Financial Crisis Flashcards
Intro
No one thought that the financial system could collapse
Sufficient safeguards were in place
There was a safety net
Prosperity and stability were evidence that the system worked.
Inflation was low
Growth was high
Policy framework built on sound economic principles combined with a bit of learning, had delivered the Great Moderation in the industrial world.
Macroeconomic causes
Global imbalances
Low interest rates
Micro economic causes
Excessive use of securitisation
and many others
Consequences
Excessive borrowing in the US/ excessive savings in emerging economies
Low interest rates
Proximate cause of the low rates was the combination of policy choices in both the industrial and emerging market economies together with the capital flows from emerging market countries seeking low risk investments
Consequences = credit book and equity boom plus excessive risk taking
Excessive use of securitisation plus more
2) consumers failed to watch out for themselves
Few people have any knowledge of the balance sheets
They assumed the system was safe
3) managed of financial firms saw a need to drive up returns on their equity to satisfy shareholders
ROE = return/assets x assets/equity
4) skewed incentives of the rating agencies
5) lack of historical data
6) governance problems in the risk management practices
Little role of senior risk management and a culture of return without risk consideration
Last microeconomic cause
Financial institutions found a way to circumvent regulation with off balance sheet vehicles
Banks are required to hold capital
Using off balance sheet vehicles reduces the capital constraint
The financial crisis was triggered by the default on subprime loans
And the massive securitisation of these loans
A house price bubble has resulted in a systematic crisis
Subprime loans
A previous record of bankruptcy, foreclosure or delinquency
A low credit score
And a debt service to income ratio of 50% or higher
Loans are often adjustable rate mortgages ARMS
Teaser interest rates
Jump to a higher rate
Works during the house bubble
- attractive for borrowers
- attractive for brokers and lenders
From the bank’s point of view, issues associated with providing subprime loans:
Riskier population
Insufficient funds for a down payment
Credit issues
Undocumented income
Lack of or erroneous information
The challenge is to lend to this population
To finance these lendings, banks used securitisation
Asset back security
A security that is made up of other financial securities, that is the security’s cash flows come from the cash flows of the underlying financial securities that back it
Securitisation process
2 steps
Originator sells the assets to a SPV
The SPV issues shares that sold to investors
Special purpose vehicle
Alternative and diversified source of finance based on the transfer of credit risk
Has extended to several assets
Mortgages
Corporate or sovereign loans
Consumer credit
Royalties
Securitisation entail several advantages
New sources of funding Reduce borrowing costs Reduce minimum capital constraint for banks The assets are off balance sheet Risk is more accurately priced
Collaterised debt obligations
Senior investors are easy to find
Funding equity tranches is more difficult
Most of the time retained by the originator or buy by an hedge fund
Creation of ASSET BACK SHARES
