The Love-Hate Relationship
Elliot Frost | 27 March 2017

Over, the last two centuries, recessions have seen to be extremely frequent. Within the UK, a recession has occurred once every decade for 40 years and in the US every decade for the past 60 years. Some economists believe that financial collapses and recessions are an integral part of modern capitalism and a frequent cyclical feature of our economic structure. Although in 2001, the U.S economy experienced a mild and short-lived recession, the economy then strongly withstood the 9/11 terrorist attacks, the bust of the dot com bubble and accounting scandals. This is highly unusual in the economy. As Andy Haldane explains, throughout the last century specifically, “we have seen a mini revolution, how the banks have gone about their liquidity provision and how they have upgraded through the 21st century”. This mini revolution has been a part natural occurrence and part caused by the financial sectors.

 

The most recent recession timings varied from country to country. However, within the US and Europe, what is known as the “Great Recession” occurred within 2007/08. It was the immediate consequence of the failure of many major financial institutions globally. During my article this will be widely referred to, most commonly as it is a great example of a recession which was fuelled by the banks.

 

Low interest rates in the U.S and Europe at the beginning of the decade and easy lending on the U.S housing market helped stimulate the largest financial collapse for 80 years. With 30 million people unemployed and people as young as 17 qualifying for a mortgage in the US, there was clearly a lot going wrong within the international economy. Housing giants such as Angelina Mozillo adapted his ‘rags to riches’ story to make out that he was a friend of the poor, allowing his company to manipulate people into sub-prime mortgages in order to attempt to afford their dream home. A large problem with the banking sector was that the private view of the market was very different to the public view of the market. Loans did not stay on the mortgage lenders books, they were packaged into financial products (really just stacks of IOU’s), then these products were bought and sold as securities. Even mortgage lenders such as Mozillo admitted that in “all his years of business” he had “never seen a more toxic product”. Many people in the city started to admit that sub-prime mortgages which were packaged and sold on “were a good piece of fruit that had turned bad”, however during the financial collapse 2007/08 everyone started to register that these packages “were rotten from the start”.

 

At the beginning of the decade, the city became a place were “you go to make as much money as possible”. Within the US, experts estimate that the total mortgage market grew from 10% to 32% between 2003 and 2005, many of these were indeed sub-prime mortgages. In order to understand why sub-prime mortgages were being allowed, especially to a level where it was a danger to the economy we need to dig deeper into who was allowing it and why.  Sub-prime mortgages are loans given to people with bad credit ratings, as a result would not normally be able to qualify for conventional mortgages. Prior to the financial collapse banks were very keen to hand out sub-prime mortgages, this was due to housing prices increasing at a rate that the banks would be happy for the consumer to decline on their payments, in the long run the bank would profit from this. Therefore, bank executives put pressure on due-diligence underwriters who accept or decline mortgages, to accept more for larger bonus’ by the end of the year, this is an example of the banks within the US committing fraud however as yet no Chief Executives on Wall Street have been charged with any type of related fraudulent activity. This meant that the protection for customers was now failing them and accepting mortgages which should not have been allowed, meaning more and more people defaulted on their mortgages. This was at the same time that housing prices were falling as there was large speculation in the market due the sensitivity and changes in interest rates. This made the cause of subprime mortgages more complicated as due-diligence underwriters would blame bank executives and vice versa.

 

This is what led financial services firm Lehman Brothers into bankruptcy in 2008, creating a domino effect to the rest of Wall Street and the rest of the world with the largest bankruptcy in history. The prospect for Lehman’s $4.3 billion in mortgage securities getting liquidated caused a major selloff in the market. When going bankrupt, Lehman brothers held 40 billion dollars’ worth of assets for its customers, by the end of the recession it had only given back under 22 billion. Instead of holding the original mortgages, Lehman Brothers would package them into securities and trade them off, much like the Icelandic model I will describe later on in my article. By collecting the original fees, this freed up the market for more capital which was re-invested and increased liquidity even more. This created the snowball effect which built momentum and led to the financial crash.

 

It was just before the crash that then Northern Rock CEO Adam Applegarth was expressing his desire for the sub-prime mortgage packages. Applegarth thought that he had made a model which was a world leader, instead he had just made a model which everyone was using but whilst doing it he had made his bank the most vulnerable. Ever since the queues formed outside Northern Rock, it has been slowly dawning on people that the banks are inherently unstable. Bank regulation has been heavily criticised during the crash, but the rules regulating commercial banks were much more stringent compared to the so-called “shadow banking system”.

 

An example of a booming financial industry previous to the collapse and suffered after is Iceland. Iceland, before 2000 had a very small financial institution, however, it was transformed by the free market principles of David Odsland. Banks were privatised during 1997-2003 to large Russian investors who lowered interest rates and flooded the market with easy credit. Once free from government control, the banks went on a ground breaking borrowing and lending spree that increased the assets of the banks by 100%. By mid-2008, Iceland’s GDP sat on par with Switzerland and one of the top rankings in the world. However, the business model used by Iceland was ‘brought in from abroad’, most commonly known was the ‘subprime’ behaviour. This triggered a real estate boom in Iceland which was clearly unsustainable. It was no surprise that Iceland became one of the first countries to freeze after the financial crash, 85% of Iceland’s commercial bank assets crashed only a week into October 2008.

