Global Financial Crisis

Question 1

What are the points on collapse raised on the comparison between WW1 and GFC (7 points)

Define systematic Risk

Answer 1

Systemantic risk is the probability of collapse of entire order

Collapse often occurs when least expected

individuals incentives make them heedless of broader consequences of their actions

Novelty exacerbates heedlessness

Trigger for collapse hard to predict

Explanation tend to be politicised

potential for cycle to repeat

Question 2

Why learn about the global financial crisis

Answer 2

Shows link between finance and macroeconomy

Question 3

How did it happen

Answer 3

Relevant to risk assessment and portfolio design. Many explanations; not necessarily mutually exclusive but highly politicised

Question 4

What is the path to recovery

Answer 4

Government responses highly contested:

(a) US bailout of large banks and companies at risk of bankruptcy
(b) Aust. taxpayer guarantee of big banks’ deposits
(c) Quantitative easing, economic growth and inflation

Question 5

What is a financial crisis?

What is a credit Shortage

Answer 5

Definition: a collapse in the value of financial assets that leads to a severe shortage of credit

Credit shortage means businesses cannot get finance for their operations

Question 6

Describe the possible triggers of what might have caused the GFC

Answer 6

US interest rates rose from 1% to 5.35% between 2004 and 2006

Default rates on US house mortgage loans rose to record levels

Impact was felt globally as
(a) US is world’s largest economy

(b) US domestic debt levels were high,
(c) lenders to US were spread across the world, and
(d) extent of losses and identity of bearers of losses not easily identified

Question 7

Explain in the context of a bank 
liquidity crisis (risk)
Solvency crisis (risk)

Answer 7

Liquidity crisis: imbalance in maturity of deposits and loans

Solvency crisis – loans become “bad debts” so the bank is unable to repay depositors

Question 8

How has Liquidity crises been mostly eliminated

Answer 8

central banks have been providing:

deposit insurance

bank loans to resolve temporary mismatches of the maturities of deposits and loans

Question 9

How has the risk of solvency been reduced by regulatory oversight

Answer 9

Risk of solvency crisis reduced by regulatory oversight aimed at constraining supply of credit to “safe” levels

Banks are subject to extensive regulatory oversight

Question 10

How did the financial system become so vulnerable.

What was the puzzling aspect of crisis

Answer 10

Financial crisis was the outcome of a solvency problem: banks made bad loans that could not be repaid

Bad loans are normal part of business

Puzzling aspect of crisis:
Bad loans made on such large scale that whole system was at risk of crashing. A prime function of the financial system is to allow risk to be better managed but it appears greater development of financial markets increased rather than decreased systemic risk.

Question 11

Explain how a shadow bank operates

Give a few example

Answer 11

Shadow banks are institutions that accept deposits and lend or invest money but, for various reasons, are subject to less or none regulatory oversight and control.

Their deposits are not guaranteed against default. They operate “in the shadow”

Hedge funds
Private equity funds
Investment banks
Superannuation funds

Question 12

What are the four types of Financial intermediate activities that a shadow bank provides

Answer 12

1. maturity transformation: obtaining short-term funds to invest in longer-term assets;
2. liquidity transformation: similar to maturity transformation; use of cash-like liabilities to buy harder-to-sell assets such as loans;
3. Leverage: borrowing money to buy fixed assets to magnify potential gains (or losses) on an investment;
4. credit risk transfer: taking the risk of a borrower’s default and transferring it from the originator of the loan to another party.

Question 13

What are the systemic threat from shadow banking

Answer 13

Little or no regulatory oversight allows shadow banking institutions to expand credit beyond prudent levels

Positive effect - Expansion of credit stimulates demand and
economic activity (recall “multiplier effect” from economics lectures)

In US in 2007; shadow bank liabilities were nearly US$22 trillion; traditional bank liabilities $14 trillion

Governments, households, & business all benefit

Who had incentives to stop the shadow bank party?

