The Legacy of the Crash

by Terrence Casey

  The initial Bush administration response to difficulties in the US housing market was simply to allow market forces to play themselves out. The Republican administration’s initial argument was that ‘a federal bailout of lenders would only encourage a recurrence of the problem. It is not the government’s job’, President Bush said in September 2007, ‘to bail out speculators or those who made the decision to buy a home they knew they could never afford’ (Financial Times, 1–2 September 2007, p. 2). As mortgage lenders themselves then began to default, the Bush administration initially restricted itself to quietly orchestrating private-sector rescues designed to contain the spreading fire. Only at the eleventh hour did the Bush administration see the need for unprecedented public intervention; but when it did, it went in for bailouts on the grandest of scales. The two main Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac, were already in federal hands by the time Lehman Brothers fell, taken into full ‘conservatorship’ (that is, effectively nationalized) by the hitherto entirely free-market Republican administration. The subsequent response of Treasury Secretary Hank Paulson to the September 2008 credit crisis was a $700 billion rescue package aimed at locating and absorbing mortgage-backed securities whose value was in freefall. The Troubled Asset Relief Program (TARP) bill that passed early in October 2008 included a congressionally-imposed $150 billion of tax breaks, limits on executive pay in bailed-out companies, and powers to ease mortgage terms to prevent foreclosure. Paulson used TARP money in the last months of the Bush administration not to buy toxic assets (quickly finding and valuing them proved too difficult) but to recapitalize commercial and investment banks, and the largest of the insurance companies and hedge funds, hoping in that way to restore inter-bank confidence and the large-scale flow of credit again.

  By the time the Obama administration came to power, the US Treasury had made available $125 billion in aid to nine major banks, an additional $125 billion to smaller banks and an extra $40 billion to AIG. Alongside the moves to stabilize individual institutions, monetary policy too quietly eased, with Federal Reserve-financed injections of yet more credit guarantees and central bank-orchestrated expansion programs for the financial industry worldwide. $900 billion in loans to banks was made available by the Federal Reserve as early as December 2007, followed by a further $250 billion in March 2008 to encourage mortgage lending, $29 billion to smooth the sale of Bear Stearns to JPMorgan Chase in March 2008, eventually $123.8 billion to bail out AIG, $620 billion in October to help foreign central banks trade foreign currency for dollars, $1.8 trillion to buy commercial paper, and $540 billion to buy assets from money market mutual funds short of cash – these last two again in October 2008. In the last 15 months of the Bush presidency, breathtaking amounts of money were poured into the financial system on a regular basis to keep institutions viable and credit creation intact.

  The incoming Obama administration quickly followed up on all four fronts of the crisis: housing, banking, unemployment and global recovery. On the housing front, and sharply reversing the Paulson policy of not using TARP money to directly help struggling mortgage holders, within a month of being in office the Obama administration put aside $75 billion of the bank bailout fund to help up to 4 million homeowners renegotiate their primary mortgages. That same month, the administration put an extra $200 billion into Fannie Mae and Freddie Mac, and then later (Christmas Eve 2009) quietly announced that the Treasury would provide unlimited financial assistance to both the main GSEs. By that point too, the Federal Reserve (with administration support) had purchased from Fannie and Freddie hundreds of millions of dollars of mortgage-backed securities, with the ultimate aim of owning $1.25 trillion of such securities.

  The banking story was more complicated: a matter of initial support and long-term regulation. The administration continued the Bush policy of giving TARP loans to major institutions: in March 2009 taking up to a 36 percent stake in Citigroup and making a fourth injection of capital into AIG; and in May putting TARP money into six major insurance companies. TARP money was still being distributed, to GMAC among others, as late as December 2009, although by then other temporary support measures were being allowed to expire on schedule. Individual bank bailouts were supplemented during the early months of the Obama administration by a three-month-long stress test to establish the financial viability of 19 major US banks; and by the launch of a toxic assets plan that had the Treasury partially financing a series of public-private investment funds to buy up unwanted mortgage-backed securities. New legislation to tighten federal and state regulation of US financial institutions took much longer to implement: first proposed by the Obama administration in May 2009, financial reform was finally enacted in July 2010. That legislation created, among other things, a new financial stability oversight council and a consumer protection bureau, and new rules on derivatives trading (details in Coates, 2010b).

