate prices would continue to go up. Thus, neither these financial institutions nor consumers were prepared for the recession and fall in house prices, and, as soon it hit, it took the whole financial market by surprise, and regardless of many efforts by the government, the economy has still not recovered.

Another important factor identified in this research is the high level of leverage used by many banks. As credit was inexpensive and financial markets boomed, financial institutions such as investment banks used leverage to finance the vast majority of their balance sheets. Therefore, big parts of the leveraged balance sheets of many financial institutions consisted of securitised mortgages; however, as soon the value of these products dropped their position in the market became unstable.

The interconnection of the market participants and their transactions is another important factor behind this crisis. The institutions and products linked to the UK’s financial and mortgage market are many and they are all closely interconnected e.g. a mortgage backed security is normally linked to many other financial institutions such as investors, mortgage brokers, issuers, credit default swaps holders and issuers, credit rating agencies, or funding issuers, etc. The system became very vulnerable due to the complex web of market participants. For this very reason, when disaster hit the mortgage market, its effects were felt by all participants. It can therefore be argued that the high level of interconnectedness in the UK’s mortgage and financial market was the reason behind the present crisis. In addition to this, bankruptcies and a rise in unemployment in United Kingdom also contributed to make the situation worse.

When combined, the factors discussed above became the triggers that caused the UK financial system to experience the difficulty it has faced for past two years now. To decide which was the single most important factor in precipitating this crisis is arguably impossible; perhaps the UK’s obsession with owning property is one, as most people countries like Germany rent their homes, or the lack of space in the UK (compared to, say, France or the US), or perhaps the power of the City is the UK was the main cause. Based on this research, many suggestions can be made in order to avoid a similar crisis in the future. This will, however, involve multiple stakeholders such as the regulators and financial institutions.

Financial institutions need to ensure better corporate governance. This means directing and controlling the organisation in the long term interests of its owners i.e. shareholders, which now include UK taxpayers for some banks. It also means that the board is responsible and accountable to the owners of the firm and their stewardship should be accounted for properly to ensure sound internal control. Senior management also needs to improve the internal risk assessment strategies and must also take into consideration the systemic risks that took place when the actions of an individual financial institutions impinge on other banks or the market. This would help reduce the spill over of any such future crises from one company to another or from one market to another, and may allow better ways of confinement if any crisis hits. Another key reason cited in the literature which was also confirmed in this research concerns the incentive structures in the financial firms that create the complex products for resale. The analysis shows that the established incentive schemes for employees encouraged them to approve risky loans to earn more commission and get other performance related benefits. Therefore, the performance management and incentive schemes should now be based on sound principles and should not be allowed to be misused. It is perhaps human nature to attempt to maximise wealth, but the prevalent incentive structure in financial companies have encouraged irresponsible, short term thinking and reckless gambles. This, however, neither supports the prudent risk management required to avoid losses nor works in the interest of other stakeholders in global financial markets. Setting the incentive structure correctly is arguably one of the key challenges faced by financial companies that can frustrate any attempts for reform. Another key factor is accounting and financial reporting; financial companies must enhance transparency and fair value accounting to regain the trust of the investors, if that is possible at all. Steps should be taken to reduce the increasingly complexity of financial reporting and develop ways of expressing performance that is less vulnerable to manipulation. The regulators must encourage financial companies to move forward on all of the recommendations mentioned above. Governments need to be more vigilant and must keep a close eye on developments in the financial sector. Therefore, with effective monitoring by regulators and other stakeholders it is quite possible to learn from the mistakes made in the last few years and avoid or contain any such crises in the future – in theory, at least.

PERSONAL REFLECTION ON THE RESEARCH PROCESS

This research has allowed me to develop various skills that will stay with me, and help me in my professional growth and career progression. To begin with, developing a feasible and suitable plan for this research, keeping in view the resource and methodological related limitation, and then utilising it at various phases within the deadlines set, allowed me to gain valuable project management experience. Later on, conducting a widespread literature review provided me valuable experience of researching, understanding and presenting information in the shape of a logical report. The literature review process needed use of many different resources including electronic resources to access e-journals and other related materials e.g. organisational archives and annual reports available on the internet, and use of the library to access books, as well as the university’s Athens facility was helpful in gaining access to these documents. During this process I learned how to go back and forth using the references provided by the writers to locate key pieces in literature. In addition to this, I also learned how toparaphrase and manage the research material in a well structured manner. Likewise, analysing the data from many different sources and then finding main points of concern also supplemented my learning process. Finally, during this research I learnt how to write, organise and present a good quality academic piece of work.

LIST OF GRAPHS

Graph 1.1: UK house price forecast Aug 2007- Aug 2009 (Source: Walayat, 2009).

Graph 4.1: Barclays Plc Revenue from 2004 to 2008

Graph 4.2: Barclays Plc Profit before tax from 2004 to 2008

Graph 4.3: Barclays Plc Share Value from 2004 to 2008

Graph 4.4: Barclays Plc Shareholder return from 2004 to 2008

Graph 4.5: Barclays Plc total dividend from 2004 to 2008

Graph 4.6: Lloyds TSB Revenue from 2004 to 2008

Graph 4.7: Lloyds TSB Profit from 2004 to 2008

Graph 4.8: Lloyds TSB share value from 2004 to 2008

Graph 4.9: Lloyds TSB shareholder return

Graph 4.10: Lloyds TSB dividend for the year

LIST OF FIGURES

Figure 2.1: Interconnections between financial and mortgage

LIST OF TABLES

Table 2.1: UK House Prices; Historical Data

Table 4.1: The top 10 mortgage banks in UK; ranked into order with their market share

Table 4.2: Key Performance Indicators of Barclays Plc

REFERENCES

Allen, F (2001) Financial Structure and Financial Crisis, International Review of Finance, Vol 2, Issue 2, pp. 1-19.

Avison , D and Fitzgerald, E (1998) “Information Systems Development: Methodologies, Techniques, and Tools”, McGraw-Hill Higher Education, 1998.

Baker, D (2008) The housing bubble and the financial crisis, Real-World Economics Review, Issue no. 46.

Banco Hiptecario (2004) “Banco Hiptecario Prospectus Page 118”, Available on: http://www.hipotecario.com.ar/media/pdf/InformacionFinanciera/Bonos/Prospectos2007-en.pdf. (Accessed on 1^st July 2009)

Barclays (2009a) About Us, Barclays Plc (www.barclays.com) [Accessed: 02/07/2009]

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