Crunch Time!
With a career in banking, you could help steer the world’s economy. Here’s how banks do it, and why it’s such a big deal in the news these days…
P ANIC! It’s all over the news: the world’s stock markets are crashing! We are all doomed… DOOMED!
As with many items in the news, it’s easy to simply shrug your shoulders and go about your day as usual. After all, what does the world economy have to do with you, especially if you’re skint?
Well, after the last major stock market crash in 1987, there were significant increases in unemployment, homelessness and drug abuse across the globe. A struggling economy can make the world a pretty depressing place, but you wouldn’t know that, because for most of your lifetime (the past 15 years or so), everyone has been happily living inside a bubble – a credit bubble, to be precise – inside which we have all been merrily spending more money than we earn without thinking too carefully about how we are going to pay it all back.
Now, that bubble has burst. Since the early 1990s, money (i.e. credit cards, loans and overdrafts) has been very easy to get hold of, and when there is a lot of money around, people tend to get excited…and also a bit silly. This is especially true of banks – they love to lend money, and when they’ve got a lot of spare cash, they are less careful about who they lend it to.
The lending game
So how do banks and loans work? Think of it this way: you’re broke, but desperately want an iPhone, so you ask the bank if you can borrow £300. They say you can have the money, but only if you pay them an extra fee of £150 and promise not to repay the loan in less than five years’ time. In effect, you’ve just written the bank an IOU worth £450, even though they only lent you £300 (not a terrific deal, but you really want that phone).
Why the strange five-year term? Shouldn’t banks want their money back as soon as possible? Well, here’s what the they don’t tell you – the bank decides to ask around and find someone who will buy that £450 IOU from them for a discounted price of £400. With this sale, they get back the money they lent you, plus an additional £100. Now it’s the buyer who has to worry about hassling you for repayment, so he or she might decide to resell that IOU to someone else, repeating the process. Over the next five years, that IOU could be bought and sold hundreds of times, with the value constantly rising until it’s time for you to pay up.
Every day, banks do this many times over, lending out thousands of pounds to thousands of people and making a fortune off of it. These ‘IOUs’ – or bonds as they are known in the trade – are bought and sold without anyone really knowing or caring who borrowed the money in the first place. The only thing that matters is that, on a certain date, the bond is guaranteed to be worth an exact amount of money. Traditionally, bonds are seen as a good investment – because unlike other financial investments, you know exactly how much it is going to be worth in the end, and during the life of the loan, the bond’s value will always increase. But sometimes, it can all go a bit pear-shaped (like now).
A subprime scenario
Ask any economist what caused our nice little bubble to burst, and they will mention the US subprime mortgage market, which is a complex-sounding term for a rather stupid thing. A Latin dictionary defines subprime as ‘not the best’ (more modern dictionaries actually define it as ‘crappy’) and a mortgage, as you probably know, is a loan that people take out to buy their house. So why on earth would anyone bother buying and selling crappy loans? The answer lies in the fact that over the past 15 years, people have managed to convince themselves that houses simply won’t decrease in value. This is utter nonsense, but like we said before – people get silly when there’s lots of money around.
So the subprime mortgage market is full of people buying and selling crappy loans that were originally taken out by poor Americans who were convinced that the value of their house was guaranteed to increase in time. And everyone was happy, selling and reselling these loans (or asset-backed securities as they are technically known). That was, until last summer, when the inevitable happened and house prices in the US stopped going up.
All of a sudden, banks woke up and started to worry (quite rightly) that perhaps the assets behind these asset-backed securities were not as reliable as they’d thought. Because the loans had been bought and sold so many times, no one had a clue who borrowed the money in the first place. Uncertainty led to panic, and banks stopped dealing with one another so freely – then everyone started to get very paranoid.
Northern Rock
Northern Rock is a bank that had been riding high on the credit wave over the last few years. By borrowing heavily from other banks and selling lots of mortgages, it quickly grew from a Newcastle building society into a large bank. When the subprime panic started to grip the banking community, Northern Rock suddenly found that it was no longer able to rely on other banks for support. So, it decided to come out and ask for help. When the bank requested a loan from the Bank of England to cover a shortfall in operating costs, many of their account-holders saw it as a sign that it was about to go bust and queued round the block to take all their deposits out. This, of course, meant that the bank needed even more money to pay them out, thus making it infinitely harder to continue with business as usual. Northern Rock had become a casualty of the credit crunch.
The involvement of the Bank of England actually means the involvement of the Government and that, by default, means everyone the Government represents (i.e. you and etc.). The financial assistance given to Northern Rock in securing its immediate future has put everyone’s money on the line, and the issue has become a political argument rather than a business decision. It’s a situation other banks want to avoid and for the time being, they are being very, very choosy about who they lend money to.
By getting involved at this stage, the Government and the Bank of England hope they can help avoid a major financial disaster – however, their action may or may not turn out to be right. Indeed, it was quick, decisive action by the Federal Reserve (the Bank of England’s American equivalent) that seems to have stopped the situation spiralling completely out of control in the USA.
The action the Federal Reserve took was to lower interest rates. A low interest rate encourages people to borrow more money, and to spend it. The idea of people borrowing more money makes the banks happy. And happy banks make for a happier economy. The trick will be keeping the banks happy, while making sure they don’t do anything silly… again.
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