Crisis, what crisis? How recession hit the UK

Despite the recession, employees still flock to work at the Canary Wharf tube station. Photo / Bloomberg

Lunchtime on London's Canary Wharf. Finance workers spill out of offices in their thousands, filling public spaces of landscaped concrete and an underground maze of shopping malls that link the three tallest buildings in Britain. There is a hint of summer in the air but almost no evidence of a financial crisis. Or even a recession, for that matter.

The shopfront signs touting cut-price suits are the only visible sign of a downturn.

It's ironic given that this was the site of Lehman Brothers' European head office - the British epicentre on the day the financial world imploded: September 15, 2008.

On that day it was the Wharf's pubs that were heaving as stunned Lehman workers deserted their offices, unsure of what they were supposed to be doing.

The shock of the Lehman bankruptcy is still reverberating around the world. In Britain it was the event that crystallised the crisis for ordinary Brits and sent the media into a frenzy of speculation about imminent financial apocalypse. With good reason.

Within weeks of the Lehman shock the British banking sector - already shaken by the collapse of retail bank Northern Rock in February - saw Halifax Bank of Scotland and Royal Bank of Scotland fail, Bradford and Bingley nationalised and Gordon Brown forced to announce a £50 billion ($128 billion) rescue package.

"It was like a funeral," recalls a financial journalist (who asked not to be named) who covered events on September 15. "There is a bar at Canary Wharf called All Bar One. It was full of Lehman people. It was like a funeral, you know, the wake. I felt bad being there."

Kiwi Patrick Brockie, a senior banker based high in the Wharf's CitiGroup tower, had a prime view of the chaos.

"I remember going home that night. There were two guys on the train with their big cardboard boxes. One of them was crying. The other one had been at the bar all day. I really did feel for them. One was telling me just how good his business had been, how well they were doing, how it was still growing and how unfair it seemed."

The collapse of the finance sector was a media sensation in Britain. Banks and bankers were vilified.

The Daily Mail called the credit crunch "a crisis generated almost entirely by banks' greed". In a leader the Daily Express said: "In any other walk of life the negligence displayed by the greediest banker would be classed as criminal."

The immediacy of the crisis made good tabloid fodder. But the pace at which the meltdown has spread through to ordinary British life has been slower than expected - in part because of the massive government intervention which followed the crash.

After the initial excitement of what felt like a history-making meltdown, there is a sense that British public interest has waned. As spring took hold this year, the literal green shoots that burst into life after the long northern winter inspired the metaphoric "green shoots" of economic recovery.

While London's financial journalists express quiet discomfort with the public appetite for optimism, they've had little choice but to follow the trend as heavy economic stories have slipped from the top of the news agenda.

"Green shoots should come with a health warning," says one senior news executive.

For the bankers there has been time to reflect on what went wrong. For most, the issue comes back to the levels of risk that became the norm within the sector.

"Banks got caught up in the target of being number one in everything they were doing," says one industry observer, who asked not to be named. "That shouldn't be a target in itself.

"The ability for people to say no to a deal was greatly diminished. Certain people in certain product areas had all the influence. They had more power, more access to capital. Fixed income was king."

The power structures within the banks were very rigid. Leaders - like Dick Fuld at Lehman - ruled with an iron fist.

CitiGroup's Brockie doesn't want to point the finger, but he has one explanation for why banks failed to accurately assess the risks they were taking.

AIG - the giant US insurer - was the counterparty to the risk on many sub-prime derivative products.

"When you look at AIG you can see how the feedback loop was created," he says. "They were happy to underwrite the risk ... so the banks assumed it must be reasonable. AIG was AAA-rated. Ratings agencies have a huge influence, but when you get meltdowns like this ratings aren't that useful."

Talking to Brockie you sense frustration at the level of public anger the whole industry has faced.

"It struck me on the train ... The guy that was crying kept telling me what a good team he had and how good his business was and how it was growing. He just felt helpless. It was demoralising for them ... and humiliating.

"I mean, how many thousands of people of have lost their jobs and how many people have really caused the losses? A handful."

But Brockie says he hasn't noticed Canary Wharf slowing down at all. "It hasn't got any easier to get a seat on the train."

