8. Financial Crisis 2007-09: Causes, Consequences and Lessons Flashcards
What were the contributing factors to the 2007-2009 financial crisis?
- 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.
Examples of mismanagement liberalisation and innovations
- Financial innovations in the mortgage markets (subprime mortgages, securitisation, opaque CDO, CDO^2)
What is securitisation?
- The process of pooling certain types of assets and selling the related cash flows to third party investors as securities.
What are the Incentives for Mortgage Securitisation? (Banks)
- 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
What are the incentives for mortgage securitisation (Investors)?
- 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.
Why is securitisation not new?
- 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)
Collateral Debt Obligations
- 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.
How are CDO’s very sensitive to correlated to defaults across underlying mortgage pools?
- 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.
What happened with CDOs and subprime mortgages before financial crisis?
- Size of both the origination of subprime mortgages and the issuance of CDOs had become vitally substantial before the crisis.
What is the theory of how Financial System created AAA-rated Assets out of Subprime Mortgages?
- 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.
What is step 1 of financial crisis/creation of CDOs?
- People take out mortgages.
- Financial institutions groups 100s of SPM into mortgage backed securities (MBS)
What is step 2 of financial crisis/creation of CDOs?
- 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.
What is step 3 of financial crisis/creation of CDOs?
- 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.
What is step 4 of financial crisis/creation of CDOs?
- 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.
What is step 5 of financial crisis/creation of CDOs?
Another FI does the same thing with high risk tranches of CDOs, creating CDO^2
What does ABS stand for?
Asset backed securities
What is a tranche?
- a collection of securities that are separated and grouped based on various characteristics and sold to investors.
What are the agency problems in this?
- 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)
What was stage one in financial crisis to economic crisis?
- 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.
What was stage two of financial crisis to economic crisis?
- 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.
What was stage three of financial crisis to economic crisis?
- Unanticipated decline in price level.
- Causes further adverse selection and moral hazard problems as well as lending contracts
- Economic activity declines further
What were the implications of this crisis?
- 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
What were the implications on structured finance from the Financial Crisis?
- More efficiency allocation/exchange of risk and mortgage rate.
- Sensitive to/become systematic risks.
- Increasing complexity aggravates the information asymmetry problems.
What were the regulation and policy implications from the financial crisis?
- 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.
What are financial crises?
- 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.
How can a financial crisis begin?
- Mismanagement of financial liberalisation or innovation.
- Asset pricing booms and busts.
- An increase in uncertainty caused by failure of financial institutions.
Debt Deflation Definition
A decline in net worth as price levels fall while debt burden remains unchanged.
Credit Boom Definition
- A lending spree on the part of banks and other FIs
What happened in the 2007-2009 lead up to the financial crisis?
- Securitisation process, along with computer technology, enabled the bundling of smaller loans (like mortgages) into standard debt securities.
How do mortgage markets differ to stock and bond markets?
- 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.
Mortgage Based Securities (MBS) Definition
- Securities collateralised by a pool of mortgages.
- Growing in popularity in recent years as institutional investors look for attractive investment opportunities.
Subprime Mortgage Definition
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.
