The present financial crisis, which originated in the USA, has now become a global phenomenon. To date, stock markets 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. The UK housing and financial markets were also hit hard by this financial crisis. Research shows that July 2007 was when the UK housing market reached to its maximum level; since then, house prices have seen falls of nearly 25%. The first UK bank to be hit by this global crisis was Northern Rock. This incident paced the deterioration of UK’s financial market and, regardless of the UK government and many efforts including announced 5% VAT cuts, £500 billion bank bailout package and the State bank reduction of the base rate to 1.5%, this turmoil is yet to be overcome. The purpose of this research is to better understand this credit 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. 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 main reasons for falling 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. After analysing the financial performances of the UK’s two top financial institutes, Barclays Plc and Lloyds Group Plc, it became evident that they are both have been badly affected by the credit crunch. Both institutions showed similar trends in almost all the performance indicators, and there is a marked decline in revenue, profit and the shareholder returns. Analysis revealed that there is a clear link between financial institutions and the housing industry. It emerged that, starting from 2007 onwards, banks have suffered major losses in their investments in subprime mortgages. When more and more customers started to default, banks had no choice but to write off 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 real estate prices plummeted and started a vicious cycle that encompassed a number of other firms and industries as well. Important lessons can be learnt from this episode, especially with regards how ambitious investment in a particular market segment (e.g. sub-prime mortgages) may cause a global financial crisis. After analysing the whole situation it is suggested that financial institutions need to ensure better corporate governance. Banks’ senior management needs to improve internal risk assessment strategies and should also take into consideration the systemic risks that arise when the actions of an individual bank impinge on other banks or the markets. Setting the incentive structure correctly is arguably one of the key challenges faced by financial companies that can frustrate any attempts for reform. Financial companies must also enhance their transparency and fair value accounting to regain the trust of investors.

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 was such that it took the whole world by storm.

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 getting affected by the global credit crisis. Since July 2008 the UK housing market started reporting considerable losses in sub-prime mortgages in which banks had heavily invested over the last few years. It is estimated that between August 2007 and April 2009, the UK housing market declined by at least 15%, whereas the capital was worst hit by a 25% decline in average house price (Walayat, 2009). A consensus among experts (ibid, Bartlett, 2008) is that heavy lending to sub-prime borrowers with a heightened perceived risk of default, a history of loan delinquency or default, recorded bankruptcy, and limited debt experience led to these losses. Therefore, although the financial sector’s heavy but risky lending in the housing market initially resulted in an increase in house prices and a boom in the housing industry, the subsequent losses suffered by the financial sector in turn resulted in bursting the bubble in the housing sector by reducing demand due to limited liquidity. This resulted in rapid reduction in house prices in UK since Aug 2007 as illustrated in graph 1.1

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

World financial systems that are subject to market forces are prone to periodic financial crises. Historic examples of these crises include the Dutch ‘Tulipmania’ of the 17^th century, the 18^th century ‘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). Although initially many experts suggested that the market failure caused in the South East Asia market was linked to corruption and weak political systems in these states, when many American countries started suffering from this financial meltdown it became clear that this crisis was rooted in the global financial system and its policies.

Research show 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 then 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 rented 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 and started meeting the requirements of UK masses (ibid).

It was summer 2007 when a few experts raised their voices about the UK housing market property crash (Walayat, 2007). Global credit market conditions continued to deteriorate. Then there was the first run on a British bank for well over a century: Northern Rock. This incident spurred the deterioration of UK’s financial market. It was April 2008 when the collapse of the UK housing market started. During the summer months, the UK house market witnessed an accelerated decrease in the house prices. By the end of August 2008, average house prices in the UK were already 10% lower than the same time the previous year. In Sep 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 panic 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. The UK market’s sentiments were very low. In November, the 2009 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).

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 rise in oil prices triggered this crisis further and it became a global phenomenon, a crisis which is considered by some worse than the Great Depression. Some key contributions have been made 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 the current financial crisis and how the housing bubble both contributed to and enhanced it. They all look into the circumstances under which the bubble began to grow and discuss how financial institutions’ greed, and the lack of a proper regulator structure, allowed the bubble to grow to even more dangerous levels and eventually to burst in a way that has placed unprecedented strain on the global financial system.

1.2 Research Objectives and Questions

These facts point towards important relationships between the housing sector, the financial industry and the credit crisis that are expected to impact 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). It is therefore important to understand the similarities and differences between the causes and effects of the current crisis and those which happened before. 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:

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

Ø To compare the effect of the credit crisis on the housing sector with its effect on the financial sector (mortgage banks).

