The Credit Crunch

Since 2007 terms such as; recession, economic depression, the double dip, the credit crunch, the downturn, the business cycle, have been on the lips of the nation but what actually is a recession?

In economic terms a ‘recession’ refers to a period of two consecutive quarters of negative economic growth. However, over the past few years the UK has seen a period of economic contraction for ‘a record six consecutive quarters’ (The Telegraph, 2010).

So where did it all go wrong?

There is much disagreement amongst economists regarding when signs for the recession officially started with some people believing the cracks were beginning to show way back in 2001, others specify the date to be 9^th August 2007. On this date the French Bank BNP Paribas halted withdrawal from three of its largest investment funds because it couldn’t accurately calculate the value of their securities.

The announcement knocked 3.4% off of BNPs share price and 1.9% off the European stock index (Bloomberg, 2007).

Economists believe on that date the first domino fell.

For years prior to 2007 lending from banks had been on the increase, loans, mortgages and credits were given out far too easily, often to people that couldn’t afford the repayments. The turn of the millennium saw the dot-com bubble burst and a terrorist attack on the world trade centre. As a result the US Federal Reserve reduced interest rates making credit cheaper, this resulted in an increase in public borrowing in the forms of mortgages and loans.

These loans were then securitized by the banks, pooling all of the loans together to form collateralized debt obligations (tranching). These “CDOs” appeared to be an attractive investment and were given credit ratings that did not truly reflect their risk of investment. Many were given AAA credit ratings which, according, to the Moody credit rating agency deems the investment: prime, maximum safety, high grade, high quality. As the CDOs began to default and become worthless, banks stopped leading to one another, in some US market segments liquidation completely evaporated, this made it ‘impossible to value certain assets fairly regardless of their quality or credit rating’ (Bloomberg, 2007).

One of the first major signs in the UK of the recession was the Northern Rock fiasco. Due to the reduction of lending amongst banks Northern Rock couldn’t secure any loans and as a last resort took financial backing from the Bank of England. As this information seeped through the media it triggered a run on the bank with thousands of savers heading to their nearest Northern Rock to essentially, empty their accounts. ‘Faith in British banking was being destroyed’ (BBC News, 2007).

Since then things simply got worse, UK manufacturing starts to decline, house prices fall, in April 2008 the UK announces its officially in a recession after ‘a run of 63 successive quarters of growth stretching back to 1992’ (Telegraph, 2010), we began to see many household brands buckle under the weight of heavy losses:

Even now, five years down the line some high-street giants are struggling to survive, HMV is set to close an addition 60 stores throughout 2012 in response to declining sales, Game announced to its shareholders just this week that it is desperately struggling to survive and on the 12^th March the company’s shares fell a shocking 65%!

So what now?

The Bank of England predicts that there is a 1 in 10 chance of the country entering a double dip recession, this would have shocking effects on the economy and could de-rail any recovery plans outlined by the government. I fail to see any solution presenting itself in the near future, the record figures for unemployment in the UK means there’s a significant lack of spending and the economy is suffering as a result.

However, in February 2012 the UK services sector (that makes up two thirds of the UK economy) has seen significant growth indicating that dreaded ‘double-dip’ could be avoided. Furthermore, we have seen a lot of stores on the high-street closing down but there are many that have thrived despite the recession, Primark for one has seen an increase in share price regardless of the state of the current economy, Dominos Pizza has also seen growth as families are cutting back on going to restaurants, opting for this cheaper alternative.

Regardless of these few anomalies the future is looking bleak; economists believe it could take up to 2016 before the country manages to haul itself out of recession. George Osbourne believes were in an economic crisis equal to, if not even more severe than the crisis suffered during the 1930s.

Could the recession have been avoided? Perhaps if the rating agencies had scrutinised and justified the credit ratings given to CDOs more thoroughly, even prior to that surely the banks should’ve implemented stricter codes of conduct when allocating loans and mortgages? I understand these were not the sole principles that got us into this mess but they certainly contributed and somebody has to take blame, if anything just to ensure that it doesn’t happen again.

Sources used:

The Telegraph (2010) 'The Story of the Recession', The Telegraph Website, [Online]. Available at: http://www.telegraph.co.uk/finance/recession/7077504/Story-of-the-recession.html (Accessed: 18/03/12).

Bloomberg (2007) 'BNP Paribas Freezes Funds as Loan Losses Roil Markets', The Bloomberg Website, [Online]. Available at: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aW1wj5i.vyOg (Accessed: 18/03/12).