x Abu Dhabi, UAESunday 20 August 2017

In the decade since sub-prime crash, what has been learned?

Could it happen again? Yes, although probably not in the same form.

Lehman Brothers name moves across a news ticker in New York's Times Square September 15, 2008. What lessons have been learned in the years since? Joshua Lott / Reuters
Lehman Brothers name moves across a news ticker in New York's Times Square September 15, 2008. What lessons have been learned in the years since? Joshua Lott / Reuters

The biggest financial crisis for 80 years started exactly 10 years ago this weekend when the French investment bank BNP Paribas, citing the “evaporisation of liquidity in certain sections of the US securitization market”, froze withdrawals from three of its funds which had substantial holdings of American mortgage-backed securities.

The funds were relatively small - less than US$2 billion - but it was the bank’s accompanying statement that terrified the markets.

 BNP said it found it “impossible to value certain assets fairly, regardless of their quality or credit rating”, which meant that no bank or fund in the world could know the value of the trillions of dollars of mortgage-backed securities they held on their balance sheets. In effect, the pricing system, on which all free markets depend, had broken down - a fact immediately understood by the markets. The Dow Jones fell 387 points, or 3 per cent, in a single session, with bank shares crashing, beginning their long decline that would wipe out almost the entire equity of banks such as Citicorp, then the biggest bank in the world, Merrill Lynch, Lloyds TSB, HBOS, RBS and, of course, Lehman.

The real carnage, which turned the market rout into an economic recession, was in the global credit markets, or interbank lending market where banks extend credit to each other on a daily basis. Mortgage securities hardly moved - the market simply froze, with trading in many securities halted. The sub-prime crisis, which had been building since the US housing bubble had burst in the summer of 2006, had begun.

The rest is history. Within a matter of weeks, unable to access the credit markets, the UK's Northern Rock was running out of money and turned to the Bank of England for help - and was refused. Early in September depositors queued up to withdraw their money, causing the first run on a British bank for over 100 years.  Gordon Brown, the prime minister at the time, later described his shock as he watched it unfold from his office in Downing Street. “It was like a scene in a film or a picture in a text book,” he said, “but not something I had ever expected to see in my lifetime or under my watch.”

Looking back 10 years later, it is difficult to imagine now the carnage among the biggest financial institutions. By December 2007, Chuck Prince, the chairman of Citigroup, abruptly quit after revealing losses on mortgage-backed securities of $11bn; Stan O’Neal, the chief executive of Merrill Lynch, announced a loss of $7.9bn and also departed (a year later Merrill, the “thundering herd” of Wall Street, was bailed out by Bank of America). Jimmy Cayne of Bear Stearns headed for the exit a few weeks later, followed soon afterwards by the bank itself, which was bailed out by JP Morgan for a pittance (valued at $18bn a year earlier, it was sold for just $240 million). Lehman Brothers staggered on until September 2008 before filing for bankruptcy, the biggest in US history, bringing down HBOS and RBS among many others in the crisis that followed. Shareholders in Lloyds, the strongest of all the UK domestic banks, lost 95 per cent of their value. The equity value of the entire banking sectors of Ireland and Iceland was wiped out.

A decade on the world has still not fully recovered. On Monday this week Eurostat announced that unemployment across the euro zone fell to 9.1 per cent in June, the lowest since February 2009, but still below its pre-crisis levels. Unemployment, particularly in the 18 to 24-year-old “youth” category, in countries such as Spain, Portugal and Greece, is still above 30 per cent. Ireland, which took a huge 17 per cent hit in GDP post-crisis, has only recently got back to where it was after a full decade of lost growth.

Could it happen again? Yes, although probably not in the same form. The overreaction of the regulators has been to force banks to increase their capital bases to the point where the stronger banks have actually got too much capital. This week HSBC unveiled a $2bn share buy-back on the back of strong underlying profit growth, bringing the total funds returned to shareholders to $5.5bn. The UK regulators have forced the big banks to repay nearly £30bn for mis-selling insurance products to customers who did not need them. Lloyds alone has paid out £18bn (Dh87.49bn) with another £1bn to go, funds which in previous times would have gone to strengthen its capital, or been paid to shareholders as dividends. In 2007/8, most of the big banks had capital ratios of 6-7 per cent. Today the figure is twice that.

Generals always fight the last war and the threat this time around may come from a different direction. On Monday Moody’s warned that UK household debts are rising to worrying levels at a time of economic uncertainty. The same trend is appearing in the United States where the Fed looks certain to raise interest rates. China, worried about its level of consumer debts, has put the brakes on and may be heading for a hard landing. An economic downturn, all too possible given the political chaos in the US and Britain, could tip many households over the edge.

 A lot of lessons have been learned in 10 years. They just may be the wrong lessons.