Ø To evaluate the strategies adopted by the housing sector and the mortgage banks that led to the current financial crisis.

Ø 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.

Ø To develop deeper understanding of the relationship between the credit crunch, the housing sector and the financial sector in UK.

Ø 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 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 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:

Ø How were the housing and finance sectors in the UK affected by the Global credit crisis?

Ø How did the housing and financial sectors in the UK contribute to the recent financial crisis?

Ø How is the current credit crunch different from the previous financial crisis?

Ø How is the housing sector in the UK being affected by the ongoing credit crunch?

Ø 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 dominant discourse over the previous year 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). Although initially many experts suggested that the market failure caused in South East Asian market was linked to corruption and weak political systems in these states, when many American countries started suffering from this financial meltdown it became clear that this crisis was rooted into global financial system and its policies.

Some of the early work is on financial crises was done by Williams (1963), who aimed to understand the financial causes and effects of the 1931 financial crisis on the UK housing crisis and mortgage lending sectors. A similar study was done by Stone (1975), who wrote series of papers, studying the USA housing sector and how two different economic approaches, capitalism and socialism, impact both the housing and financial markets. His research highlighted some major flaws in the capitalist approach and he recommended that it is of utmost important that the USA should reconsider their existing housing and mortgage strategies. His research resulted in the formation of a transitional socialist housing program (Stone, 1978). In the same era Rosen (1977) examined the magnitude of the USA housing crisis, its causes and effects on the financial sector, and outlined a proposal which could help alleviate the crisis.

Bernanke (1983) presented a case study of 1930s US financial crisis. His work was based on the Friedman-Schwartz work. He studied the background of the 1930-1933 financial crises, its sources and its correspondence with aggregate output movements. He also explained how the runs on banks and extensive defaults can reduce the efficiency of the financial sector. Bernanke (1983) presented a theoretical framework to understand the 1930s financial crisis. Among other sectors, he studied the effects of the financial crisis on the housing market. In 1985, Diaz Alejandro tried to analyse financial liberalisation in Latin America; his study focused on the imperfections in financial markets. He suggested that instead of following the US model of liberalisation, Latin American countries should find their own ways which would better suite their domestic market. The key focus of his study was on the housing market.

Boddy (1989) also researched financial deregulation and UK housing finance. His research looked into the building societies act 1986 and its impact on the housing market future in the UK. 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) wrote a classic article on the credit crunch. It documents the decline in the supply of credit in the 1990-91 recession and also studies 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 combined effect of the lack 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 decline in the values of bank capital, and secondly to analyse the conditions imposed by bank supervisors, regulators 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 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. 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 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. The authors investigated the Asian financial crisis and noticed that the most affected countries first experienced a collapse in property prices which weakened their banking system before experiencing an exchange rate crisis. The authors first discuss 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 the banking system in determining prices. An 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 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. This research showed that both decades have seen prolonged build-ups and sharp collapses in asset markets such as housing, stocks and exchange rates. 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 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 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 announced 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% expansion in 2007, globally growth have slowed to 3.7% in 2008 and is expected to further drop by 2.2% 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 loss confidence in the value of securitised mortgages in the United States, resulting 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 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 recent rise in oil prices triggered this crisis further and it became a global phenomenon. As this is an ongoing phenomenon, not a lot of academic literature exists on it. Some key contributions have been made 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 the 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 discuss 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 an unprecedented strain on the global financial system (Murphy. 2008).

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 bankruptcy of Lehman Brothers , the sale of Merrill Lynch, 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 citied as the major cause 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, Martin Wolf, the recent credit crisis has significant similarities to the previous financial crises or turning points in the economy, e.g. the emerging markets crises in 1997-98 or 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 credit is a great tool if used wisely. However, in the last few decades credit went unchecked in economies such as the US and the UK and it got 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 take irresponsible risks. Thousands of individuals took out loans larger than they could afford. They hoped that they could 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. A lot of people 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 getting worse 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 growth of the subprime mortgage market in the US. In the second half of 2007, US sub-prime mortgage foreclosures raised 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 individuals with nonstandard credit profiles or 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 to write off large losses and this made them very reluctant to lend any further, especially in the subprime sector. As a result, all around the globe a great many markets have dried up and it has become very difficult 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, UK house prices have fallen considerably (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 residential mortgage-backed securities and covered bonds 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 %	Annual Change %	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 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. In literature, shortage of mortgage finance is identified as one of the most important factors in falling demand for house-buying in the 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 the year 1991. Figures clearly indicate that till July 2007, mortgage providers were very competitive and were 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 profile or those who were not able to commit 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 struggling 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 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% 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 house prices to incomes has risen to an all time high