A few kilometres west in the City of London - the traditional centre of British banking - the environment is more subdued. Cost cutting, redundancies and closures have cut the working population by a third. City journalists say the days of being wined and dined at long lunches are over.

In the City the toll has been hard on the hundreds of mid-tier and boutique financial organisations.

The Bloomberg news agency reported last month that the City already has enough empty offices to hold two-thirds of Canary Wharf. About 840,000sq m are available in the City and that may climb to 1.1 million sq m by the end of this year, according to CB Richard Ellis Group, the biggest commercial property broker. By next year almost 19 per cent of all City offices may be vacant.

"It has been a lot easier to commute," says Kiwi Brent Cook, a City-based banking executive.

"The thing I noticed most was you could never get a cab in the morning. Now it is no problem. It hasn't been across the board. A lot of the more traditional areas were relatively unscathed. Anything exotic was hit hard - structured derivatives, credit derivatives. No one is doing structured products and the risk taking is far less than it was."

Cook - managing director of proprietary trading for Deutsche Bank - has his own war story from the Lehman collapse.

He was relaxing at home on Saturday night when he took the call from the US office. Deutsche was among those that had been called in to a meeting with the US Federal Reserve on the weekend Lehman failed. The investment banks were asked to bail it out. No one put their hand up.

That night Cook was told he had a day to get his team together and work out every piece of exposure they had to Lehman before the market opened on Monday morning.

"We knew it was action stations. Def Con 5 stuff. War footing," he says.

"As soon as Lehman announced they were filing Chapter 11, we had to assume that any trade we had facing them didn't exist any more, thus we would have unhedged and unstable market portfolios of risk - just as volatility was about to reach almost unprecedented levels." Lehman filed for Chapter 11 late on Sunday New York time, while markets were opening in Asia.

"From the small hours of Monday morning replacement trades had to be enacted to offset and stabilise our market risk," Cook says. "The trouble being that everyone else was doing the same. Although it would all be zero-sum, these transactions were not hitting the markets at the same time, which ensured enormous and completely random volatility, exacerbating losses in many cases. Market participants then started to speculate on losses due to this volatility and who would be 'next to fail' ... panic spiralled and institutional paranoia led to the whole system teetering on the brink."

Continuing the military analogy, Cook describes it as less a case of "tactical air strikes" and more like "bayonet charges in no man's land".

"It really was chaotic. This market state lasted for most of the following week as some were slower than others to quantify what hedging needed to be done. Wave after wave of transactions came to the market with less willing counterparties prepared to take the other side. The market was broken."

Even before Lehman's collapse there had been a sense of foreboding in the industry, Cook recalls. US investment bank Bear Stearns had collapsed in March and that had seemed like the crash.

"Everyone thought Bear Stearns was the big one," says Cook. "So when Lehman went the uncertainty was enormous. There was a feeling that, 'Oh my God, none of us are safe'. For four months the world stopped."

The panic ended when world leaders met at the G20 summit in London in January, he says. They made it clear they were going to guarantee the banks.

"The G20 told us no one else would fail."

Prime Minister Gordon Brown briefly looked as though he was winning the confidence of the British people after the G20 - in the days before the parliamentary expenses scandal broke.

He has also led the world in a call to arms for governments to provide economic stimulus to fight the downturn.

The Brown Government has committed about £25 billion to boosting the economy with measures such as a base-rate income tax cut, a temporary 2.5 per cent cut in value added tax (sales tax), the fast tracking of £3 billion worth of investment spending, new funding to train unemployed young people and a scheme to help the car industry which provides a £2000 subsidy for a new car purchase if it means scrapping a car more than 10 years old.

On top of that a £20 billion Small Enterprise Loan Guarantee Scheme has been introduced and the Bank of England has been effectively printing money. The Bank's quantitative easing programme has injected £125 billion into the British economy.

In the face of that degree of stimulus it would be surprising if Britain had seen no rebound off the lows it hit immediately after the crash.

But bankers such as Brockie and Cook share the the financial journalists' Continued from page 13

scepticism about the sustainability of the green shoots story.

"There has been a bounce, but the market will overdo it," says Brockie. "I suspect the recovery will be long and slow. In the real world, industries like the steel industry and metals will take a long time to recover and will only very gradually increase investment in new capital."

