The bank bailout – how would it affect us?

On 2 October 2008, the US Senate approved a revised version of a $700bn rescue package for the troubled Wall Street financial system. The bill then went to the House of Representatives, who had already thrown out a previous plan at the end of September.

The world’s oldest investment vehicle, Sigma Finance, had collapsed, marking the final chapter of the “shadow banks” industry which fuelled credit outside the traditional mould and was once worth trillions of pounds.

It underlined that extent of the global financial crisis – from now on, whatever the various bailout plans, the crisis would change the very fabric of the system, not just in high finance, but for every aspect of people’s lives: mortgages to shopping habits.

The message and promise from the political leaders was that credit availability would return to some sense of normality. Yet at the source of the abundant fountain of credit, Channel 4 News found some pretty dark unregulated corners of global finance – the so called “shadow banking” system worth 10 trillion dollars. Though you may never have heard of it, now that it is gone, you will feel its absence.

Leading economist at the Stern school of business, NYU, Professor Nouriel Roubini told Channel 4 News: “We created a system that was bound to collapse. Trillions and trillions, the shadow banking system in terms of assets and liability was as large, or probably larger than the banking system at this point.”

If you ever wondered how Northern Rock could ever offer 125 per cent loans, why your credit card limit was being extended without request, and why in 2005 bankers could cry ‘credit for everybody’ and why tiny funds could takeover some of the world’s biggest corporations – the answers lurk in Wall Street’s dark corners.

Old school banking required personal vetting of loans risk and intrusive regulation from authorities meant conventional banks were constrained to lending out around 10 times the value of their assets.

Traditionally the Wall Street investment banking titans dealt in high finance, but they discovered ways to bypass the constraints of conventional banking and lent up to 50 times their assets even though they had no traditional depositors.

Professor Nouriel Roubini predicted just six months before the collapse that all five US investment banks would fold.

He told Channel 4 News: “A shadow banking system was either not regulated at all. Private equity, hedge funds or very unregulated like this – broker dealer, merchant banks, investment banks and other ones, they were fundamentally more fragile and more unstable than banks because of greater leverage, greater risk taking, without getting the safety net of the deposit support of insurance or the liquidity support of a central bank. That’s why it was a fragile, very unstable and bound to collapse system. It was really an accident waiting to happen.”

Lehman Brothers was the most spectacular example of this collapse. Alongside four others, Lehmans stood on top of a financial food chain. The models they built and exported across the world were wrong. The formulas used presume that house prices could never slump. When they did and the actual mortgage payments in the system disappeared it prompted that collapse of the whole system.

Professor Robert Shiller, author of The Subprime Solution, told Channel 4 News: “We began to think that the people who work hard for a job are losers, suckers, ‘I can make more money in one trade than you make in one year’, and so we started to think of ourselves in that kind of way.

“When the stock market failed us, we shifted to something else.

“We were advising everybody to buy a house and borrow 90 per cent, 95 per cent in the midst of the biggest bubble we’d ever had.

“You can see its craziness. Now the prices have started falling and obviously it’s putting people in a difficult situation.”

The era of easy credit was gone and along with it the many consequences. The remortgaging revolution where we assume a better value mortgage deal every few years curtailed; the presumption that banks pass on interest rate cuts, gone for years potentially; anyone wanting a house would now need a hefty deposit; savings would surge; companies heavy with debt now found difficulties refinancing, prompting job fears.

The banking system would need to shrink – whatever the result of any bailouts.

Professor Nouriel Roubini said: “A lot of the growth in both economies was very fast. Greater than other parts of the advanced economies, but it was an artificial growth led by an asset and a credit bubble.

“So the question is can the UK and US grow at a sustained rate without these bubbles?”

Professor Robert Shiller said: “Japan had a housing bubble and a stock market bubble and then the bursting of that bubble. Home prices in Japan or urban land prices fell for 15 consecutive years from 1991 to 2006. And the economy was sluggish throughout that time. I don’t know why people haven’t taken that seriously. They should have taken that seriously during the boom.”

Robert Zoellick, president of the world bank told Channel 4 News: “What you see going on in other areas with Goldman Sachs and Morgan Stanley – two very well run and good institutions, I used to work at Goldman, is that they’re changing their model to become a bank holding company.

“So you have to change and adjust with different circumstances in the markets. When you don’t want to throw out the baby with the bath water, but you do want to learn the lessons from mistakes.”

Britain’s bank bailout

Just a week later on 8 October 2008, Britain passed its own £500bn bailout. The money would be pumped into the banks and building societies to strengthen the institutions’ resources and ensure the system had the funds to maintain lending in the medium term.

A Treasury statement on the day announced that the following companies would participate in the government-supported recapitalisation scheme:

• Abbey
• Barclays
• HBOS
• HSBC Bank plc
• Lloyds TSB
• Nationwide Building Society
• Royal Bank of Scotland
• Standard Chartered

The government would receive in return for the bailout money, preference shares in the institutions.

In addition the Bank of England would make available at least £200bn to banks under the special liquidity scheme. This would facilitate banks’ short-term borrowing and was intended to promote greater liquidity.

For the first time in more than a decade, the interest rate cut was announced in the Commons by the Prime Minister, rather than the Bank of England. The Chancellor Alistair Darling said the package would help to “un-bung a big problem” – banks’ unwillingness to lend to one another.

The emergency rate cut by the Bank of England was larger than the reduction that followed the 9/11 terrorist attacks and was made in concert with central banks around the world. It was meant to restore confidence in the British economy, alongside the package to save the banking system.

Money for the package would come from the taxpayer in what amounted to the part-nationalisation of institutions taking part. But on the stock market, fears of recession trumped any hope generated by the government’s scheme.

The then prime minister, Gordon Brown said the Bank of England’s decision to cut interest rates by 0.5 per cent was to “assure people that all action is being taken in the economy”.

Gordon Brown said: “The whole House will want to know that the Governor of the Bank of England has just announced an immediate 0.5 per cent cut in interest rates.

“He has done so in a co-ordinated action that is happening round the world in which the US Fed has cut interest rates by 0.5 per cent, the ECB by 0.5 per cent, the Swiss, the Swedes and other members of the G10 have all cut interest rates showing that global problems are best dealt with by global action.”

Brown’s statement to the Commons came hours after the government unveiled a half a trillion pound rescue plan for British banks to encourage them to start lending to each other again.

The prime minister called the plan bold and far reaching.

He insisted the three-part stability and restructuring programme was “comprehensive, specific and breaks new ground”.