Ten years later
Have lessons really been learnt from the sub-prime implosion?
Ten years ago today, the financial crisis began. Few people knew it at the time. The first milestone was French bank BNP Paribas’ decision to freeze three hedge funds that specialised in sub-prime loans, a market not previously much noticed outside the world of high finance. Nonetheless, the world was tumbling over the precipice. Banks collapsed, unemployment soared, and some governments even went bust.
For a decade, politicians, regulators and financiers have sought to find ways to recover from the crash and stop any similar catastrophe from happening again. So have they succeeded? To judge the present, we should start by looking back to that turbulent summer a decade ago.
The warning signs were there. The US sub-prime mortgage market was imploding. Motivated by profit, cheap “adjustable rate” loans had been handed out to families with little thought about future affordability. After all, it didn’t matter when prices were rising. When US house prices started to fall and families couldn’t refinance their loans, defaults became more common.
Banks spent much of the start of the crisis insisting that this was an isolated problem. Baudouin Prot, BNP Paribas’s chief executive at the time, insisted that just three of the bank’s managed funds had sub-prime exposure. These investments, he stressed, were exclusively “AA” and top rated “AAA” tranches. The story of what lay beneath these gold-plated assets has been told many times. But, in effect, 10 years ago today, BNP stopped panicked investors from withdrawing money from these funds, blaming a “complete evaporation of liquidity in certain market segments of the US securitisation market”. It was just the start. The scars of the 2007-08 financial crisis remain today. The UK economy shrank 6.1pc from peak to trough, triggering a spike in unemployment and a collapse in wage growth. Output remains weak and the productivity puzzle is yet to be solved.
Ten years on, how is the global economy faring and where are the new risks?
Post-crisis reforms have made the financial system safer. Janet Yellen, the chairman of the US Federal Reserve, said in June that the system was robust enough to ensure another crisis would not happen “in our lifetimes”.
Ken Rogoff, a former chief economist at the International Monetary Fund, says another crisis is inevitable. “The problem is human nature,” he says. “It’s always the case that after a deep financial crisis governments take radical measures – if anything, they overkill the risk of another crisis. But over time there will be a boom again. And when there’s a boom, lessons of the last crisis tend to be forgotten because everything looks so good, and booms can go on for a long time, asset prices can skyrocket. And it’s during those times that the regulations get pulled back or taken away – it’s human nature.”
Mark Carney, the Governor of the Bank of England, is confident that a similar crisis cannot happen now as banks’ capital buffers – the resources they need to hold to cushion against a crash – have been improved radically.
Speaking at the time of the 2016 stress tests, which simulated the impact a major recession would have on banks’ finances, he said that if banks had this much capital when the financial crisis struck, they would have survived and kept on lending.
Capital buffers have more than doubled in the past decade, a substantial step towards making banks more stable.
Their impact is evident, too, in banks’ financial performance. When lenders have to hold more capital against their loans, they cannot generate the same scale of returns on their capital. It is not good for investors, at least in the short term, as they earn lower dividends.
Returns on equity peaked at 18.6pc in September 2007, across the banks in the FTSE 350. Over the past five years they have averaged just 3.2pc.
Those lower returns are also bad for banks’ share prices. A combination of weak returns plus the disappearance of some major banks means the FTSE 350 banks index has not recovered to where it was before the financial crisis. The index peaked at more than 11,500 in early 2007. It is still languishing below the 5,000 level.
While there are few signs of exuberance in the banking sector itself, the borrowers that use the banks tell a different story. Debt shares across the global economy are far higher than before the financial crisis.
The Government’s national debt in the UK has more than doubled as a share of GDP, rising from 42.2pc in 2007 to 88.8pc now. Eurozone government debt is up from 64.9pc to 91pc, while in the US the figure has shot up from 64pc to 108.4pc. Rogoff believes this is sustainable. “Debt levels are not problematic, if interest rates stay so low. Real interest rates on US 30-year debt are at 1pc, when historically they’ve been 3.5pc, and all global real interest rates are very low,” he says.
Rogoff highlights that historically, debt crises in developing countries are triggered not by a global recession but when an advanced economy booms.
Private sector debts have followed a different path. After the financial crisis, households took something of a breather, paying down their debts, or at least not taking on more debts, while waiting for their incomes to rise. Pay growth has been relatively slow, but debt burdens have fallen back a little. Mortgage debts peaked at 113pc of households’ average income in 2008 and have slid back to 101pc now. Total debts, adding mortgages to consumer loans, passed 150pc of incomes in 2008 and fell to 130pc in 2014. Nonetheless, there are signs of strain in the system. Those total debt ratios have crept back up to 134pc of incomes, for example. Average UK house prices climbed to just over £190,000 in late 2007, according to the Office for National Statistics, after extraordinary growth. Sale prices crashed to around £156,000 just 18 months later, before plateauing for several years at around £170,000.
But since early 2013, prices have been back on a sharp upward trajectory, which is either a sign of households’ finances recovering, banks lending properly once more, or of another bubble being inflated. The average home sold in May 2017 went for more than £220,000, though the market has slowed in recent months.
Officials at the Bank of England have applied limits, capping the proportion of loans that banks can give to home buyers who seek to borrow more than 4.5 times their incomes, for example.
But if the mortgage market is under a degree of control, the consumer credit market may be a new source of worry. Borrowing across categories including credit cards, consumer loans and car loans has shot up at a pace of more than 10pc per year in recent months, a pace not seen since the years building up to the financial crisis. The rise in debts relative to incomes has been driven by consumer loans, not mortgages. That worries Carney, who warned against complacency in June, when presenting the Bank of England’s latest Financial Stability Report.
“Consumer credit has increased rapidly. Lending conditions in the mortgage market are becoming easier. And lenders may be placing undue weight on the recent performance of loans in benign conditions,” the Governor said. “I think it is forgetting some of the lessons of the past, or not fully learning the lessons of the past.”
Ten years on from the start of the crisis, that is a serious warning indeed.