23 Sep 2009

Financial fallout: the roots of the crisis

Cracks were showing in Britain’s banking powerhouses as early as 2005, as bad debt was sold and consumers were sucked into a credit vortex. An “ugly” correction was on the cards.

In 2005 Britain’s banks were booming. With a collective profit of £30bn the UK’s largest banks claimed record returns were a reflection on a strong economy and low unemployment.

But their accounts also raised questions about freewheeling lending, as the banks made big money in loans and credit cards sold to customers.

A study by a former banking executive, seen exclusively by Channel 4 News, said banks and credit card companies were lending too much money to those who couldn’t afford it.

The credit card mania was being hid, the report suggested, urging that action was needed form the government to protect up to four million people struggling with debt.

“Lenders used to be viewed as doctors. You went to the doctor and he would know what you needed, he would prescribe the appropriate drug. He also would know how it would interact with other drugs,” Anthony Elliott, former group risk director at National Abbey and report author, told Channel 4 News.

“I’m afraid to say now the lenders are more like bartenders serving drinks to people who’ve already had too much.”

Hiding credit mania

Louise Gowens was one such customer facing mounting credit with no end in sight. After borrowing from multiple lenders she ended up with debt costs soaring to £29,000. It was expected to take her eight years to repay.

Although accepting responsibility for her debt, Ms Gowens said she wanted more help from the bank.

“I had never had credit before,” she told Channel 4 News.

“One quickly returned to two – and then you’re into the trap of moving it around and by the end it was six with consolidation loans on top of that.

“I was ringing them and saying, “Look I don’t wish to be treated any differently but I’m really having problems here. Can I get some help?”

“They said: “That’s just it, you’ve run up this debt, you have to deal with it.”

“At the time when I was left with no money, I thought there should have been an alarm bell ringing somewhere. But there never was”.

In 2005 HSBC reported a profit of £9.5bn – up 37 per cent – with a large amount of growth made in consumer finance. The bank’s worldwide credit card growth had increased by 69 per cent in just four years.

Anthony Elliott told Channel 4 News that people more likely to incur higher interest charges will end up being more profitable for the lender.

“Inevitably there will be more of those customers that they take on,” he warned.

Losing track of lending

In 2007 one of Britain’s leading economists warned Channel 4 News that changes in the way banks dealt with company debt were creating massive risks for the future.

Exotic new forms of tradable lending were being conjured up at the big banks and the risks associated with that lending and being shunted off their books.

Banks were selling off debt to a complex and opaque network of investors meaning that it was unclear who owned what debt to whom. The market in just one form of this debt was exploding from $157bn in 2004m, to $273bn in 2005, which then doubled again to $550bn in 2006.

The banks said the new way of doing business was spreading risk throughout the financial system making it more stable – but leading city figures didn’t agree.

Professor Willem Buiter told Economics Editor Faisal Islam he was increasingly concerned by the way banks sold on billions of pounds of corporate debt to private investors, including hedge funds. The system was creating an “ugly” correction he said.

The former Bank of England committee member said: “The real problem for regulators and supervisors is they don’t know where the risk is ending up because a lot of the new players are unregulated, non-supervised, they’ve bought very little of anything.

“So we really don’t know, with many of these new instruments and the new players the hedge funds, the private equity funds even with some investment banks we don’t know who owes what and to whom.

“The fact that banks can sell their loans doesn’t mean that they’re gone – somebody else has to be willing to hold them. So if everybody believes they can always get rid of whatever exposure they in the aggregate they must be wrong.

“I believe the world is underestimating credit risk in a major way. This will be corrected and when it does it will be ugly.”