15 years after the start of the financial crisis, risks persist as inflation is endemic

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  • On August 9, 2007, the French bank BNP Paribas froze three of its American funds due to problems with subprime mortgages in the United States
  • The value of mortgage debt has collapsed and banks have stopped lending to each other
  • Bailouts grew in number and speed in 2008 as investors lost confidence in the banking system
  • Parallels today as volatility hits equities, housing markets begin to cool, and an energy crisis shocks
  • Central banks now lack the tools to mitigate the slowdown and instead focus on reducing inflation
  • Interest rates were 5.75% in August 2009 with a possibility of falling, they are now at 1.25% and should increase further
  • Banks now more resilient and deemed sufficiently capitalized to cope with a further deterioration in the outlook
  • Risks remain on the horizon, including in commodity markets, which threaten to amplify supply crises

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Troubles in US subprime mortgage markets

The first raindrops suggesting a financial storm could be on the way fell when French bank BNP Paribas froze three of its US funds, citing problems in US subprime mortgage markets. These refreshing splashes heralded a deluge of destruction that tore through financial markets. Trillions of dollars in loans issued to borrowers with poor credit ratings had been cut up, repackaged and sold in the financial markets with a deplorable lack of oversight and when the housing bubble burst it rattled the financial institutions that had joined. to the dream of derivative products. There were other doom-laden dates to come in the thunder and lightning that followed when the banks stopped lending to each other, but August 9 marked the first seizure of the system. Funds were suspended and investors were prevented from withdrawing cash, after BNP Paribas deemed it had become impossible to value the assets, with a highly questionable quality rating attached by rating agencies.

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The financial crisis exposed major vulnerabilities not only within the banks, which had become household names, but also exposed major flaws in the economic health of eurozone member states in the years that followed. Bailouts increased and grew rapidly as investors lost faith in banks and then in the ability of countries to repay their huge debts.

At first glance, there are parallels to be drawn with today, given the volatility ravaging equities, moves in bond markets signifying potential recessions and scorching house prices showing signs of cooling. There are renewed fears that the euro zone is facing a serious crisis, this time caused by an energy shock.

The good news is that UK banks are seen as sufficiently capitalized and sound enough to withstand the risks of a further deterioration in the economic outlook. In its latest financial stability risk report, the Bank of England says that although the outlook for the UK and the world has deteriorated, UK banks have the capacity to support lending to households and businesses. Rules to ensure the retail and investment activities of UK banks are closed came into force in 2019, aimed at preventing contagion should risk-taking cause further global economic shocks.

Consumers could face the biggest price rises in four decades right now, but compared to the months before the 2008 financial crisis, the Bank of England says households are not as likely to take on debt any further. The Bank expects businesses as a whole to continue to struggle. It will be more difficult for small businesses to repay their loans and some businesses are expected to fail, but overall it will take a much bigger shock to see a domino collapse of businesses unable to repay their debts. debts.

Inflation is galloping

The less good news is that central banks have fewer tools at their disposal to weather the economic storm looming today. In August 2007, interest rates in the United Kingdom were at 5.75% compared to 1.25% today, which left the Bank of England a lot of leeway. In the years that followed, the rate fell rapidly to stimulate demand in the economy, and a massive bond-buying program was launched to reduce borrowing costs. Today, these levers cannot be used as they creak under the pressure to be pulled to get us through the pandemic. With interest rates cut to rock-bottom levels, the era of cheap money has helped fuel the fires of inflation that central banks are now desperate to put out. So instead of heading into a recession, hoping that there will be another lifeline thrown in to pull the economy out of a slump, the aid currently being deployed is being quickly withdrawn.

Bank of England Governor Andrew Bailey stressed the paramount importance of bringing inflation back to the 2% target, saying there would be no ifs and buts. It’s far from a comfortable place, but a shrinking economy is seen as the price to pay for stemming an inflationary spiral. The additional difficulty facing policymakers is that much of the inflation is imported and driven by external shocks rather than domestic forces, which will make it much more difficult to reduce the price spiral.

While rates are expected to continue to rise, the risk of a rapidly deflating housing market bubble is also increasing. Ring-fencing rules designed to make banks more robust have been blamed for fueling higher prices. The criticism is that the new regime has trapped a big cushion of cash in the UK bank fence and the extra cash circulating has helped fuel the era of super cheap mortgage deals. However, a Treasury report earlier this year cited ultra-low rates introduced by the Bank of England and pandemic support for the housing market as the main drivers of intense mortgage competition in recent years.

There are concerns about the number of UK mortgage holders who are dependent on short-term mortgage deals compared to other countries. Homeowners benefiting from ultra-cheap two-year rates will likely find that their financial resilience will diminish in the face of the shock of higher monthly payments. In the United States and many parts of Europe, longer-term mortgages have become much more the norm, shielding more households from the short-term shock of sharp rate hikes. Longer-term rates are increasingly popular in the UK, which could help mitigate risk for the market as a whole.

There are other clear and present dangers on the horizon. Emerging markets are very sensitive to commodity price spikes, new waves of Covid are an ongoing risk, and China’s fragile property market is still seen as a potential threat to stability. Although at present the UK financial system appears poised to stay calm, carry on and weather the ongoing turmoil, another clap of thunder still threatens to shatter confidence and resilience. The Bank of England is uncomfortable that the buck will always stop at Threadneedle Street and that as an institution it will always be able to step in and try to save the day . He is also very concerned that the functioning of commodity markets risks amplifying supply crises. Going forward, it will likely require more market participants, not just the big banks, to ensure that they have built up enough reserves to adequately protect against severe but conceivable shocks.

Economic uncertainty and market volatility can be confusing to investors, but it’s been shown that tough times don’t last forever and markets eventually recover. With inflation looking rampant and recession looming, times are clearly tougher for consumers and businesses, but it’s important for investors to think about their long-term strategy and remain resilient when markets are jittery. We’re not sure what’s in store for you, but staying calm and carrying on, instead of selling impulsively, could benefit you in the long run when prices eventually recover.

Article by Susannah Streeter, Senior Investment and Market Analyst, Hargreaves Lansdown

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