  What the Obama administration brought new to the table, when compared to its Republican predecessor, was a stimulus package aimed at alleviating the general recessionary impact of the credit crisis. The $787 billion American Recovery and Reinvestment Act included $276 billion in tax cuts for low- and middle-income Americans and for small businesses, and over $500 billion in a series of spending programs. The Obama White House rendered specific assistance to the US auto industry, even taking partial temporary ownership of GM; and like the Bush administration in its brief post-crisis moment, continued to press other major industrial economies to adopt similarly loose fiscal and monetary policy. US pressure for fiscal largesse met increasing resistance over time, particularly from the German government. In 2008, every major government had briefly been fiscally liberal. By 2010 that was no longer the case.

  UK contagion

  As in the US, the financial problems experienced in the UK in 2008–09 had their domestic origins in the local housing market where – as in America – subprime mortgage loans had become increasingly common and mortgage-backed securitization had been accompanied by declining underwriting standards (Stephens and Quilgars, 2008, pp. 199 and 205). In the UK as in the US, as more people received loans to finance home purchases, the demand for homes had increased and house prices had soared. By 2007, the total value of housing assets in the UK was 3.5 times as large as the total value of housing debt. In London as in New York, housing and finance markets had become intertwined as consumers borrowed more based on their home equity, and as lending secured on dwellings had drastically increased. The warning bells of an impending financial crash began to sound in the UK just after they were heard in the US. In September 2007, Northern Rock, a mortgage lender, was forced to turn to the Bank of England for cash. When banks increased the cost of inter-bank lending in response to concerns about bad loans in the US, the inter-bank money markets on which Northern Rock depended for funding dried up. Concerns about Northern Rock’s liquidity led to a run on the bank, the country’s first in more than a century.

  Initially Northern Rock seemed to be a localized and isolated problem caused by a reckless business model; over time, however, as US-exported uncertainty hit the inter-bank lending markets in London, lending by UK-based banks and building societies occurred more slowly and at higher interest rates for both banks and consumers. Demand for houses decreased and the price of homes fell, cutting into the equity on which consumers had heavily borrowed. Climbing interest rates for consumers increased the pain of homeowners and debtors who had to pay off their various loans. Repossessions began to rise, and increasing numbers of borrowers began to default on their loans. As in the US, securitization then spread these problems to even more institutions. September 2008 was a traumatic month in London no less than in New York. Amid the blows to their finances and the growing uncertainty, London-based banks also began to shut their doors to new mortgage customers and to decrease their loan availability. The frozen banking system and resulting lending slump led to a credit crunch in the UK which affected not only the ability of consumers to borrow and spend but also the
ability of firms to obtain the funding necessary for their growth. So, as in America, unemployment rapidly rose in the UK, from 5.3 percent in 2007 to 7.6 percent in 2009. UK GDP declined at an annualized rate of 2.8 percent in the last quarter of 2008 and by 3.7 percent in 2009. The Bank of England cut its interest rates in an attempt to stimulate the economy; however, it did so more slowly than the Federal Reserve. While the Bank incrementally decreased its rates from 5.75 percent in December 2007 to 0.5 percent in March 2009, the rates were still as high as 3 percent in November 2008, and the economic contraction, despite rate cuts, lasted throughout 2009.

