Tag Archives | finance

The great housing boom

Readers Question: In 2008, did banks lend money to people who wanted to buy a house because they believed that the value of the housing market would keep rising? So even if people defaulted on their loan repayments then the banks could reposes the house as it was used as collateral. As the value of the house would be of greater worth than the loan so that the banks could make a profit. Is this correct? Thanks!

This is partially correct. The great housing boom lasted from 1994 to 2006/07. But, in particular the period 2000 to 2007.

Mortgage lenders in both the US, UK and Europe became very keen to lend more mortgages because of rising prices, but also other factors, such as over-confidence, ability to borrow short term money / resell mortgage bundles. There were also significant differences between US lending and lending in Europe. In the US, mortgage lending was the most aggressive. UK and Europe retained some controls, but even so, mortgage lending rose sharply.

US Housing boom in historical context

us-housing-prices-Shiller_IE2_Fig_2-1

US house prices historical context – Shiller at wikipedia

The US Housing boom

The US housing boom was caused by a number of factors, but extravagant mortgage lending was a key factor.

  • Rising property prices created a positive wealth effect. This encouraged people to try and get on the property land (people who previously rented).
  • Rising house prices also encouraged banks to lend mortgages because – as you say – even if people defaulted, the bank could make a profit on its mortgage lending by selling the house at a higher price. Usually lending a mortgage is quite a good investment for a bank, especially if house prices rise.
  • The rising demand and rising supply of mortgages created a strong effect for pushing up house prices. It became a mutually reinforcing circle. Rising house prices encouraged banks to lend. More bank lending encouraged people to buy, pushing up prices.
  • Over-confidence. This climate of rising house prices definitely encouraged over-confidence in the banking sector and amongst householders. There was a feeling that housing was one of the best forms of investment – you couldn’t go wrong with a house.
  • Short-term bonuses. In the US, a feature of mortgage lending was that people were employed to sell mortgages who had no interest in checking whether it was suitable in the long term. There were very lax mortgage controls. Mortgages were sold with ‘teaser’ deals to make the first two years cheap and the later higher rates hidden from view. These mortgage sellers were not considering whether it made sense, they were just trying to sell the mortgages to get their commission. Financial bodies were happy to have these rogue salesmen because they thought house prices would keep rising. Also, bankers often got substantial bonuses from the mortgage boom; risky lending often paid high bonuses – encouraging a climate of risk taking.

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Labour plans for bank reforms – UK Bank market share

Readers Question: would you be able to comment on what the Labour party’s latest proposal to break up the banks to create competition? I can see some reasons that relate to safe guarding possible failures of large banks which can prove costly if the government are needed to bail them out. However, in terms of helping to stimulate economic growth, would it help or is it like shuffling a deck of cards? I would greatly appreciate hearing your opinion on this.

Labour bank reforms include:

  1. A cap on the size of banks’ market share; this will involves splitting up large banks, such as Lloyds and RBS
  2. The introduction of two new challenger banks with an 8% market share.
  3. Refer the issue of banking competition to the Competition and Markets Authority (CMA), within one year of being elected.

Motive for bank reforms

  • The UK banking sector has become more concentrated in recent years. This has created less competition and more market power. If the government is able to reduce market concentration and increase competition, then they hope that consumers will benefit from more choice and greater price competition. If the banking sector becomes more competitive, the theory is that it will put downward pressure on the cost of borrowing, and upward pressure on saving rates.
  • The OFT found in a review of the current account market that, while the share of the four largest providers fell from 74 per cent in 2000 to 64 per cent in 2008, it then rose to 77 per cent in 2010.

bank-marketshare

  • A report by Bain & Company,  showed that the market share of the top six banks together account for 91% of retail deposits. The problem of high market concentration of retail banks is that market power leads to dominance in related financial products, such as mortgages, loans and overdrafts.
  • Reducing the size of banks helps to deal with the issue of banks which are too big to fail. After the credit crisis, the government had to bail out large banks, at a cost to the taxpayer. Reducing the size of banks means that any bailout will be less costly. Continue Reading →

Credit Policy

Credit policy / financial policy is the use of the financial system to influence aggregate demand (AD). Monetary policy affects AD through the Central bank controlling interest rates and the money supply. Fiscal policy affects AD through the use of government spending and taxation.