Question 14

Explain Lehman business model and how this caused the collapse of Lehman

Answer 14

Near the end Lehman had $700 billion in assets but only $25 billion (about 3.5%) in equity.

Most of the assets were long-lived or matured in over a year but liabilities were due in less than a year. Lehman had to borrow and repay billions of dollars through the “repo” market every day in order to remain in business.

This was normal for investment banks, but if counter parties lost confidence in Lehman’s ability to repay, this market would close to the bank and the business would fail

Question 15

What are the popular explanation to why loans were made so recklessly?

Answer 15

Popular explanations:

Poorly understood risk from financial innovation

Greed: Excessive pay in finance sector; Insiders rigging the system in their favor

“Irrational exuberance”

Global “distortion” in money supply

Question 16

Ostensible innovation: Debt securitisation & subprime lending

1. Explain how the process of financial intermediation and how participation increased on a large scale

Answer 16

Banks used to rely on local depositors for the money they had to lend. This limited the scale of banking activity in any one region.

Improvements in information technology that decreased cost of financial transactions and financial deregulation allowed non-bank institutions to engage in financial intermediation (“shadow banking”) on a large scale

most significant channel of shadow banking was “debt
securitisation

Question 17

Explain how the CDO market works

Answer 17

An investment bank opens a line of credit to a local bank.

The local bank uses the credit to make loans to individual borrowers. The loan is immediately sold to a pooled loan trust.

The pooled loan trust thus receives a large stream of cash (from the interest and principal repayments of the individual debts) over a period of time.

Trust then sells the rights to these cash flows by issuing securities. CDOs are thus securities whose collateral comprises the underlying
loans.

(draw a diagram)

Question 18

Define a collateral debt obligation works

Answer 18

A collateral debt obligation is a security that generates payments out of the cash flows from a pool of loans made to people

Question 19

Explain how risk return can be catered for through CDO

Answer 19

The risk of the securities can be tailored to suit the risk/return preference of investors.

For a given pool of loans, a bank can issue securities with different levels of risk:

Senior tranches of securities get paid first and so offer lower returns;

mezzanine tranches get paid second and get higher return for taking on more risk;

subordinated equity gets paid last and so offers the highest rate of return.

Question 20

How did subprime borrowers get access to debt markets

Answer 20

Supply of lenders for alternative investments grew partly due to low interest rate sustained by US government

The group of potential borrowers with good credit background diminished as they were able to access credit.

So, some bankers decided to lend to people wishing to buy houses who normally would not qualify as prime credit risk or subprime borrowers

Question 21

If subprime loans pooled it would be easier to assess their risk and investors would be able to get a higher rate of return, what is wrong with this scenario

Answer 21

DUNNO??

Question 22

Explain the emergence of financial crisis through subprime borrowers

Answer 22

Crisis arose because the risk of the subprime borrowers was very substantially underestimated.

It is true that bundling the loans makes it easier to assess risk but people assumed (wrongly) that the actual risk of subprime loans were far less than they truly were

Bond rating agencies (e.g., Moodys and Standard & Poor) have been blamed for giving high credit ratings to subprime based securities. They argued they do not guarantee the credit worthiness of the party but provide an opinion

Question 23

Explain the fundamental weakness in mortgage-backed securitization markets (MBS)

Answer 23

Key participants in the MBS market have incentive to underestimate the risk

1. agents who work on commission to find borrowers,
2. investment banks that get a cut of the revenue to sell the
   securities to investors, and
3. agencies such as Moody’s and Standard & Poors who are paid by the banks to rate the risk of securities and rely on their reputation to have their ratings accepted.

Question 24

Explain the “horizon problem” with incentives

Answer 24

When exceptionally high returns can returned in the short-term and the associated risk off-loaded to other parties with low prospect of their finding out in a timely way, then a willfully cavalier not to say,
fraudulent attitude to risk-taking is almost certain.

There is not much “irrationality” in such behavior. We don’t need psychological theory to explain it”

Question 25

What is the predicament on irrational exuberance according to Alan Greenspan

Answer 25

But how do we know when irrational exuberance has
unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in
Japan over the past decade?

