The Financial Crisis Of 2007/2008 Led To A Global Recession

Corporate Financial Management
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Corporate Financial Management
Introduction
The 2007-2008 global financial crisis is considered as one of the worst crisis to ever affect the modern financial environment since the 1930s Great Depression. The crisis started in the U.S. with the subprime mortgage crisis in 2007 and it managed to spread across the global banking institutions such as the Lehman Brothers in the U.S. and Northern Rock in the UK. According to Thakor (2015, p.166), most financial institutions engaged in massive risk-taking behaviors which magnified the real value of the global financial market thus leading to the financial crisis. Governments across the world were forced to bail out their financial institutions using fiscal and monetary policies in order to avert the collapse of the global financial system. This essay critically analyzes the course of the 2007/08 global financial crisis based on the UK experience, with a specific focus on the Northern Rock PLC.
Factors that led to the Financial Crisis of 2007/8
The roots of the global financial crisis date back to the 1970s deregulation policies initiated in the United States, United Kingdom, and other European economies, promoting minimal control of the financial systems and these policies gathered pace in the financial markets during the 1980s. Studies have revealed that deregulation loosened numerous regulatory policies by the government, thus freeing financial institutions and enabling them to operate across broad financial instruments and wide territories (Shin, 2009, p. 102). For instance, before 1970s, banking institutions, stockbrokers, investment banks (called merchant banks in the UK), and insurance organizations operated independently by specializing in their own line of business (learnhigher.ac. n.d).
Banking institutions were also subjected to strict financial and capital controls, particularly when it comes to the percentage of funds from depositors which could be given as loan to clients. Relaxation of the controls enabled financial institutions to access funds from both depositors and other financial markets(Ekmekcioglu, 2012, p.154). Credit liberalization influenced the huge expansion of debt, which includes mortgage debt, which was at times more than seven times the income of the borrowers.Returns were high on these forms of transactions and bankers underestimated the huge risks involved in raising these funds, a process that was known as securitization.
The sharp rise in the price of oil, increasing unemployment rates, and the resulting trade recession contributed to mortgage defaults, particularly in America where financial institutions had secured numerous mortgages. This contributed to the confidence crisis that made banking institutions to be wary of lending short-term finances to other banks (Scanlon & Whitehead, 2011, p.13). The liquidity problems spread across other countries such as the UK and European markets
In the past, the sound conditions in the financial markets encouraged financial institutions to engage in financial transitions that were highly risky and which motivated high leverage in the financial markets. For instance, financial innovation led to the development of complex financial instruments that were based on securitization of loans and they included collateralized debt obligations (CDOs) as well as a wide range of asset backed securities (ABS) (Dimsdale, 2009, p.1). Presence of credit derivatives that grew rapidly, especially the credit default swaps (CDS) tended to provide protection against risks to individuals who purchased highly risky assets. The traditional banking model where financial institutions held assets until maturity before financing its lending from deposits ended up being displaced by what is known as the “originate and distribute.” This model was composed of a chain of agents starting from the first to the last investor who lacked enough information concerning the quality of loans from the first investor.
Loans passed from one individual to another (subprime loans) and this increased the risks of these financial instruments and it contributed to the subprime crisis. The quality of loans deteriorated since the loans were given to individuals who lacked the capacity to repay. The behavior which begun among banking institutions in the U.S. was quickly emulated by other financial institutions across the world, and this was one of the main contributors of the collapse of Northern Rock (Scanlon & Whitehead, 2011, p.13). Furthermore, this behavior was quickly adopted by financial institutions that wanted to securitize their loans and consequently sell them to different investors like the pension funds. There was a huge increase in profitability since assets were turned over instead of holding them to maturity.
Moreover, the sale of securitized debt increased funding since institutions managed to borrow on wholesale across the money market. This made most financial intermediaries to possess numerous toxic assets and thus ended up suffering huge losses. This is the reason why there was a huge increase in lending that was supply driven such that loans that were securitized were passed on be intermediaries who continued to hold them in their balance sheets (Ekmekcioglu, 2012, p.154). Pooling loans and classifying them into risk groups formed the securitized debts that were offered at attractive returns. However, they brought the challenges of risk assessment, particularly when borrowers defaulted. Such a trend affects an economy that is subject to shocks, thus affecting the entire financial system compared to micro shocks that affects individual borrowers.
Impact upon Northern Rock
The financial crisis had a huge impact on Northern Rock thus contributing to nationalization. Certain banks were heavily reliant on interbank market to finance their operations, including holders of mortgages. Northern Rock was a leading example of a bank that depended heavily on these transactions to finance its mortgage portfolio that was growing at a fast rate by securitizing mortgages and selling them on (Dimsdale, 2009, p.2). The weakening of the securitized product market due to concerns of investors forced Northern Rock to rely on the wholesale market to receive funding. Furthermore, money market pressures jeopardized the bank's finances and this prompted the management to seek financial assistance from the Bank of England (Marshall, 2012, p.7). The public came to know about this leading to a run by depositors and this forced Chancellor Alistair Arling to guarantee all the deposits and this initiatednegotiation that led to the nationalization of Northern Rock.
The Bank of England decided to lend financial assistance to the institution in the fourth quarter of 2007 in order to avoid a run on the institution’s cash by depositors. Ultimately, by the time it was reaching February 2008, the government saw that it was necessary to nationalize Northern Rock (Michie, 2013). The government became the major shareholder since taxpayers' money was used to support the bank. The bank run, which started in 2007 when depositors started to panic and withdraw their deposits was as a result of the need for liquidity which was affecting Northern Rock. Evidence shows that before the advent of the subprime crisis, Northern Rock used to borrow in the short term and lend at a longer term. According to Dimsdale (2009, p.2), Northern Rock is one of the clearest examples of banking institutions that used to depend on short term finances to fund the holding of long term mortgages.
Moreover, presence of securitization enabled the banking institution to have liquidity and make huge profits using the same leverage. Although the leverage did not have an extreme yield, evidence shows that equity returns were more than 20%. However, the problem that was facing Northern Rock, just like other banking institutions across the world, was the fact that liquidity was only attributed to 30% of customer deposits, while the rest of the finances were from refinancing. This implies that the bank faced the severe problems as households became unable to make repayments on their loans (Ekmekcioglu, 2012, p. 154). This was worsened by the end of the securitization process, yet the amount of loans in the balance sheets was huge.
As banks became wary of lending to other financial institutions, Northern Rock became a casualty since it could not find a place to borrow money to finance its daily operations. When depositors got wind of what was happening at the institution, they became anxious and started to withdraw their money, in the thought that those who arrived first will be the one to be served (Scanlon & Whitehead, 2011, p.13). This initiated the bank run process which ultimately made the bank to go bankrupt. In the UK, the economy minister usually insures in totality all the bank deposits in order to prevent a bank run.To prevent the bank from eventual collapse, 28 billion pounds were given to Northern Rock by the Bank of England, but the amount was still inadequate to prevent the failure of the institution (Etienne, 2009, p.17). This became the main reason why Northern Rock was nationalized by the government.
The inability of the Northern Rock to attract depositors from the market was the main reason that precipitated the collapse of the institution. The inability was associated with stressful factors in the wholesale markets and not about the concerns of the portfolio of the bank. It failed due to the withdrawal of funding in the short-term category and not run by the depositors. Studies have also shown that there was a similar mismatch between long-dated assets and short-term finance, which took place in different demutualized building societies (Michie, 2013). Institutions that heavily relied on wholesale money market are the ones that were most affected because money could be withdrawn from an institution, thus forcing it to liquidate its portfolio as a result of unfavorable conditions.
Post Nationalization...