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
Subprimes securitisation
Mortgage backed security was the largest market of securitisation
The bubble burst
Very low default rates from 2002 to 2005: 6%
Consequences = lower credit scores and reduced chances of obtaining credit in the future and higher interest rates
Housing market slow and began to decline in 2006-2007
Default rates skyrocketed: 40%
Led to a sever credit crisis
Capital loss
Funding costs
Escalated and spilled over the rest of the economy
TED spread
Excess of the three month Eurodollar deposit rate over the three month treasury interest.
Eurodollar deposits are dollar deposits maintained outside the USA. Eurodollar represent all the deposits in the USD held by a bank outside of the US.
They yield a higher rate for investors
What went wrong
Excessive optimism
Excessive lending
Excessive use of securitisation by banks
Belief in the ratings attributed by credit rating agencies
Aftermath
Dodd Frank Act
Prevents lenders from using teaser rates to get borrowers into loans they might not ultimately be able to afford, requires lenders to verify that borrowers have sufficient income to repay their loans even after the teaser rate expires
Bank regulation
Market regulations
Stage one of financial crisis
Losses from subprime mortgages
Downgrade of Asset backed shares and collaterised debt obligations
Liquidity shortage to cover the losses
No bank failure but a weakened financial system
All in March of 2008
Stage two events leading up to the Lehman brothers bankruptcy march - September
Early signs of deepening recessions
Stress on banks and interbank market
Huge losses in the mortgage market
Increase spread of collateral debt shares
Stage 3 September - October
Lehman brother filed for bankruptcy protection
Crisis of confidence
The CDS crisis
Risk of contagion among banks
Stage 4 investors focus on the global downturn October to March 2009
Deepening recession
Fears of bank collapses
Dramatically low interest rates from central banks
Flight to quality: very low government rates
Rescue packages
Stage 5 - fist signs of stabilisation mid march 2009
Volatility declined and asset prices recovered
Unconventional monetary actions maintained e.g quantitative easing which is an injection of massive amount of cash
Start of the European sovereign debt crisis
Securitisation
Way of transferring assets and assets and risk to investors, and generating funding for more assets.
A bank might lend to homebuyers. It can put these mortgages in a special vehicle (company) which then issue bonds.
