Financial crisis Flashcards
What is a financial crisis?
- Financial crises are major disruptions in financial markets characterized by sharp declines in asset prices and firm failures.
- Beginning in August 2007, the U.S. entered into a crisis that was described as a “once-in-a-century credit tsunami.”
- But economic and financial crises have been a recurrent event in global economies (Great Depression, dot com bubble, black Monday, greek debt crisis)
What are the causes of a financial crisis?
- both moral hazard and adverse selection are still present.
- Asymmetric information
= when information flows in financial markets experience a particularly large disruption. Financial markets may stop functioning completely.
What happens in stage one of a financial crisis? (3)
• Credit Boom and Bust:
- elimination of restrictions, introduction of new types of loans or other financial products (loan losses accrue, asset value falls, leading to a reduction in capital =deleveraging) , no one can evaluate firms, hence moral hazard arises.
• Asset-Price Boom and bust
- pricing bubble, assets are overvalued, when bubble burst and prices falls the corporations net worth falls as well. Moral hazard increases as firms have little to lose.
• Increase in Uncertainty
- can lead to stock market crashes or the failure of a major financial institution (Lehman Brothers)
- with information hard to come by, adverse selection and moral hazard increases, reducing lending and economic activity.
What happens in the second stage of a financial crisis? (4)
- Deteriorating balance sheets lead financial institutions into insolvency. If severe enough, these factors can lead to a bank panic
- Panics occur when depositors are unsure which banks are insolvent, causing all depositors to withdraw all funds immediately (bank run)
- As cash balances fall, F’Is must sell assets quickly (fire sales), further deteriorating their balance sheet
- Adverse selection and moral hazard become severe – it takes years for a full recovery.
What happens in the third stage of a financial crisis? (3)
- debt inflation: a consequence of a sharp decline in prices, where asset prices fall but debt levels don’t adjust, increasing debt burdens.
- leads to a increase in adverse selection and moral hazard, followed by decreased lending
- economic activity remains depressed for a long time
What happened during the Great Depression? (5)
- In 1928 and 1929, stock prices doubled in the U.S.
- The Fed tried to curb this period of excessive speculation with a tight monetary policy.
- But this lead to a stock market collapse of more than 20% in October of 1929, and losing an additional 20% by the end of 1929.
- furthermore sever droughts led to decline in agricultural production (external circumstances)= 1/3 of banks went into bankruptcy
- led to moral and adverse selection, credit spreads increased and companies were not able to get financing for productive funds
What was the outcome effect? (5)
- The deflation during the period led to a 25% decline in price levels.
- The prolonged economic contraction led to an unemployment rate around 25%.
- The Depression was the worst financial crisis ever in the U.S.
- Bank panics in the U.S. spread to the rest of the world, and the contraction of the U.S. economy decreased demand for foreign goods.
- The worldwide depression caused great hardship, and the resulting discontent led to the rise of fascism and WWII.
What happened during the global financial crisis? (7)
- The Global Financial Crisis started with a crisis in subprime mortgage lending.
- In 2000, only 2% of mortgages were subprime. This climbed to 17% by 2006.
- The average FICO score was 624 for subprime borrowers. Prime mortgage borrowers were 742.
- New mortgage products (2/28 ARMS, Option ARMS, NoDoc loans) made expensive houses “affordable” (sort-of).
- The creation of CDOs helped create deal flow to continue lending in subprime markets
- While house prices were increasing, subprime borrowers had an out if problems arose.
- Lending standards also allowed for near 100% financing, so owners had little to lose by defaulting when the housing bubble burst.
- Rating agencies assumed in their models that default correlations were low. This assumption actually implies that the number of AAA tranches were very high
- By moving loans off their books, the banks reduced the amount of regulatory capital they were required to hold, thereby improving their earning
= was designed to benefit lenders, investment bankers, and investors
What is FICO? (3)
- Lenders will also order a credit report from one of the credit reporting agencies, the score reported is called the
- The range is 300 to 850, with 660 to 720 being average.
- Payment history, debt, and even credit card applications can affect your credit score.
What was the real estate bubble?
- Between 2000 and 2005 home prices increased an average of 8% per year. The run up in prices was cause by two factors:
•The increase in subprime loans created new demand for housing
• Real estate speculators
What are ABS, MBS and CDO’s?
Asset backed securities: securities whose income payments are financially backed or secured by a financial pool of underlying assets
mortgage backed securities: securities whose come payments are backed by a mortgage or collection of mortgages
collateralised debt obligations: a package of debt securities which contain MBS, and other debt obligations, which are structured into tranches and sold to investors
What role did the CDS play?
- A CDS is a credit derivative that transfers the (potential) loss due to a credit event (e.g., the default of a firm).
- The counterparty who buys protection pays a periodic fee as long as the credit event is not declared.
- In exchange, the counterparty who sells protection is obligated to compensate the protection buyer for the loss by means of a specified settlement procedure.
- With a CDS, you can buy or sell protection against the default of a bond that you don’t own.
What was the source of fragility in the 2007-2008 crisis?
- The huge amount of securitisation and lack of transparency as to who was exposed to subprime risk
- The dependence of many FIs on short-term debt markets and the shadow banking system. This refers to any financial activity that transforms short- term borrowing into long-term lending without a government backstop.
What was the role of REPO in the financial crisis? (4)
- The majority of repo agreements are for short-term (overnight). Thus, in order to hold a security over time, repos are renewed with the same or with another counterparty.
- Under pre-crisis conditions, the (average) haircut was around 2%. This meant that the dealer could hold securities with little incremental capital
- As mortgage default rose, banks began the deleveraging process, selling assets and restricting credit, further depressing the struggling economy
- Banks became less willing to lend to each other (LIBOR, T-bill and haircut increased)
What was the outcome of the Great Recession (2007-2008 crisis) (2)
- The fall in real GDP and increase in unemployment to over 10% in 2009 impacted almost everyone.
- The recession that started in December 2007 became the worst economic contraction in the United States since World War II, and is now called the “Great Recession.”
