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Financial Economics Year 3 > 8. Financial Crisis 2007-09: Causes, Consequences and Lessons > Flashcards

8. Financial Crisis 2007-09: Causes, Consequences and Lessons Flashcards

1
Q

What were the contributing factors to the 2007-2009 financial crisis?

A
  • Mismanagement of financial liberalisation and innovations.
  • Long term loose monetary policy (low interest rates)
  • Capital inflows from emerging market economies.
  • House price bubble fuelled over optimistic expectations prior to 2006.
  • Burst of the housing bubble after 2006 as prices corrected towards fundamentals.
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2
Q

Examples of mismanagement liberalisation and innovations

A
  • Financial innovations in the mortgage markets (subprime mortgages, securitisation, opaque CDO, CDO^2)
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3
Q

What is securitisation?

A
  • The process of pooling certain types of assets and selling the related cash flows to third party investors as securities.
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4
Q

What are the Incentives for Mortgage Securitisation? (Banks)

A
  • Loan Originator
  • Improved risk implications from off-balance sheet activities and SPVs.
  • New tool to meet risk-based capital requirements
  • Focus on originate-to-distribute model
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5
Q

What are the incentives for mortgage securitisation (Investors)?

A
  • Pensions Funds, Money Market Funds
  • New class of liquid long-term investments
  • Cheaper rates and wider pools of capital to loan originators.
  • Credit rating agencies: new profiting business.
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6
Q

Why is securitisation not new?

A
  • Creating “stock” or public limited company (PLC)
  • Converting corporate loans/debts to tradable bonds.
  • Securitisation of loans/debts - CLOs CBOs
  • Securitisation of Mortgages - Mortgages-Backed Securities (MBS)
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7
Q

Collateral Debt Obligations

A
  • Created by further securitisation on the junior tranches in MBS
  • Can further generate safer tranches than the underlying junior tranches of MBS
  • CDO^2s are created from the tranches of other CDOs
  • CDO^3s are created from the tranches of other CDO^2s
  • Gets more and more complex.
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8
Q

How are CDO’s very sensitive to correlated to defaults across underlying mortgage pools?

A
  • Pool of junior tranches of MBS are assumed uncorrelated.
  • Even senior tranches from those further descendent CDOs have nested enormous systematic risks.
  • Modest default rate/decline in house prices can trigger the avalanche of values losses to many AAA-rated CDOs and market panics.
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9
Q

What happened with CDOs and subprime mortgages before financial crisis?

A
  • Size of both the origination of subprime mortgages and the issuance of CDOs had become vitally substantial before the crisis.
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10
Q

What is the theory of how Financial System created AAA-rated Assets out of Subprime Mortgages?

A
  • Financial institution packaged and re-packaged securities built on high-risk subprime mortgages to create AAA- rated assets.
  • It worked if mortgages didn’t default at once, which it did.
  • Therefore, not enough money to pay off mortgage related securities.
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11
Q

What is step 1 of financial crisis/creation of CDOs?

A
  • People take out mortgages.
  • Financial institutions groups 100s of SPM into mortgage backed securities (MBS)
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12
Q

What is step 2 of financial crisis/creation of CDOs?

A
  • Securities grouped into tranches by levels of risk and earnings potential for bond holders.
  • When people can pay their mortgage in full each month, each group of bond holders get paid.
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13
Q

What is step 3 of financial crisis/creation of CDOs?

A
  • Mortgage payments collected by FI and payments distributed to bond holders.
  • Higher rated tranches paid first.
  • When monthly mortgage payments not made, payments may not reach holders of lower-rated tranches.
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14
Q

What is step 4 of financial crisis/creation of CDOs?

A
  • Collateralised Debt Obligations (CDOs) were created by taking lower-rated tranches out of the MBS and repackaging them.
  • Most of CDO is highly rated, even though built of high-risk of assets.
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15
Q

What is step 5 of financial crisis/creation of CDOs?

A

Another FI does the same thing with high risk tranches of CDOs, creating CDO^2

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16
Q

What does ABS stand for?

A

Asset backed securities

17
Q

What is a tranche?

A
  • a collection of securities that are separated and grouped based on various characteristics and sold to investors.
18
Q

What are the agency problems in this?

A
  • Both loan originators and ultimate credits have less incentive to screen out the mortgage takers.
  • Increased housing price fed the growth of subprime mortgages.
  • House price bubble was fuelled while everyone seemed to benefit.
  • Until the tipping point of the bubble burst (enough number of defaults)
19
Q

What was stage one in financial crisis to economic crisis?

A
  • Initial phase
  • Asset-price decline lead to a deterioration in FI’s balance sheets
  • An increase in uncertainty and the deterioration lead to adverse selection and moral hazard problems worsen and lending contracts.
20
Q

What was stage two of financial crisis to economic crisis?

A
  • Banking Crisis
  • Economic activity declines
  • Causes banking crisis
  • Causes further adverse selection and moral hazard problems as well as lending contracts
  • Economic activity declines further.
21
Q

What was stage three of financial crisis to economic crisis?

A
  • Unanticipated decline in price level.
  • Causes further adverse selection and moral hazard problems as well as lending contracts
  • Economic activity declines further
22
Q

What were the implications of this crisis?

A
  • When music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got get up and dance (Chuck Price, Citigroup CEO)
  • Structured Finance Implications
  • Regulations and Policies Implications
23
Q

What were the implications on structured finance from the Financial Crisis?

A
  • More efficiency allocation/exchange of risk and mortgage rate.
  • Sensitive to/become systematic risks.
  • Increasing complexity aggravates the information asymmetry problems.
24
Q

What were the regulation and policy implications from the financial crisis?

A
  • More regulation for information transparency.
  • Agency problems and conflicts of interests.
  • Challenge in international coordination on macroeconomic and financial policies
  • Irrationality and imperfect of markets always exist.
25
Q

What are financial crises?

A
  • Major disruptions in financial markets that are characterised by sharp declines in asset prices and the failures of many financial and non financial firms.
  • Occur when adverse selection and moral hazard problems in financial markets become more significant.
  • Frequently lead to sharp contractions in economic activity.
26
Q

How can a financial crisis begin?

A
  • Mismanagement of financial liberalisation or innovation.
  • Asset pricing booms and busts.
  • An increase in uncertainty caused by failure of financial institutions.
27
Q

Debt Deflation Definition

A

A decline in net worth as price levels fall while debt burden remains unchanged.

28
Q

Credit Boom Definition

A
  • A lending spree on the part of banks and other FIs
29
Q

What happened in the 2007-2009 lead up to the financial crisis?

A
  • Securitisation process, along with computer technology, enabled the bundling of smaller loans (like mortgages) into standard debt securities.
30
Q

How do mortgage markets differ to stock and bond markets?

A
  • Usual borrowers in capital markets are government entities and businesses, whereas usual borrowers in mortgage markets are individuals.
  • Most mortgages secured by real estate, whereas the majority of capital market borrowing is unsecured.
  • Mortgages are made for different amounts and different maturities, developing a secondary market has been more difficult.
31
Q

Mortgage Based Securities (MBS) Definition

A
  • Securities collateralised by a pool of mortgages.
  • Growing in popularity in recent years as institutional investors look for attractive investment opportunities.
32
Q

Subprime Mortgage Definition

A

Loan for borrowers who do not qualify for loans at the usual market rate of interest because of a poor credit rating or because the loan is larger than justified by their income.

Financial Economics Year 3 (9 decks)

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