In the UK’s housing market many potential buyers are struggling to get a 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 unemployment exceeded 9 percent. 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 199, 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 was the largest business and it accounted for 7.9% 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 is determined by herding behaviour. This means that most of the rise in demand is rooted in 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 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 consumer confidence and spending. The housing market is especially vulnerable 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

Methodology provides an overall framework and implementation strategy to conceptualise and conduct an inquiry and construct scientific knowledge (Collis and Hussey, 1997). Careful planning is required to complete most medium to large scale research projects including a master’s dissertation including this study of the causes and effects of UK financial crisis, especially with reference to the housing sector and mortgage banks. A well thought out and clear research plan is therefore imperative for the success of this research project. It enables the author to think about what the key objectives of research are and how the author going is to achieve these. Another important point to note at this stage is that the process of developing a research plan started much earlier: before devising a research methodology, the author has gone beyond the research methods prescribed in the literature to discover their roots and match these with his own personal beliefs/preferences, a method suggested by Yin (1994).

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 Philosophies

There are two main philosophical traditions indentified in literature, often referred to as paradigms (Kuhn, 1970); positivism and social constructionism (ibid). The choice of paradigm is dependent upon the nature of the research and its philosophical assumptions. However, there is no right or wrong choice of paradigm, especially in the field of management and financial studies (Kane and O’Reilly-De Brun, 2001).

3.2.1 Positivistic Paradigm

Positivism is based on the conviction that there is an objective real world (Schrag, 1992), which is predictable and orderly; and social reality is autonomous of human perception and exists in spite of whether we are aware of it or not (ibid). Positivism’s approach is based on verifiable and quantifiable facts and according to it results should be confirmable, and the researcher must be independent. The paradigm suggests hypothesis and deduction. A hypothesis is made before research and it is then tested through observation and evidence. The main strength of this approach is that it produces extensive coverage of situations; it is cost-effective and fast; and results are highly dependable (Easterby-Smith et al, 2002). However, the main criticism of the positivistic approach is that it may not be high in external validity as it is normally carried out in experimental conditions, so the results produced if repeated could change. Positivism may pay no attention to relevant results by imposing many constraints (Kane and O’Reilly-De Brun, 2001).

3.2.2 Phenomenological Paradigm

Phenomenological paradigm proposes that “the reality is not objective and exterior, but is socially constructed and given meaning by people” (Easterby-Smith et al, 2002: 29). The Phenomenological approach normally takes place in a natural setting where research is the study of a natural phenomenon (Kane and O’Reilly-De Brun, 2001). The researcher following this approach is perceived to be a part of the whole process; therefore, the validity of the research is extremely dependent upon the researcher’s ability and skills (ibid). The main advantage of this approach is that the study has greater depth; however, the overall process can be time consuming and expensive, and there may be greater subjectivity, thus the reliability of the results may be lower (Kan and O’Reilly-De Brun, 2001). In the history of management and financial studies research (1972-2002), phenomenological paradigm has been the most dominant approach (Mingers, 2002). For the purpose of this study as well, I shall follow the phenomenological point of view as I view the causes and effects of the UK financial crisis (2007-2009); issues are epistemologically subjective and thus conform to an interpretive approach.

The methodological choices are influenced by the researcher’s epistemological preferences that are in turn based on ontological beliefs. Ontology deals with the essence of reality (or the question of what reality is) while epistemology is about how we make sense of it (or the way in which reality needs to be investigated). Many scholars (Hamel, 1993; Avison and Fitzgerald, 2003) have identified two extreme contrasting positions for each of these issues. Two ontological extremes are of ‘realism’ and ‘nominalism’. Realism believes in the existence of structured and predetermined reality which is independent of the views of individual observers, while ‘nominalism’ views reality to be complex, confusing, constantly changing and a social construct distorted by cultural beliefs and values. Similarly, two contrasting extremes of epistemology are positivism and Interpretivism. Positivism assumes that there exist general laws and relationships that can be studied using rational/scientific ways while Interpretivism believes that individuals understand the world differently and perceptions of each individual are as legal and correct as other. These philosophies gave rise to two basic approaches for conducting social research. These are ‘Positivist’ and ‘Social Constructivism’. The Positivist approach is based on the ontological extreme of realism and the epistemological extreme of positivism, while Phenomenological is based on nominalism and interpretivism, which is also the basis of this thesis.