Credit policy looks at factors such as:

  • Bank lending rates to firms and households in the economy.
  • The supply of credit and availability of loans from banks to firms and households.

In normal economic circumstances, it was felt the Central Bank could adequately control the economy through changing base rates.

When the Central Bank (e.g. ECB, Bank of England) changed interest rates, it had a strong influence on bank lending rates. When the ECB cut rates in 2001-03, bank lending rates fell, when the ECB raised rates in 2006-07, bank lending rates rose. Bank lending rates closely mirrored the Central Bank. Therefore, there was little attention paid to bank lending rates – there was no need.

However, since the credit crunch, the normal relationship between Central bank base rates has broken down. In particular, when the main base interest rate was cut, firms – especially small and medium sized firms (SME) didn’t see the actual interest rate they paid cut.

base-rates-bank-rates

See also bank and base rates in the UK

Implications of divergence between base rates and bank rates

This is very important for the effectiveness or not of monetary policy. Usually, if interest rates are cut from 5% to 0.5%, we would expect the loosening of monetary policy to boost lending, consumption and aggregate demand. But, that hasn’t been happening. Lending rates are still high, and credit tight. The base rate of 0.5% has become misleading to the actual reality of firms who face high borrowing costs.

Problems in the Eurozone

bank costs

Source: Economists – Central bank has lost control over interest rates

This problem of bank lending rates is most noticeable in the peripheral Eurozone countries. Since the crisis, small and medium sized firms have actually seen an increase in borrowing costs. Bank rates have increased, making the 0.5% ECB rate meaningless. The Economist reports

‘SMEs in Spain and Italy must pay over 6% to borrow; money is tighter there than it was in 2005, even though the ECB’s rate is far lower.’ (Woes for small business in Europe)

The problem for SME (small and medium enterprise firms) is that they are too small to sell their own bonds. They are reliant on bank lending. But, because of the credit crunch and fears over bank stability, they are finding their borrowing costs increase.

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Functions and Examples of Financial Intermediaries

Definition of financial intermediaries

A financial intermediary is a financial institution such as bank, building society, insurance company, investment bank or pension fund.
A financial intermediary offers a service to help an individual/ firm to save or borrow money. A financial intermediary helps to facilitate the different needs of lenders and borrowers.

For example, if you need to borrow £1,000 – you could try to find an individual who wants to lend £1,000. But, this would be very time consuming and you would find it difficult to know how reliable the lender was.

Therefore, rather than look for individuals to borrow a sum, it is more efficient to go to a bank (a financial intermediary) to borrow money. The bank raises funds from people looking to deposit money, and so can afford to lend out to those individuals who need it.

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World Financial Crisis AD/AS diagram

Readers Question: how to illustrate the world financial crisis by using the graphs of aggregate demand and aggregate supply?

The financial crisis has essentially caused an unprecedented fall in aggregate demand.
AD fall

Aggregate demand has fallen because:

  • Bank lending decreased due to the credit crisis and shortage of bank funds. The shortage of bank lending has reduced investment and consumers spending (both components of AD)
  • Falling house prices. The credit crisis has reduced the availability of mortgages and therefore reduced demand for buying houses. Also house prices were overvalued. So with less mortgages available prices have been falling significantly.  The fall in house prices has caused a negative wealth effect. This has led to lower consumer confidence, lower equity withdrawal and a decline in consumer spending.
  • Fall in global growth. The decline in economic growth has caused a decline in exports and world trade, further reducing aggregate demand.
  • Decline in confidence. The well publicised problems of the banking sector and stock market falls have reduce consumer confidence and led to a change in attitudes. Rather than spending on credit people are trying to improve their savings and reduce their debt.

In  early 2008, there was an increase in oil prices which led to cost push inflation. This caused AS to shift to the left and encouraged Central Banks to keep interest rates relatively high. This possibly aggravated the recession. But, I don’t think it was a major factor.

For more details see: Financial Crisis explained