He believes the world really needs to see US real estate hit bottom and has concerns about rising rates of credit-card debt hurting the banks as unemployment grows.

"We've seen a lot of provisioning for bad debt already, and I think we'll see more in the second quarter," he says. "Green Shoots gives the impression that things are heading back to normal."

Cook agrees.

"Clearly we did overshoot on the downside," he says of the market downturn immediately after the bank collapses.

He blames that partly on an environment where brokers and traders became fixated on their computer screens at the expense of observing what was going on in the real-world economy.

"We thought everyone would stop buying groceries," he says. "They didn't. But that doesn't mean they're about to start buying Ferraris."

Cook believes banks have some work to do on fixing their balance sheets before they can start lending long term again with any degree of comfort.

He sees credit card defaults and commercial property defaults - particularly in the US - as big problems that still have to flow through the system.

Cook doesn't see any sense in the banks rushing in to lend until they can be sure the underlying structural issues are dealt with.

The message from some politicians has been unhelpful, he says.

"We saw Gordon Brown attacking the banks and blaming them for getting into the mess. Now he is yelling at them to start lending again. Clearly it is prudent for banks to remain cautious until they can be sure they won't be headed back to the brink again."

For the past two months it has been Gordon Brown on the brink, not the banks.

The expenses scandal which has shaken the parliamentary system and dominated headlines has also overshadowed the economic crisis through spring and early summer.

Some observers have interpreted the anger over the scandal as the public's way of venting their frustration with the economic mess.

But the revelations about MPs' expenses have also diverted attention from the crisis.

As they celebrate the summer, the general public appears to have put worrying about the economy on hold.

Even economists have accepted there is a disconnect between the theory and reality of the downturn.

"At some point you do have to stand back from the figures," concedes Neil Prothero - who as the Economist Intelligence Unit's UK specialist spends plenty of time immersed in them.

"We're saying this is the worst recession for 70 years. But on the street in London that is not always obvious."

Anyone who visited Britain in the 1980s, or even through to the end of the 1990s, can see it is a wealthier place now. Ten years of strong growth hasn't suddenly been wiped away by a year of recession.

GDP per worker grew by 43 per cent between 1991 and 2007. In terms of GDP per hour worked, Britain's productivity increased by 52 per cent in the same period. By the end of this year the recession is expected to have knocked about 4 per cent off GDP. As unemployment rises things may change, but for now those with jobs are paying less on their mortgage, less for petrol, and shopping in a buyers' market for consumer goods.

In hip enclaves of central London - like the old East End where tribes of affluent web designers and video editors now graze on boutique beers and Vietnamese spring rolls - there has been little impact. The trousers and ties might be skinny again, but the 80s revival is one of style over substance.

London life is still wrapped in trappings of multimedia gadgets, celebrity scandals and fashion trends. It bears little resemblance to the grim world of Margaret Thatcher's 1980, let alone the 1930s.

In the Sunday newspaper magazines recession is reduced to a middle-class lifestyle fad - like going green.

Feature articles focus on growing your own vegetables to beat the recession or going camping in the West Country instead of partying in Spain.

But Prothero warns that - despite the fact that the worst of the financial crisis may be behind us - the worst is yet to come for the general public.

"Unemployment is always the lagging indicator. Which is why we are always cautious in how we're forecasting," he says. "If unemployment rises then people won't be able to keep spending." Higher unemployment would also mean more mortgage defaults and more pressure on house prices.

Debt levels are the other big concern for Britain, Prothero says.

The country's household indebtedness is about 110 per cent of GDP. That level makes it higher than any other developed THEN & NOW: Leaving Lehman Brothers' Europe office at Canary Wharf, box in hand; Shoppers still abound on Oxford St. Pictures / Bloomberg (left), AP

economy, Prothero says. Public debt levels are another worry - about 53 per cent of GDP and climbing fast. Bank of England governor Mervyn King has already delivered a pointed warning to the Government that it cannot afford to keep spending to prop up the economy.

As for the here and now, there are some structural reasons why the financial sector collapse has not flowed so dramatically through to the wider economy.

Despite strong growth over the past decade, Prothero points out that the sector only contributes about 7 to 8 per cent of British GDP.

Manufacturing is a bigger driver of the economy, with Britain the sixth or seventh biggest exporter of manufactured goods in the world.