  Unlike the Bush administration, the Brown government never left the resolution of the UK’s growing financial and economic problems simply to market forces. Instead, the members of the tripartite arrangement2 took action even before the crisis of September 2008. They addressed the looming failures of important lending institutions, prevented further bank runs by protecting depositors’ funds, and worked to restore liquidity and encourage lending. Only days after the run on Northern Rock, the Treasury guaranteed all of the bank’s deposits. After several failed attempts to find a private buyer for the bank, Northern Rock was officially taken under temporary public ownership in February 2008. The New Labour government also orchestrated a rescue takeover of HBOS by Lloyds Banking Group in September 2008, and took Bradford & Bingley into partial public ownership. In November 2008, the government took a majority share in the Royal Bank of Scotland (RBS): that stake was later increased to 68 percent in return for the bank’s pledge to extend more loans.

  The Bank of England began its Special Liquidity Scheme (SLS) as early as April 2008, lending banks £50 billion in government bonds in return for collateral in the form of the banks’ high-quality mortgage-backed and other securities. In October 2008, the Treasury began a recapitalization scheme, initially purchasing £25 billion of Tier 1 capital from eligible institutions and spending a further £25 billion on preference shares. Through this scheme, the government invested £37 billion into RBS and HBOS/Lloyds. The government also proposed a £200 billion extension of the SLS, created a £250 billion credit guarantee scheme, and cut fees to banks in an effort to stimulate their lending. In February 2009, the Brown government proposed an Asset Protection Scheme (APS) through which the Treasury would underwrite a bank’s toxic assets in return for an agreement to lend more to homeowners and businesses. In addition to pouring public funds into the bailout and assistance of banks, in October 2007 the government extended depositor protection to guarantee the first £35,000 of a depositor’s savings. A year later, this guarantee was increased to cover the first £50,000 of savings. As in the US, UK monetary policy was also eased to restore liquidity and encourage credit creation. In September 2007, the Bank of England announced that it would inject £10 billion into the money market to bring down the cost of inter-bank lending, and in December 2007, it participated in a coordinated international move by five major central banks to inject £50 billion into world money markets. In March 2009, the Bank of England began its Asset Purchase Programme (APP), or quantitative easing policy. The APP began at £75 billion. In August 2009, it was expanded to £175 billion, and it became £200 billion by 2010.

  Additionally, the Brown government took medium- to long-term measures on the same four fronts on which the Obama administration also moved: housing, banking, the global recovery and the role of government stimulus. Far less was done in the UK than in the US directly to assist housing. In one of his few measures to help the housing market, the New Labour Chancellor, Alistair Darling, raised the value of residential property to which stamp duty land tax would apply, first to £175,000 in 2008 and then to £250,000 in 2010. In 2008, New Labour pressed major mortgage providers to extend the minimum period before commencing repossession and provided help to the unemployed with interest payments on their mortgages. In April 2009, New Labour also introduced a modest Homeowners Mortgage Support Scheme which, though directly helping only 34 households in its first year, was widely credited with ‘a positive impact on mortgage arrears management, encouraging greater patience from lenders when borrowers missed payments’ (Land, 2010). In contrast, the new Conservative–Liberal Democrat Coalition government elected late in the crisis (May 2010) capped housing benefits, scrapped regional house-building targets and reduced the housing budget. On the banking front, in August 2009 the Financial Services Authority (FSA) mandated that bankers’ pay deals be linked more closely to their banks’ long-term profitability. In November 2009, Darling required banks such as RBS and Lloyds to create and eventually sell new banks from their existing branch networks. In December 2009, the Treasury implemented a one-off punitive supertax of over 50 percent of bankers’ bonuses; and in February 2011, bonuses for the directors of bailed-out banks were deferred over three years and restricted to shares. Both Darling and his Coalition successor, George Osborne, examined the efficacy of the tripartite regime. While Darling did not plan to change its fundamental structure, Osborne quickly transferred many of the FSA’s powers to the Bank of England, essentially stripping the FSA of its responsibility and ending the tripartite system. In June 2010, Osborne announced a 0.04 percent tax of bank balance sheets, which would begin in 2011 and increase to 0.07 percent in 2012. He also presided over the successful participation of four UK banks in the European stress tests. Finally, in July, the Coalition government announced plans eventually to sell its state-controlled banking assets and to allow several of New Labour’s liquidity schemes to be withdrawn in 2012 as planned.

