Monetary Policy and Investment Bank Bear Essay

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MODULE TITLE: International Human Resource Management
MODULE CODE: PGBM18
MODULE TEAM: Sandy Drossou / Lesley Mearns/ John Reilly O’ Donnell
HAND-IN-DATE: 14th May 2012
HAND-IN-TIME: ONLY Turnitin Submission – NO HARD COPIES Before 12.00pm

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THE CREDIT CRUNCH CRISIS OF 2008

In October 2008, the world financial system came within a whisker of complete meltdown. In September 2008, the US government had decided to allow the investment bank Lehman Brothers to go bust, and in October the UK government nationalised Royal Bank of Scotland (RBS) and Bradford & Bingley, and forced Halifax Bank of Scotland (HBOS) into a shotgun takeover by Lloyds funded by government money. Also in October, the US government nationalised the massive insurance group AIG. Meltdown was avoided, but the world moved rapidly into recession, with an almost complete shutdown of bank lending and rapidly rising unemployment.

What went wrong? The seeds of the crisis were sown with the terrorist attacks of 11 September 2001. The US economy was already slowing before the attacks, and Alan Greenspan, the head of the US Federal Reserve, felt that decisive monetary action was needed to avoid outright recession. He quickly slashed US interest rates to an unprecedented 1 per cent, and the Bank of England and the European Central Bank followed, although not to the same extent. US interest rates were held at this low level for several years.

With hindsight, it is clear that Greenspan went too far, too fast. The economic impact of 9/11 proved to be short-lived, and by 2004, the US economy was back in boom. In normal circumstances, such as loose monetary policy would have rapidly let to rise in inflation, but retail prices in the US, the UK and the Eurozone were kept down by the boom in cheap imports from China. Instead, inflationary pressures built up on asset prices, particularly house prices.

Mortgage lenders in the US started an aggressive lending programme, buoyed by the expectation that house prices would continue rising indefinitely. Many specialized in lending to so-called ‘ninja’ borrowers – no income, no job and no assets – in the so-called sub-prime market. In the UK the ex-building society Northern Rock followed a similar policy, lending on mortgages of 125 per cent of the value of the property, financed by its own borrowing from the wholesale money market. The money markets themselves became contaminated. In order to spread their risk, the US mortgage lenders packaged up their mortgages (a process known as securitization), into so-called collateralized debt obligations (CDOs) – a package of mortgages sold as a bond to other institutions. By 2007, CDOs in the US were valued at US $1.3 trillion, and this was the tip of an enormous syndicate debt iceberg worth US $14 trillion, 7 per cent of total US GDP. The securitised bundles were so complex that an individual bank found it almost impossible to assess the risk it was running.

Like any pyramid scheme, the whole thing only worked as long as house prices continued to rise. Unfortunately, as US interest rates began to rise again, the ninja borrowers were no longer able to meet their mortgage obligations. US house prices peaked in summer 2006, and fell 25 per cent over the next year.

The first victim of the crisis was Northern Rock, which failed in September 2007, and was eventually nationalised by the UK government. In March 2008, the US government rescued the investment bank Bear Stearns, and in July it rescued the two major US mortgage providers, Fannie Mae and Freddie Mac. As explained above, the crisis then reached its peak between September and October 2008.

An underlying contributory factor was the very loose supervision of financial institutions in the UK, and to a lesser extent
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