"The troubles of the British car industry get a lot of press but there are sectors of British manufacturing bearing up well - telecommunications, biotech and pharmaceuticals.

"Sterling depreciation can't help but have a positive effect," he says.

The service sector is the biggest contributor to the economy, accounting for about 75 per cent of GDP.

That has buffered Britain against the immediate impact of the global slump in production and made the slowdown look less dramatic than in manufacturing, export-led economies such as Japan and South Korea, he says.

Then there is all the money that has been pumped into the economy by the Bank of England, helping to buoy things, Prothero adds.

Whether that will be a long-term success is very difficult to say, he notes.

But like the bankers themselves, Prothero doesn't see a real recovery coming until the banks have stabilised and begun to lend again.

"Over time the situation will improve," he says. "But there are still doubts about how strong the banks are. Unemployment will rise, defaults will rise. There is no easy way out of this at all. It is always a slow process. Given the scale of what's been going on."

The first signs a real recovery is underway may come with a revival of merger and acquisition activity on capital markets - something that stopped dead in the months after the crash.

New Zealander Pip McCrostie has a finger on the pulse of that sector as Ernst & Young's global vice-chairwoman of transaction advisory services.

She took the job late last year - already aware that it was going to be a tough environment in the corporate finance arena.

Before that she had ridden the heights of the boom, advising on private equity deals for 15 years - the biggest 15 years in that sector's history. "Fantastic time to be in that market," she says.

The same could not be said of the mergers and acquisitions market in the first half of 2009. "It has significantly quietened down on the transaction and deal side."

But she remains confident that activity will recover. Ernst & Young recently surveyed global CEOs and found that half were looking to sell assets, she says.

They are either looking to seize new opportunities - to sell and raise cash to buy assets not previously on the market - or to make a defensive sale. "In terms of defence there are those who think they have way too much leverage; they might need to dramatically improve their balance sheet."

After years in which sellers could name their price there is now a valuation gap.

"There is a mis-match in expectations: buyers don't trust the cash projections that the sellers are putting forward, while many sellers are still pricing assets based on pre-recession market valuations. So there is a real difference of opinion."

Confidence in the market remains low.

"But we have moved on from where we were in October and November last year when there was almost paralysis. That was like popping a mega-balloon. Suddenly doing nothing was likely to get you into less trouble than doing something. So the market died."

McCrostie is optimistic about the signs of recovery, although she keeps it in perspective.

"We are starting to see articles in financial papers about tiny green shoots in some countries and data suggesting the rate of decline is slowing in others. The mood and feeling is that we are no longer heading for a systemic meltdown. We don't think we are going to have Armageddon of the financial world. The big question is how soon the recovery comes and what speed it will it be."

But she is conscious of how these economic cycles have played out in the past: "Often you see a second wave of restructuring and insolvency 18 months after the recession has bitten.

"People manage to take strong measures and hang on, but still go to the wall over an 18-24 month period. That can undermine market confidence again."

But we have avoided total meltdown, she says, so there is reason to be optimistic.

Back on Canary Wharf queues are forming in the myriad of trendy lunch bars. If everything else comes crashing down, at least the long economic boom will leave a legacy of a greatly improved food culture on the streets of Britain. Scores of clever young entrepreneurs - aided by the banks, presumably - have established upmarket eateries, making sushi, Mexican wraps, noodle soups and gourmet burgers everyday fare.

If debt and unemployment drive this downturn to the extremes, some expect we may yet see workers forced to head for the office carrying their sandwiches in brown paper bags. But in London in the summer of 2009, that day is not here yet.

Business Herald editor Liam Dann travelled to Britain on the Newspaper Publishers' Association's Cardiff Fellowship, with support from the British High Commission and Air New Zealand.

State of the nation

"[Britain's] economy is in a severe recession, with output projected to decline by 4.3 per cent in 2009 and recover only mildly in 2010. The financial crisis has severely impaired the supply of credit and house prices have fallen sharply, thus restraining business and household spending. The depreciation of sterling is mitigating the downturn, but cannot overcome falling foreign demand. The unemployment rate is projected to rise towards 10 per cent in 2010, with inflation well below the 2 per cent target for an extended period."

Source: OECD Economic Outlook