Examples of Market Failure in the Financial Sector (Financial Markets & Regulation) Flashcards
What is LIBOR? What does it measure?
The London Inter-Bank Offered Rate - the interest rate charged by banks in London when they lend to each other in the short-term.
What was the “LIBOR Scandal” in 2012?
- Whistleblower from Barclays went public with info on banks, e.g. HSBC, Barclays, RBS + more.
- They’d under reported their inter-bank lending rate (as a lower rate makes their banks look stronger, trustworthy and creditworthy - not risky).
- This would increase investors and generate greater profit.
Who were the losers from the “LIBOR Scandal?”
- Extra costs to US local gov’ts was $6bn.
- 7 yr Investigation in the UK cost £60+ million.
What type of Market Failure was in the LIBOR Scandal?
- Market-rigging due to oligopoly power, i.e. banks formed cartel.
- Principal agent problem: banks shareholders were only interested in profit so banks tried to do anything to remain profitable.
- Assymetric info: local gov’t officials didn’t have same amount of info about financial makrets as others and thus exploited into buying expensive interest-rate swaps.
What was the ENRON Scandal?
- Used Mark-To-Market (MTM) Accounting which made Enron seem finanacially sound to boost share price, despite being in huge debt due to failed projects (e.g. Enron Oil).
- Hid huge debt in “shell companies” - companies that didn’t exist but Enron’s executives, e.g. Jefferey Skilling, moved debt into accounts of these shells.
- Enron’s managers rewarded using “stock-options” so performance directly linked to share price - incentive to make Enron look profitable.
What is Mark-To-Market accounting?
Accounting practice that involves adjusting the value of an asset to reflect its value as determined by current market conditions - listing project profits rather than their actual profits .
How much money did “Enron Oil” lose?
Enron reported $85 million, but the true loss was between $140-190 million in 1987.
What happened to Enron?
- Filed for bankruptcy in 2001.
- Share price fell from $90 to less than $3 at the end of 2001.
- 21,000+ people lost their jobs.
What type of Market Failure featured in the Enron Scandal?
- Principal agent problem: managers at Enron paid in stock options so only focused on profit and not the best interests of the shareholders in the long term.
- Assymetric information: Lay Skilling and Fastow were some of the only people who understood the underhand accounting practices; shareholders had to trust info given to them form Enron and Arthur Andersen.
- Speculation/herd mentality: analysts at Wall Street believed Enron were financially sound so invested like everyone.
What happened during the 2010 Wall Street Flash Crash?
- Dow Jones Index plummeted nearly 1000 points in a matter of minutes, before rebounding within 30 mins - largest daily drop in the Index history.
- 2015, US Department for Justice brought charges against Navinder Singh Sarao (London-based HFT) for “spoofing” the markets.
How much money was wiped off the New York Stock Exchange?
$1 trillion off the value shares on the NYSE.
What are HFT’s?
High-Frequency Traders - computersied trading programmes that buy and sell shares within milliseconds to make profit.
What did Navinder Singh Sarao do?
How much did Navinder Singh Sarao earn?
US authorities think he earned $40 million as a result.
What type of Market Failure was the 2010 Wall Street Flash Crash?
- Network externalities: crash on stock market spread to equities market.
- Speculation
- Info assymetry: computers work faster than humans. HFT knew this would happen but no one else did.
- Moral Hazard: Mr Sarao lives in London and can’t be removed from the UK to face trial in the US without permission from a UK judge. UK’s HR Act provides protection to Mr Sarao.
What happened during the 2008 Sub-Prime Mortgage Crisis?
- Gave mortgages to those with bad credit scores.
- Securitization - these loans were pacakged up with loads of other forms of loans (Collateralized Debt Obligations - CDOs) which were sold to investors and given AAA ratings from credit raters (e.g. Fitch).
- Mortgage loans also insured (by Freddie-Mac and Fannie-Mae).
- People defaulted on loans, causing CDOs to turn toxic and big liabilities.
- Anyone who invested in these ended up owning loads of sub-prime mortgage debt, but they didn’t see risk due to the AAA rating.
- Banks go to insurance companies for insurance, but they don’t have enough capital leading to massive UK and US gov’t bailouts (cost a lot of taxpayer).
How did the financial crisis cost to gov’ts?
- 2008/09 alone cost US $498 bn (according to prof. Deborah Lucas).
- UK spent around £123 bn.
What was the Market Failure featured in the financial crisis?
- Assymetric info: pension funds had less info than mortgages provides about quality/riskiness of financial derivatives; households taking mortgages in sub-prime mortgage sector didn’t understand nature of housing market or conditions of their mortgages’ regualtors weren’t skilled enough; individuals taking loans knew their ability to pay off mortgage; credit raters knew the true riskiness of CDOs but banks didn’t.
- Moral hazard: banks “too big to fail” and knew they’d be bailed out by gov’t - so acted risky.
How much did some banks recieve in bailouts?
- JP Morgan Chase & Co = $25bn+
- Morgan Stanley = $10bn+
- Goldman Sachs Group = $10bn+
- Citi = $25bn+
- Bank of America = $15bn+
