Financial Crisis Flashcards
What is SONIA/LIBOR?
Sterling Overnight Index Average and the London Interbank Offered Rate, SONIA (LIBOR) is the main benchmark short-term money market interest rate.
What are loans often in the form of in terms of SONIA/LIBOR?
Loans are often in the form of SONIA/ LIBOR plus, i.e. SONIA plus 10 basis points (+0.1%). SONIA is determined by the Bank of England and is backward looking, LIBOR by the markets (banks) and is forward looking.
Who decides the LIBOR?
Big bankers in the large banks
What happened with LIBOR?
Bankers set rates in order to gain profits
Who controls SONIA?
The BofE
What is the interbank market?
Banks borrow and lend to each other in short-time periods
What is mark-to-market?
This is a way of valuing assets by their most recent market price
What was mark-to-markets influence during the financial crisis?
During the financial crisis this became difficult for many bank-held securities, as the market for them broke down.
What are reserves?
Reserves are part of a banks assets, being a certain percentage of the deposits that are not lent out.
What is capital?
Capital is the share holdings of the banks owners.
Why do banks need capital? (2)
Need it for loans.
They can write loss off against their capital account- which acts as a buffer
What does default mean?
Failure to repay a loan, can be full or partial (haircut).
What are the 4 types of financial crisis are there? (5)
Banking crisis
Banking crisis II
External debt crisis
Domestic debt crisis
Exchange rate crisis
What is a banking crisis?
Systemic failure of banking system, there is at least a run on one major bank leading to take over by the public sector
What is a banking crisis II?
Financial distress but no bank runs.
What was the first bank run in 2007?
Northern Rock
How does a bank run work?
People queue to get their money out of the bank, when the bank runs out of liquidity, no on else can get their money back
What’s put in place to stop bank runs?
Insurance
How do failing banks get other banks to save them?
Cheap loans
Banking licences- the central bank can get involved
What are external debt crisis?
Sovereign default is when the government fails to meet payments on its debts
How can external debt crisis occur?
Changes in exchange rates
What are Argentina thinking of doing to stop inflation and a debt crisis?
Switching to the dollar
What is a domestic debt crisis?
The government fails to meet payments on domestic debts
What is a currency crisis?
Exchange rate collapses
How have currency crisis been battled?
Countries joining a floating exchange rate system
What are leading indicators of banking crises? (5)
-Sharp rise in asset prices, especially house prices.
-Sharp rise in domestic credit.
- Capital flows from abroad increase.
-Public borrowing increases before the crisis, much of which is hidden.
-Sovereign debt rises sharply both during and after the crisis.
Why was globalization not a good thing for GFC?
News spread around the whole world and world more interconnected
What caused the global financial crisis?(4)
- Failure of the financial regulators? (Bernanke)
- Failure of monetary policy in the years leading up to the crisis? (Taylor)
- Credit rating agencies giving inappropriate ratings to sub-prime assets?
- Current account imbalances leading to excessive capital flows between economies.
Political failure
Why is it hard to regulate the financial sector?
Externalities- systemic risk
What did the credit rating agencies do?
Rated the securities at AAA ratings when really they were a lot lower, more like BBB
Why did the credit agencies over rate these securities?
As these investment banks were paying for their services and they wanted to keep their business
What are CDOs?
Collaterlaised Debt Obligations
This is a mortgage-backed security, which involves securitisation, where security purchasers are divided into different
groups with different risks
How did CDOs payments work?
Payments are firstly to the most risk-averse investors, then to more risk-loving
investors.
How were a lot of these CDOs sold?
Over the phone or email
What is securitisation?
The conversion of an asset, especially a loan, into marketable securities, typically for the purpose of raising cash by selling them to other investors.
What are the benefits of securitisation?
Increase liquidity
What is a CDS?
Credit Default Swaps
These are forms of insurance taken out against holders of bonds, in which
the bond holder receives payment in the event of the bond issuer defaulting.
What are the payments for CDS?
The payment is made by the writer of the CDS, usually an insurance company or
bank.
Who was issuing the CDS during the FC?
Banks and AIG (biggest insurance company in the world)
What grew in the UK and USA between 2000 to mid 2000s and why?
The housing market
What did the growth in the housing market lead to?
to a speculative bubble, whereby house prices were substantially above long-run equilibrium levels.
What increased in 2006? What did this effect?
Interest rates
Mortgage repayments
What was much of the lending to the housing market through?
Mortgage-backed securities (MBS), held by the banks ‘off-balance sheet’,
What was much of the lending by banks during the FC?