There is a difference in both philosophies with regards to the logic of reasoning as well. There are three main sets of reasoning. Deductive, which is based on a positivistic approach, and primarily deals with testing/verifying theory. It suggests that data may not necessarily be theory loaded. The second way of reasoning is Inductive, which follows the phenomenological tradition, and is more about theory generation, and suggests that theories without facts are possible (Yin, 1994). While the third and last logic of reasoning, which is followed in this study, is Retroductive which attempts to overcome the pitfalls of both purely inductive and deductive research processes. It uses a predictive theory but sees it as a ‘conceptualisation’ rather than an ‘ordering framework’ as considered in deduction (ibid.).

Depending on the nature and aim of the study, research can be divided into two types: Explanatory research, which is about understanding a phenomenon, and explaining ‘what’ has happen (Kane and O’Reilly-De Brun, 2001) and Exploratory Research in which researcher aims to explore a phenomenon on the basis of an evidence-based approach, stating what happens and why it happens. The research aims to generalise its analysis but only within the confines of the study. Exploratory research provides ‘how’ and ‘why’ answers on the basis of current events but also tries to predict the outcomes for similar events in the future (ibid). This study can be categorised as explanatory as it attempts to understand the phenomenon rather than to create a theory.

3.3 Research Method

There are various research methods used in social science research, many of which have been applied to financial and management studies. The most commonly used ones are: cross sectional studies, experimental studies, longitudinal studies, surveys, ethnography, and case study. However, in this research I shall use case study method, which is the most commonly used strategy in management studies research. It can be defined 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 (Yin, 1994). The advantage of case study is its applicability to real-life, contemporary human situations and its public accessibility through written reports. These can be of two types:

Multiple Case Studies: These allow the researcher to identify and study patterns of commonality amongst cases and theories. Evidence produced from multiple case studies is more compelling and results are considered more vigorous. However, it requires extensive resources and time (Yin, 1994).

Single Case Study: The key strength of using a single case study is that it provides greater opportunity for depth of evidence and data. It also allows studying several contexts within the same case. In a limited time this approach is the most productive approach (Voss et al, 2002). The main disadvantage of pursuing a single case study is that generalising results may not be possible, and misjudgement of a single event can produce totally incorrect results. However, due to time and space limitations, in this thesis I shall follow the single case study method.

Case study research is the most common qualitative method used in information systems and is well suited to understanding the interactions between information technology related innovations and the context in which they operate. Case study also exhibits the following characteristics:

Researcher gets the opportunity to study the information system in a natural setting, learn about the state of the art, 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 UK financial crisis, especially with reference to the housing sector and mortgage banks. 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, 1994) where it provides an explanation of the observed phenomena that help to establish understanding of the research topic in its real life context and environment (ibid). Case study methodology helps to provide a rich and multi-dimensional picture of the situation being analysed. It is therefore most appropriate for this thesis.

3.4 Data Collection methods

Yin (1994) has identified six data collection methods for case study research including interviews, direct observations, physical artefacts, participant observation, documents and archival records. However, in this research I shall be using documents and archival records, which are most relevant to any case study research (Yin, 1994). These include: administrative documents, progress and written reports of event, formal studies, books, news papers, journal articles, and mass media articles. The data however can be categorised as qualitative and quantitative (Table 3.1 presents the differences between the both).

3.4.1 Quantitative methods

These are based on numerical data and calculations. The key strength of this method is that it can provide wide coverage, is fast and commercial, the results have high validity, and are less dependent on researcher skills (Easterby-Smith et al, 2002). The major criticism of this method is that it tends to be inflexible and artificial, not very helpful in generating theories, and is not very effective in understanding the whole process of research and normally follows a positivistic approach (ibid).

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)

3.4.2 Qualitative methods

These are mostly subjective in nature and can be defined as an “array of interpretative techniques which seek to describe, decide, translate and come to terms with the meaning of more or less naturally occurring phenomena in the social world” (Collis and Hussey, 1997; 62). The paradigm followed for this thesis mostly uses qualitative methods. The major strength of qualitative methods is that it is open ended, dynamic and flexible, it provides depth of understanding, and is a richer source of ideas. The major criticism of this technique is lack of reliability (ibid).

After evaluating the attributes of both methods, it is evident that qualitative methods are most suitable for this research which is case study based. This is a more flexible approach and enables a researcher to understand the context in detail and in depth. Therefore, the research will be more focused on qualitative methods but supported with some quantitative analysis if required (e.g. analysing the survey etc).

