Financial Crisis Examples (GFC/COVID) Flashcards
How did the Banking Crisis impact nations, especially the Eurozone Area?
- Conversion of Interest rates across 10 year Govt. bonds meant that Italian bonds “=“ German bonds
- Perceptions of the bonds change, which increases the spreads
- Markets perceived default risks in specific nations due to market inefficiency and no bailouts
- Sovereigns faced the mismatch of long-term assets and short-term liabilities
- Any Govt.could be immediately insolvent if investors decided refused to buy bonds
Why do banks hold Government bonds?
- Banks don’t have to hold any capital Vs Government bonds
- Liquidity requirements favour Govt bonds
- No limit on concentration of sovereign risk, for banks, there is a limit of exposure of 25%
- Banks can hold more Govt bonds
- European banks exposed to bonds of the home Govt
- Free market in EU, therefore small adverse shift and expectations can trigger less demand for sovereign debt
- Interdependence between sovereign credit and bankings system- LOOP
What is each transmission mechanism? Give examples of each
- Financial Sector risk can be transmitted to sovereign risk (Ireland, Spain)
- Sovereign risk can be transmitted to the financial sector (Greece, Portugal)
What is the Diabolic Loop with sovereign risk? What would trigger this?
- Sovereign risk increases, which reduces loans to firms so bank risk / equity risk increases
- This increases the bailout probability and thus sovereign debt increases
- Similarly, if sovereign risk, this reduces growth and taxes and sovereign debt increases
- The trigger was either a banking or financial crisis
What happens to house prices on average during a financial crisis?
- Takes 6 years to recover
- -35.5% effect on house prices
What happens to equity prices on average during a financial crisis?
- Fall -55.9%
- Takes 3.4 years to improve
What happens to unemployment levels on average during a financial crisis?
- Takes 4.8years to recover
- Rises by 7%, but was 20% in 1930 depression
What happens to GDP levels on average during a financial crisis?
- -9% in GDP, but fell by 30% in 1930 depression
- Takes 1.9 years to recover
What happens to real public debt levels on average during a financial crisis?
- Up 86.3% in the following 3 years
What caused the GFC? What happened as a result?
- A rise in Sub-Prime mortgages defaults
- In 2007, more than 40% of adjusted rate SPMs defaulted, whilst 20% of fixed rate SPMs
- All that were securitised defaulted
- Decline in mortgage CDSs, as AAA price rated fell by 60% on the ABX
What is the ABX? When ABX index falls, what happens?
- ABX: Basket of 20 CDS referencing ABS containing SPMs
- When ABX index falls, the up front fee rises and previous sellers of CDS suffer losses
What is an ABCP? What happened to Asset-Backed Commercial Papers (ABCPs) across a 6 month period?
- ABCP: collateralised, short-term debt in the form of commercialised paper
- $1.2trn to $700bn
What is the TED spread? What happened and why was this a shock?
- The TED spread is the difference between the interbank lending rate and treasury bill rate, which measures counterparty risk
- This shot up, which was surprising because it was historically very low because of financial liberalisation
What is the TAF? How high did the TAF get?
- The Term Auction Facility was created in December 2007 and allowed banks to borrow short-term against a spread of collaterals
- Reached $500bn in a single day
What was the TSLF? What did it aim to achieve and what happened?
- The term security lending facility allowed for swapping MBS for treasury bills for 28 days
- Increased liquidity within the financial markets
- Was very successful, so was scheduled up to $200bn
What was the PDCF? What happened?
- The primary dealer credit facility was announced in March 2008 for IB only
- Immediately jumps to $150bn after DW public
What happened to the Fed’s balance sheet? What was it made up of?
- Rose from $1trn to $4trn in just 5 years
- Made up of MBS and US treasuries increases
How did the US crisis spread to Europe?
- US households use wholesale lending to european banks
- European banks provide shadow banking to US borrowers
- The interconnectivity of the world banking system
What was the issue using conventional monetary policy? What was an example of unconventional monetary policy?
- Largely ineffective due to ZLB in UK, USA and EU
- Size of the FIs BS, Central Banks had to increase their BS for FIs
- CBs must borrow at low cost injections
- QE was the best example of unconventional MP
Explain QE via portfolio rebalancing
- BoE assets purchase (MBS as well) which increases confidence and it is good policy signalling
- Asset price goes up, return goes down
- Investors have to purchase other assets for higher yield, this would increase the price of other assets and reduce IR on LT assets [Portfolio Rebalancing]
Explain Portfolio Rebalancing in greater depth
- Reduces IR and Cost of Borrowing, therefore investment and borrowing increases and therefore GDP growth increases
- This increases asset prices leading to the net worth of investors and increase wealth
- This increases liquidity and reducing uncertainty, which reduces risk of default
Was QE successful in the GFC?
- Comparing 1929 recession with 2008, US had a fall of 8% in 2008
- But in 1929 it fell by 28% with a quick recovery
- Hence, QE reduces the downfall but takes longer to recover
Briefly outline the impact of the COVID-19 pandemic using indicators
- Unemployment jumped to almost 15%, an 80 year high
- Similarly, LFPR declined from 66%-61% (-2%)
- PCE bottomed out at -12%, then jumped to 8% in 3 Quarters
- GDP fell to about -9% and although a jump y-o-y
What was the difference between COVID and GFC economic crash?
- COVID had real impacts on the economy
- GFC hurt financial markets more
- Government learned from GFC for COVID
What happened to financial markets during the COVID pandemic?
- Investors looked towards cash/liquid assets, as the TED spread liquidity fell
- FED used tried-and-tested unconventional MP, so that the market wasn’t spooked
- Within 3 months of COVID beginning, the FED made the spread completely die down
- Businesses, states and local Govts increased cash holding by selling securities, this covered near-term expenses to avoid a loss/margin spiral
What Monetary Policy was used during COVID?
CONVENTIONAL:
- Fed cut rates to near 0% and this was committed until economy was back on track
- Fed BS rose from $4trn to $7trn because of COVID
- Announcement of programmes were enough to establish trust
UNCONVENTIONAL;
- Purchase $2trn of securities
- Introduced liquidity/lending facilities (provided $150bn)
- Lower costs at which banks can borrow from the Fed
- Expectations of Fed as LOLR was enough to restore confidence and break the loss/margin spiral