To sub-prime borrowers, who
had little if any income, savings or capital to pay the mortgage
interest rates.
What did the rise in house prices cause?
The sub-prime sector could pay
the interest by withdrawing equity (re-mortgaging), thereby paying a
high return on the MBS to compensate for the higher risk.
Why do banks require capital?
To act as a buffer, can be used to write off losses
Internationally who controls Banks capital requirements?
Basle Accord
Is Capital expensive to raise?
Yes
To escape high capital requirements, what can banks do?
Move their business to lower regulatory environment or off balance sheet
Why do a central banks if needed to get involved within the baking sector, get involved at the weekend?
Markets are closed on weekends
Why do banks often hold fee income off their balance sheet?
Doesn’t require same level of capital or regulation
Greenspan, former head of Federal Reserve, cur interest rates to what in 2002? When did they next increase?
1%
2005
What was the Glass-Steagall Act? When was this repealed?
Assured banks had to split retail business from their investment banking.
1999
What did the UK form in 1997?
Tri-partite system
- BoE
- FSA
- Treasury
What is the diagram for the process of securitisation during the FC? (Look on slides)
- Homeowner gets mortgage from mortgage organiser (Wells Fargo)
- Mortgage organiser sells the loans to the mortgage-backed security issuer (Goldman Sachs)
- Goldman Sachs issues the securities by pooling together many loans
- A Trustee (Dusteche bank) is hired by Goldman to manage the securities
- Securities are rated and sold to investors
Who paid the investors the interest payment?
The homeowners’ mortgage payments
Why did the mortgage backed security issuers during the FC sell them onto a trustee?
Was this situation always the case?
Specialisation
No, some banks created the securities and sold directly to investors
What was the first effect of the crisis?
What was the catalyst?
A substantial rise in LIBOR interest rates.
HSBC said they were having problems with mortgage-backed securities
What did a rise in LIBOR cause?
Who did this effect more?
Banks stopped lending between each other- money markets stopped functioning
Those banks which relied on the wholesale money markets for funds were the first to experience problems
What happened in September 2008?
Lehman Brothers collapsed after heavy losses due to exposure to US sub-prime housing market.
Why did Lehman Brothers collapse?
What was the knock-on effect of the collapse?
Was due to the potential losses on asset-backed mortgages, however allowing it to collapse had important externalities for the whole financial industry
What was the first US bank to get in trouble?
Bear Stearn
What is moral hazard in terms of banking?
If the authorities bail a failed bank out, banks are led to believe the authorities will always rescue them, there is no incentive for them to do appropriate risk management, they will lend to ever more risky ventures, with the consequent higher return, until a crisis, then rely on support from the government.
What is a reason lehman brothers was allowed to collapse?
It was an IB so there was no retail banking
What was introduced on the 13th October 2008?
TARP equity plan
What was TARP?
The Troubled Asset Relief Programme (TARP) :
The scheme involved the US authorities buying toxic assets and equity from the banks to improve their balance sheets. Increased liquidity within the banking sector
What was one of the problems of TARP?
Pricing many of the toxic assets correctly.
Why was TARP introduced?
US couldn’t let huge insurance companies (AIG) fail
Similar schemes to TARP were introduced in the UK, what else was attempted?
What else did the UK do for some banks?
Recaptalisation
Nationalise them
What happened to LLoyds Banking Group during the FC?
HBOS took over LLoyds with government support
What were CDOs divided up into?
What are these?
Tranches
Each tranche having different risk and return characteristics
What is the first tranche of a CDO called?
What risk is this tranche?
Equity tranche
The riskiest
What is the second riskiest tranche of a CDO?
Junior tranche
What is the third tranche of CDOs?
What risk is this tranche?
Mezzanine tranche
Medium risk
What is the 4th tranche of CDOs?
Senior tranche
Why did banks create CDOs?
To free up capital that the bank would otherwise be forced to hold against loans
What is a special purpose vehicle?
A legal entity set up for a specific purpose such as administering the cash flows from a CDO to the buyers of various tranches
What is the special purpose vehicle for typical securitisation?
A trust
If the sponsoring entity go bankrupt, what happens to the SPV?
SPV is structured in a way that it cannot itself become bankrupt.
Why do banks set up SPVs for relations to CDOs?
To mitigate risk by writing down on assets
What is a structured investment vehicle?
A pool of assets and liabilities that attempts to exploit the difference between short and long terms interest rates
Why do banks use SIVs?
To raise funds at the short end of the market at relatively low interest rates and invest those funds in longer-term securities at higher yields