 

A major player of the financial crash in the UK was innovation and deregulation which was persevered by Gordon Brown, in the last speech before becoming primes minister, just as the crash was about to occur praised the bankers for their ‘remarkable achievements’ and predicted that the following years and decades would be a ‘golden age for the City of London’. Clearly, in all that he said prior to the financial crash, he was wrong. Regulatory arbitrage, which gave British banks access to larger funds than their competitors abroad was used by Gordon Brown in order to make London the financial capital of the world. However, instead Brown relaxed what were already diminished regulations in the ‘shadow-banking’ firms such as Lehman Brothers or Goldman Sachs who instead used this to act however they wished. Banks had grown too quickly and started to believe that they were too large to fail, therefore concluding that the ‘light touch’ regulation which had been put in place had not prevented any type of mismanagement within the financial services district.

 

What is significant about this recession and the period of time around it is that events moved at such a dramatic pace. After the collapse of the Lehman Brothers on 15th September, and before anyone had an idea of how to adequately respond to the crisis, the US House of Representatives rejected a $700bn rescue plan for the US financial system, sending a huge shockwave into the international market. The shock from the financial collapse was recorded in London no longer than three weeks later. The Business Confidence Monitor index for London fell from -32.2 to -61.4. This showed that in London there had been a complete collapse in confidence during the month of September. On 29th September 2008, stock market volatility had reached its highest level since records began in 1990, even surpassing peaks reached in the previous recession and after the 9/11 terrorist attacks. In total, this lead investment in the service sector to fall by almost 23% between the third quarter of 2008 and the second quarter of 2009. With all of its different factors, the most recent recession has shown us that banks can have a serious role in the diminishing the growth of our global economy.

 

If it is true that recessions have a natural cyclical occurrence, then there must be positives for our economic structure for them to happen naturally. A natural recession is good as it gets rid of excess within the economy. This allows inventories to drop to a more sustainable level and allowing natural demand and supply for products to pick back up, this is much like the Keynesian theory. Recessions and some depressions help keep economic growth along a sustainable trend. This stops the economy growing at an unsustainable rate and stopping the economy experiencing uncontrolled inflation. This means during a recession consumers cut back in response to falling wages, letting the economy grow at a normal level without prices rising unsustainably. A recession also allows an opportunity for people to buy assets such as housing and land, possibly for future investment and development. Recessions can also change the mind-set of some consumers, it forces many people cut back from unaffordable lifestyles. Allowing for children to understand the value of goods and services, possibly making future generations wiser. However, recessions can also have some unprecedented and unusual circumstances. They can rise unemployment by record amounts and demand falls for goods and services, and therefore rising unemployment is a sign of a recession, as consumers cut their spending, businesses have a loss in profits and therefore cannot keep on staff and cut payrolls. Although recessions cut out the excess in the economy, as the demand drops shops for example order less and the supply becomes more sustainable, the economic downturn can be very painful and harmful for businesses. During a time of recession, confidence becomes hugely diminished, people become fearful that the economy will never return to its original state and a cut in spending hurts the economy even more.

 

In order to understand the mentality of why the banks can so often lead our economy into despair, we should recognise their motivations. Throughout the 2000’s the city was thriving with ‘light touch regulation’ and was developing as a purely ‘bonus system’. This created a generation of city personnel who only cared about the end of year figure rather than thoroughness of their jobs. CEO’s knew that they needed to reach goals, making as much profit as possible. If using sub-prime mortgages benefited the amount of money the firm was making then this would be the strategy used. CEO’s knew that even if they did get fired, they would still not lose out. Such as ex AIG CEO Joseph Casseno, who was fired from AIG for his main contribution to the failing of AIG’s large CDO’s (collateralised debt obligations). Regulatory arbitrage in the ‘shadow’ banking system allowed for many bankers to lower their expectations of the system and started to become ‘greedy’ from the words of congress during the investigation of the 2007/08 banking collapse. This greed was shown by ex-stock broker Bernard Madoff, who is a prime example of how untrustworthy characters in the city can be. Madoff who is also the former Chairman of the NASDAQ stock exchange operated the largest fraudulent scheme in US history. Madoff’s asset management scheme was fuelled through greed and the need to be the biggest and best on Wall Street. This is an example of how Wall Street bankers are motivated and driven through the need to make the most money.

 

Recessions have become a cycle of our natural world, we have ‘boom and busts’, this is now a cyclical occurrence. However, we must understand that it can be healthy for our economy to refresh and start from the basics every now and again. Like the Wall Street Crash used in my example. I feel this is a natural recession/ depression which could not have been stopped. However, like 1857 and our most recent recession, I feel that these were indeed fuelled by the financial system and that desire and passion made people ignore the signals which has affected many people in the process. In this article, I have reviewed people such as Angelina Mozillo and Joseph Casseno who both took the risk of the people in order to push their own professional boundaries. It is therefore to conclude that within the last two centuries, where recessions have been born and have grown on a cyclical scale, that banks are heavily responsible by fuelling what could have been avoided. However, we have also learnt that banks should not be blamed for all economic turmoil. Natural recessions do occur and therefore it is when both a natural recession and banks ego come together than we result in a heavy recession that could have been avoided if treated in the right way. 

James Routledge 2016