Crisis

Question 1

2 theories of cause of crisis

Answer 1

1. TAYLOR: low interest rates by FED
2. SHILLER: bubble in housing market –> irrational exuberance due to expectations (subprime mortgages - less restrictive rules on borrowing)

SHILLER’s argument is only sufficient if accept TAYLOR’s

Question 2

Estimated output cost of crisis

Answer 2

$30 trillion
1/2 annual world GDP

100x initial mortgages losses
- suggests trigger = US housing P falling but effects amplified

Question 3

Capital ratio

Answer 3

Capital:assets

Question 4

Leverage ratio

Answer 4

Assets:capital

Question 5

SIV (Structured Investment Vehicle)

Answer 5

= a virtual bank

• borrows from investors via S-T debt (leverages)
• holds securities (assets)
• have guarantees to provide funds
• shadow banking system = leverage of whole naming system = higher than perceived

Question 6

AIG (American international group)

Answer 6

= insurance –> bank = worried about default on security = buy CDS (Credit Default Swap) from AIG = promised to pay back bank in case of default
–> in crisis= didn’t have funds

Question 7

CDS

Answer 7

Guarantees against default of financial institutions

Problem = many fail at once

Question 8

Securitisation

Answer 8

Securities (bundle loans/mortgages) based on bundle assets

Question 9

Mortgage based security (MBS)

Answer 9

Title to the returns from bundle of mortgages

Senior = 1st claims on returns (appeal those want little risk)
Junior = after (willing take more risk = CDOs)

CDOs = collateralised debt obligations

Question 10

Toxic assets

Answer 10

Underlying mortgages = bad = can’t assess value MBS, CDOs

Question 11

Fire sales

Answer 11

Fire sales = assets sold at very low prices as complex and hard to sell

Question 12

Amplification

Answer 12

Housing prices declined –> some mortgages went bad –> high leverage = decline capital of banks = sell assets –> selling is hard and very low prices –> complexity securities (MBSs, CDOs) and true balance sheets = v difficult assess solvency and risk of bankruptcy

Eg September 15 2008: Lehman bros bankrupt (>600bn assets)

Other banks conclude they’re at risk too –> reluctant to lend –> LIBOR rate = rate banks willing to lend

Question 13

US –> world

Answer 13

1. Decrease in X
2. Capital flows - capital inflows emerging countries =decrease
3. Decreases in confidence - another Great Depression?

–> shift IS left

Countries very open trade and with large net debt / v large current account deficits suffered most

Question 14

Federal deposit insurance increased

Answer 14

$100,000 –> $250,000 / account

Question 15

Tarp

Answer 15

Troubled asset relief program

Created by treasury after concerns with toxic assets

$700bn October 2008

Initial goal = remove complex assets from balance sheets = decrease uncertainty
New goal = increase capital banks

Question 16

Leverage

Answer 16

Assets/capital

Lower leverage means more likely to absorb losses and less chance of bankruptcy

Increased leverage = increased expected profits

Question 17

Initial policy responses

Answer 17

To prevent bank runs federal deposit insurance increased $100,000-$250,000 per account

Fed provided widespread liquidity to financial system
-liquidity makes easier to borrow from FED = allows banks etc to pay back investors w/out having to sell assets and lowers incentives of investors to ask for their funds and facilities decrease risk banks go bankrupt

TARP

Question 18

Fiscal policy

Answer 18

American recovery and reinvestment act

• $780bn new measures (tax decrease spending increase)
• budget deficit increased 2.7% GDP 2007 to 12.7% 2009

Question 19

Monetary policy

Answer 19

Fall 2007 FED decrease fed funds rate
- by Jan 2009 was 0
–> liquidity trap
Rather than buying treasury bills through open market operations = buy other bonds eg mortgages or gilts as able to decrease I on those bonds therefore increase demand
- BoE bought £200bn worth gilts = 10% GDP = lowered i on those gilts by 1% = increased GDP by 1.5-2%