3. 5 Primary and Secondary Data collection

There are two ways of collecting the data.

Primary data can be collected by doing surveys, interviews, or and by conducting experiments etc. Collecting primary data provides unique original results to the researcher; however, using this method is time consuming and expensive (Yin, 1994). Secondary data is the data which already exists in documented sources. This includes data from published articles, reports etc. This is a cost effective and quick method, which can help a researcher to identify any gaps in literature, and to get background information. The data used in this research is all from secondary resources.

3.6 Limitations

Being a masters thesis, major limitations were time and budget as the thesis required significant study of the relevant literature. Finding the required journals and books, however, was made easy due to the availability of electronic databases such as ABI Inform and access point such as Athens, along with the extensive use of the library and availability of many key reports online.

This thesis uses the single case study method, which also has its inherent limitations, e.g. it is questionable to what extent the results obtained can be generalised and what inference can be made to the wider body of knowledge. In addition to this, this research is mainly based on qualitative data, and this technique lacks ‘reliability’. Also, it was not possible to obtain primary data. The author did try to contact many banks, but due to the sensitive nature of this subject perhaps, banks were not willing to corporate. The author therefore had to rely on secondary resources. Another important point which should be considered at this stage is that the literature available on this crisis is limited (as it is a new and ongoing phenomenon); therefore, this dissertation is unique and an important contribution to the body of knowledge.

3.7 Conclusion

The research shall 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 researcher shall be analysing the single case study of the UK financial crisis. Data collected is all from secondary resources and is qualitative in nature.

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 the revenue, profit, shareholder return, share value and the dividend paid to the 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 in the London, New York and Tokyo stock exchanges (Barclays, 2009a). The firm operates in various regions of the world including Europe, North America, Middle East, Latin America, Australia, 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 US$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 the stage 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%	20.3%	24.7%	21.1%	21.7%
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’ stance following the decline 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 US$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 US$4.7bn, primarily fuelled by the losses in subprime mortgage and other credit related investments. This resulted in Barclays Capital posting total losses of US$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 US$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 US$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 US$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 soared 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 injections from the government of 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;n.p)

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 additional losses came from the continued ‘market dislocation’.

The Chairman and the CEO further argued (Wearden, 2009;n.p):

“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,” they argued.

Some positive impact of the share prices was 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 taking part in its asset protection scheme that was announced by the government in June 2009. The scheme would allow banks 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 percent 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 announced that it has sold its 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).

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 the Prime Minister 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 worst then 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 £9.6 bn in 2006 to £10.5 bn 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%	28.20%	26.60%	25.60%	22.80%
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 £11.1 bn in 2006. However, due to losses suffered during 2007, it was reduced to £10.7 bn and then further dropped to £9.8 bn 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 £2.5 bn mark during 2004 and 2005 and some increase was seen in 2006 when it touched almost £3 bn and further increased to £3.3 bn 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 the analysis that the both financial institutions, Barclays Plc and Lloyds Group Plc, have been and are badly affected by the credit crisis. Both institutions show similar trends in almost all the 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, real estate prices hit rock bottom and started a vicious cycle that encompassed a number of 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 the financial markets especially the mortgage banks and the housing sector; to understand the relationship between the credit crunch, the housing sector and the financial sector; to analyse the similarities and differences between this crisis and those experienced 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 interconnection 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 past few 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 institutes 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 identified as another important factor behind this crisis. The institutions and products linked to the UK’s financial and mortgage market are many. 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 a 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 interconnection in 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 worst.

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 trigger of the crisis is arguably impossible. 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 the 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. 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 arise when the actions of an individual bank 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. Another key reason cited in the literature which was also confirmed in this research is about 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. 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. 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.

PERSONAL REFLECTION ON THE PROCESS

The study enabled me to develop skills that will go a long way in my professional development and career progression. First of all, devising a viable and appropriate research plan for this study keeping in view the methodological and resource related limitation and then managing its various stages within the deadlines set, provided valuable project management experience. Then, conducting a comprehensive literature review provided experience of searching, learning and presenting information in the form of a coherent report. This involved use of various resources such as library to access books, and extensive use of electronic resources to access electronic journals and other materials such as organisational reports available on the internet. The Athens facility was very useful in providing access to these documents. Also, I learned how to go back and forth using the references provided by the authors to identify key pieces of literature. I also learned how to paraphrase and organise the material in a structured way. Similarly, analysing the data from a variety of sources and then identifying key points of concern also added to the learning and finally, and above all, I learnt how to write an academic piece of work and how it needs to be organised and presented.

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

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