Question 26

Define Hedge, Speculative and Ponzi Borrowers

Answer 26

Hedge borrowers: can repay interest and principal from investment cash flows

Speculative borrowers: can repay interest only from investment cash flows. Require capital appreciation to repay principal. Need to rollover debt
when financing period ends

Ponzi borrowers: cannot repay interest or principal from investment cash flows. Rely on capital appreciation for investment to be profitable.

Question 27

Financial Instability Hypothesis

Answer 27

Proportion of Ponzi borrowers increases in extended period of good times possible “irrational exuberance”

Financial crisis occurs when lenders to Ponzi borrowers become disillusioned

Question 28

What are Minsky financial instability hypothesis inconsistency

Answer 28

Availability heuristic: “When judging the probability of an event or being asked to assess outcomes, people will often reach back for the most recent examples and underweight earlier examples”

Overconfidence: “Confidence intervals assigned to estimates of outcomes are too low. Their 98% confidence intervals includes the true outcome only about 60% of the time.”

Question 29

What are the six bubble characteristics identified by Charles Kindleberger

Answer 29

Every bubble is different and every bubble is the same

1. Initial displacement that grabs attention (e.g. a real boost to “fundamentals”)!
2. “Smart money” response!
3. Channels for speculation are invented!
4. Authoritative blessing!
5. Crash!
6. Political fallout

Question 30

Explain the relationship between irrational exuberance and the crisis

Answer 30

It is plausible over-confidence contributed to the crisis.
Problem is bubbles much easier to identify ex post than ex ante

A case can be made that regulators and academic economists exhibited “irrational exuberance” by facilitating rise of “shadow banking”

Question 31

What is the Precondition for the Crisis

Answer 31

Savings glut in Asian countries led to large pools of money looking for a home. US was seen as “safest” market to invest

Parking money in the US helped keep Asian exporting
countries’ currencies low

Financial system of Asian countries not well developed enough to link savings with potential borrowers

US financial institutions developed “innovative” ways to channel Asian deposits to borrowers

Savings from Asian countries funneled back to the US (and Europe) via purchase of government bonds

US Federal Reserve and the European Central Bank normally would control impact of inflow on their economies by taking action to increase interest rates. But, Fed Reserve and ECB focused on consumer price inflation, not on asset price inflation. Consumer price inflation was low due to low cost of goods imported from the Asian countries.

As a result of the US Fed and ECB focusing on low consumer inflation rate, interest rates went very low.

Low interest rates meant that people could afford to buy assets that were previously unavailable.

Boom in real estate and also other speculative ventures (e.g., takeover market)

Increase in interest rates led to massive bad debts that sparked the financial crisis

Question 32

According to Atif Mian and Amir Sufi, why is it taking so long to recover from the crisis

Answer 32

Mian and Sufi report total amount of debt for American households doubled between 2000 and 2007
to $14 trillion as a result of rising property prices and homeowners borrowing against increase in
value of home equity

“The debt-fueled housing boom artificially boosted household spending from 2000 to 2006, and
then the collapse in house prices forced a sharp pull-back because indebted households bore the brunt of the shock.”

Question 33

How best to proceed according to Atif Mian and Amir Sufi

Answer 33

Mian and Sufi contend that more aggressive debt forgiveness after the crash is more effective in restoring consumption and inducing economic growth

They also propose that we can get rid of bubble-and-bust episodes if the financial system moves away from its reliance on inflexible debt contracts.

They propose new mortgage contracts that entail risk-sharing between creditors and borrowers

Question 34

Summarize the GFC

Answer 34

How it happened informs us about how financial markets work
Interaction between macro economy and finance

Crisis tests classical economics view & behavioral view
– People responded to incentives
– High return associated with high risk
– Behavioral factors remain relevant

Path to recovery unclear
Principal channel for recovery seems to be renewed spending by households but high levels of indebtedness are hindering the recovery