Britannia Radio

From The Times

January 1, 2009

How the financial system nearly crashed in 2008

Our correspondent charts a year when old certainties went out the window

Patrick Hosking, Banking and Finance Editor

It was a stinker of a year by almost any measure. Most homeowning, pension-saving Britons finished 2008 strikingly poorer than they started it. They feel less secure in their jobs. And they face having to pay higher taxes years into the future to fund a rescue package whose success still hangs in the balance.

It was a year when the old financial certainties went out of the window. The orthodox notions that banks were safe places to deposit money, that shares over the long term go up, that multibillion-pound frauds were impossible, that cheap loans would always be available and that ordinary taxpayers would not be tapped to bail out bust firms were all challenged.

It was a year when things financial didn’t just get worse, but got worse at an accelerating pace; when the balance of power shifted dramatically from the City and Wall Street to Westminster and Washington.

It was a year when some of the world’s most senior bankers and financiers were exposed as negligent, corrupt, complacent or greedy and sometimes all four; when ministers and central bankers abandoned all normal policymaking and fiscal rules, arguing that to abide by them was to risk economic calamity.

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It was a year when regulated capitalism, the default setting for the West for the past 40 years, came perilously close to collapse. At the height of the crisis, George Bush reportedly exclaimed: “This sucker’s going down”, referring to the entire financial system. He voiced a sentiment that was felt in every bank boardroom, on every share-dealing floor, in every finance ministry. Twelve months ago most business leaders and consumers were braced for a middling sort of downturn. We were five months into the crunch. The panic at Northern Rock had been stemmed. Perhaps recession could still be avoided, perhaps not, but the consensus was that the economic pain would not be too great.

Within the first few weeks of the year that view was starting to look hopelessly optimistic. In mid-January Citigroup, until recently the biggest bank in the world, admitted that it needed $14.5 billion (£10 billion) to shore up its ravaged balance sheet. A week later the French bank Société Générale disclosed that a single junior trader by the name of Jerome Kerviel had lost it ¤4.9 billion (£4.7 billion) in unauthorised trades.

In February the Chancellor announced that he hadn’t managed to find a rescuer for Northern Rock and that the bank would have to be nationalised. The immensity of the crisis was becoming apparent: some of the biggest banks in the world were exposed as insolvent without lashings of additional emergency capital; controls within financial institutions were so lax and investment positions so complex that unimaginable sums could be lost. The private sector alone was held incapable of solving its problems.

It was a pattern that was to be repeated again and again in the months that followed. In Britain most of Bradford & Bingley was nationalised after successive attempts at private rescues failed. Royal Bank of Scotland, Lloyds TSB and HBOS all went to the Government for rescue capital.

In the US the two mortgage finance giants Fannie Mae and Freddy Mac and the insurance giant AIG had to be rescued, while Lehman Brothers was allowed to fail — a decision that rocked the financial world and triggered a fresh bout of panic. What started as a purely financial disaster spread into every corner of the economy as credit, the lifeblood of business, was withdrawn or not renewed by banks desperate to conserve cash and shrink their balance sheets. Confidence — of shoppers and business leaders alike — trickled away.

Companies started to lay off staff in ever greater numbers. A net 277,000 people in Britain joined the unemployment register in 2008, but it was the exponential nature of the rise that was most alarming: each month was worse than the month before. Business failures rose, with Woolworth’s and MFI joining holiday operator XL Leisure in the corporate knacker’s yard.

The value of houses and shares, the two biggest components of private wealth, fell by 13 per cent and 31 per cent respectively. Millions of employees in defined contribution pension schemes are in for a shock when their annual statements arrive in the next few months and they learn that their pots have shrunk dramatically.

By April the Bank of England was making tens of billions of pounds available to banks in order to lubricate the money markets and so help to bring down commercial interest rates. It was the first of a series of moves to help banks in Britain and across the West. Total government help, including capital injections, loans and guarantees came to more than £4,000 billion.

The Bank started to cut the base rate aggressively from October as the immensity of Britain’s problems sank in and as deflation replaced inflation as the policymakers’ bogeyman. By December the base rate was 2 per cent, the lowest since the Second World War, compared with 5.5 per cent 12 months earlier. Alistair Darling abandoned his fiscal rules, announced a £12 billion cut in VAT in an attempt to keep people spending and prepared to embark on a borrowing spree.

Sterling slid throughout the year, with the falls turning into a rout in the last few weeks as Britain was named by the International Monetary Fund as the economy facing the deepest recession in 2009. Against the currencies of our biggest trading partners, the pound was worth 24 per cent less by the end of the year, making imports more expensive and holiday spending money go less far, but leaving exporters and the tourist industry looking competitive.

So, a stinker of a year then, but one that at least had the virtue of spurring policymakers into measures that give Britain a fighting chance of ensuring that 2009 is not much worse