  The approach of the Coalition government to the question of global recovery differed from those of its New Labour predecessor and the Obama administration. While New Labour ministers had often spoken of the danger of ending fiscal stimulus programs prematurely, the Conservative Chancellor quickly joined the dominant voice within the European Union (EU) which was promoting a turn to fiscal moderation. These divergent views are illustrated by the differences in the measures taken by the two governments to stimulate the UK economy. In November 2008 New Labour launched a significant economic stimulus package: £20 billion of tax cuts and government spending. This followed a call by Brown for governments around the world to adopt similar measures, a call which briefly earned the beleaguered prime minister wide praise in financial circles on both sides of the Atlantic. In contrast, Osborne’s first move was a £40 billion austerity budget that cut welfare spending, increased value added tax (VAT) to 20 percent and imposed a £2 billion levy on banks and building societies. As UK politics moved right, fiscal restraint became the new route to economic growth in the UK, the kind of fiscal restraint favored in the US by the Republican Party.

  Similarities and differences

  Housing

  Herman Schwartz places both the US and UK in the ‘liberal market’ quadrant of his comparative typology of housing systems (Schwartz, 2008, p. 268). Liberal market systems share certain characteristics: relatively high levels of private ownership, relatively high levels of mortgage debt in relation to GDP, easy and relatively cheap refinancing of mortgages, and a significant degree of securitization of mortgage loans. In such housing systems, ‘people are likely to see housing as a form of investment to a greater degree than in systems dominated by socially provided rentals’ (Schwartz and Seabrooke, 2008, p. 244) of the sort common elsewhere in much of western Europe. Three shared features of the two housing markets stand out as particularly significant here: regulatory changes prior to the crisis, growing securitization and house price inflation. In the years leading up to the housing bubble, both countries experienced a shift from more regulated mortgage providers to private mortgage providers which were not bound by the same regulatory standards.3 In the US, ‘at its peak in 2005, more than $1.1 trillion in residential mortgage-backed securities were issued and sold to investors’ (Zandi, 2009, p. 116), 40 percent of which were subprime and near-prime loans. In the UK a third of all new mortgages contracted between the second quarter of 2005 and the third quarter of 2007 were similarly subpri
me or near-prime. In the US, house prices which had been virtually flat for four decades prior to 1995 then effectively doubled in a decade. In the UK, the pattern of house prices was more volatile over time, but similarly exploded in the years following financial deregulation.

  There were and remain significant differences on both the demand and supply sides of each housing market. The supply-side differences are the more visible. The UK is a small island with a large population, extensive planning controls and limited building land; by contrast, except in its urban centers, the US is not. The supply of housing in the latter in the last decade has been far more buoyant than it has in the former. ‘Between 2001 and 2006, the United States built more new homes than would have been required by the growth in its population. In contrast, countries such as … the United Kingdom … barely managed to build enough homes to keep up with growth in the number of households’ (Ellis, 2008, p. 3). On the demand side, the manner in which house purchases are financed in the two economies also differs. There is no tradition in the UK of the US fixed-rate 30-year amortized mortgage of the kind generalized by Fannie Mae; the purchase of most UK houses is still financed through bank/ building society-provided adjustable-rate mortgages of variable length. In addition, the tax regimes in the two systems are very different. The UK phased out tax relief on mortgage interest payments in the 1980s, the very time that the US was extending tax relief to take in not simply first mortgages but also second ones. The UK levies a substantial stamp duty on house purchases; in the US, such taxation occurs only at the state level and is generally lighter. There was no UK equivalent to the US Savings & Loan crisis of the late 1980s; rather, there was a slow and incremental demutualization of UK building societies, made possible by the 1986 Building Societies Act. In the run-up to the crisis, the UK housing market had a lower level of subprime lending than did the US housing market; and after the crisis (and in spite of its more onerous tax regime) the UK initially saw a more rapid return to stable or rising house prices.