Financial Crisis Flashcards
What are the 3 stages of a financial crisis?
- Initiation of financial crisis
- Banking crisis
- Debt deflation
What are the key points of stage 1 - initiation?
Managing financial innovation/liberalisation:
- Financial innovation
- Financial liberalisation
- Credit boom
- Deleveraging
Asset price boom and bust:
- Fundamental economic values
- Asset-price bubble
Stage 1
What is financial innovation?
When an economy produces new types of financial products
Stage 1
What is financial liberalisation?
The elimination of restrictions on financial markets
Stage 1
What is a credit boom?
A lending spree where financial institutions expand their lending at a rapid price
In 2008 - credit card debt was almost $8 trillion
Resulted from banks lending out CDOs and selling the debt to investors. The bank didn’t worry about the people defaulting on their debt because they could just sell it on. Made them less disciplined in adhering to strict lending standards.
Stage 1
What is deleveraging?
When financial institutions cut back on their lending because they have less capital
2007 crisis - Banks refused to lend money to other banks because they didn’t want any more CDO’s on their balance sheets in return
Stage 1
What is an asset’s fundamental economic value?
Value of assets based on realistic expectations of their future income streams
Stage 1
What is an asset-price bubble?
Increase in asset prices in the stock and real estate markets that are driven well above their fundamental economic values by investor psychology
Stage 2
What is a bank panic?
The simultaneous failure of many banks, as during a financial crisis
Stage 2
What is a fire sale?
Forced, rapid sales of assets to raise needed funds
What is a subprime mortgage?
Mortgages for borrowers with low credit ratings
Since the borrower has a larger-than-average risk of defaulting on the loan, higher interest rates are charged to compensate for carrying more risk
Causes
Subprime mortgages in the 2008 financial crisis?
NINJA loans were given out - mortgages to people with no income, no job, no assets
Interest rates were “teaser rates” which started low for the first few years but then ballooned over time making it hard to pay the principle of the mortgage
When the housing market started to decline, they found themselves underwater - where their home values was lower than their mortgage
Many of these mortgage owners defaulted, which caused problems on mortgage-backed securities
What is securitisation?
Process of bundling smaller loans (like mortgages) into standard debt securities
Making a security
Securitisation
What is a mortgage-backed security?
A mortgage loan is collateralised, the owner can have the property if the borrower defaults
Mortgage loans were bundled together into standard debt securities
These securities are then sold to investors who would receive the interest payments on the mortgage and take the risk
Selling mortgage securities provided a new source of funding these mortgages
Causes
Financial Engineering
Collateralised debt obligations (CDO’s)
Structured credit products that pay out income streams from a collection of underlying assets, designed to have particular risk characteristics that appeal to investors with different preferences
