Global Financial Crisis Flashcards
What are the points on collapse raised on the comparison between WW1 and GFC (7 points)
Define systematic Risk
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
Why learn about the global financial crisis
Shows link between finance and macroeconomy
How did it happen
Relevant to risk assessment and portfolio design. Many explanations; not necessarily mutually exclusive but highly politicised
What is the path to recovery
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
What is a financial crisis?
What is a credit Shortage
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
Describe the possible triggers of what might have caused the GFC
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
Explain in the context of a bank liquidity crisis (risk) Solvency crisis (risk)
Liquidity crisis: imbalance in maturity of deposits and loans
Solvency crisis – loans become “bad debts” so the bank is unable to repay depositors
How has Liquidity crises been mostly eliminated
central banks have been providing:
deposit insurance
bank loans to resolve temporary mismatches of the maturities of deposits and loans
How has the risk of solvency been reduced by regulatory oversight
Risk of solvency crisis reduced by regulatory oversight aimed at constraining supply of credit to “safe” levels
Banks are subject to extensive regulatory oversight
How did the financial system become so vulnerable.
What was the puzzling aspect of crisis
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.
Explain how a shadow bank operates
Give a few example
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
What are the four types of Financial intermediate activities that a shadow bank provides
- maturity transformation: obtaining short-term funds to invest in longer-term assets;
- liquidity transformation: similar to maturity transformation; use of cash-like liabilities to buy harder-to-sell assets such as loans;
- Leverage: borrowing money to buy fixed assets to magnify potential gains (or losses) on an investment;
- credit risk transfer: taking the risk of a borrower’s default and transferring it from the originator of the loan to another party.
What are the systemic threat from shadow banking
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?
Explain Lehman business model and how this caused the collapse of Lehman
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
What are the popular explanation to why loans were made so recklessly?
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
Ostensible innovation: Debt securitisation & subprime lending
- Explain how the process of financial intermediation and how participation increased on a large scale
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
Explain how the CDO market works
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)
Define a collateral debt obligation works
A collateral debt obligation is a security that generates payments out of the cash flows from a pool of loans made to people
Explain how risk return can be catered for through CDO
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.
How did subprime borrowers get access to debt markets
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
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
DUNNO??
Explain the emergence of financial crisis through subprime borrowers
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
Explain the fundamental weakness in mortgage-backed securitization markets (MBS)
Key participants in the MBS market have incentive to underestimate the risk
- agents who work on commission to find borrowers,
- investment banks that get a cut of the revenue to sell the
securities to investors, and - 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.
Explain the “horizon problem” with incentives
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”
