introduction to financial crisis and great recession Flashcards
sub-prime d
credit or loan arrangement for borrowers with a poor credit history, typically having unfavourable conditions such as high interest rates
what does the phrase “financial crises are an equal opportunity menace” mean
hit small and large countries as well as rich and poor,
domestic or external origins,
different shapes and sizes,
large scale government
financial crisis d
extreme manifestation of interactions between financial sector and real economy
what do financial crises cause/result in
substantial change in credit volume and asset prices,
disruptions in financial intermediation and supply of external financing to various actors,
large government support
explain financial crisis (short)
low interest rate, increase in demand mortgage, asset price bubble, burst, price down, can’t pay mortgage, default on loan, foreclosure, unemployment and low growth
what is a global savings glut
due to lots of saving by countries such as brazil and argentina, capital markets in advanced countries were awash in additional saving in search of good investment opportunities, this demand for investments contributed to rising asset markets in the US, including the stock market and the housing market
how did the financial crises of countries like Argentina and Brazil end in the 1990s
money stopped being lent,
have to support themselves domestically,
change to savings > investment,
(more funds so can lend abroad (capital outflows))
what is the technical term for money lent or borrowed from another country
capital inflows / capital outflows
capital inflows always _______ price of assets
increase
what is a chain of events following capital inflows increasing the price of assets
lower interest rate, in order to increase investment
how did the financial crisis start (why were there initial low interest rates)
government want to promote ownership because jobs in construction
explain the initial model of the mortgage market before the change
banks loan money to consumers at interest rate (banks not dependent on deposits),
funds flow from investors to banks in return for interest,
interest goes to investors
where is the secondary market in the mortgage market
where banks sell the mortgages to investors or investment banks
what was the change in the mortgage market from 1990 to 2000
1990 only banks and investors,
2000 banks and investment banks
investment banks are the _______ in the mortgage market
intermediary
bonds d (to do with mortgages)
multiple mortgages bundled into one,
investors now buy from investment banks
who creates the mortgage backed securities
investment banks (these are what is sold to investors when loads of mortgages are bundled into one)
how come loads of sub prime mortgages were given out
because strongly encouraged by the government in order to boost the construction sector
central banks are ______ of governments
independent
central banks decide how much ________, commercial banks need to keep on balance sheet
reserves
describe the model with central bank setting interest rate to consumer getting credit
central bank sets its policy rate (0.25),
lends funds to commercial banks at this rate,
commercial banks lend money to consumers at rates higher than this (to make profit),
rates offered to consumers can be different depending on what the product is,
banks lend to each other at the LIBOR rate (slightly higher than base rate)
what is the libor rate
rate at which the commercial banks lend money to each other
why would banks use the interbank market (libor) as oppose to borrowing from the central bank who have a lower interest rate
in order to keep good relation with other banks,
if consistently borrow from central bank shows that bank has liquidity problems
describe the interest rates for these periods,
2000-2006
2006-2008
end 2008
2000-2006 low interest rates to encourage houses,
2006-2008 increase in interest rates to avoid inflation,
end 2008 fall massively to stimulate growth
how did a rise in interest rates from 2006-2008 cause inflation
i high to avoid inflation,
interest rate increase on loans so people default,
drives down investment and consumption,
takes economy into recession
as i increases the number of ______ on loans increases
defaults
what does an increase in the money supply always cause
fuels inflation
equation for risk spread
libor - base rate
why is the base rate not necessarily indicative of the rate
because of the risk spread
what is a government bond
pay the government money with a promise that they will pay you back + interest,
(riskless because government always pays debts)
are government bonds a safe investment
yes
what was government action after the financial crisis
bank of america buys $8.4 billion of merril lynch’s debt,
ben bernanke and tarp $700 billion bailout,
collapse of lehman brothers
unemployment rate equation
unemployed / labour force
what was at the heart of the financial crisis
large decline in housing prices
in the decade leading up to ____, housing prices grew rapidly before collapsing by __% over the next several years
2006,
40
what was the increase in housing prices fuelled by
demand pressures of ‘new economy’,
low interest rates,
ever-loosening lending standards
how did the global savings glut contribute to the rise in asset prices in the us
once countries like brazil and russia recovered from the savings glut they had savings > investment so were looking for good investment opportunities (stock and housing market in united states)
why did large numbers of borrowers take out mortgages and purchase homes between 2000 and 2006
low interest rates,
increasingly lax lending standards,
belief that housing prices could only continue to rise
what does sub-prime borrower mean
borrower who’s loan application did not meet mainstream standards
why did the fed increase the rate and what happened
increased in order to prevent inflation,
because lots of loans on flexible rate many borrowers could no longer afford to pay back loans,
furthermore higher interest rates lead to decline in demand for houses so reduced the price of houses
securitization d
lumping together large numbers of financial instruments such as mortgages and then slicing and dicing them into different pieces that appeal to different types of investors
what does CDO stand for
collateralised debt obligations
what type of securities would a hedge fund and a pension fund take
hedge fund may take riskiest piece in hope of high return,
pension fund may take relatively safe portion, constrained by the rules under which it operates
what was the problem with combining large numbers of sub-prime mortgages
underlying mortgages proved to be significantly riskier than most investors realised,
when the fed increased the rate more and more subprime mortgages went under and housing prices fell leading to more and more defaults (look up why)
why was this financial crisis different from the dot com bubble of 2000
in 2000 the stock market risk was diversified across a huge number of investors,
relatively small number of financial institutions held a large amount of mortgage-backed securities, putting their insolvency at risk
how did the libor rate change as the crisis was starting
banks got worried that other banks were backed by a a large number of bad mortgages so increased the libor rate, spread went from 0.2 percentage points to 4.5 percentage points
liquidity crisis d
situation in which volume of transactions in some financial markets falls sharply, making it difficult to value certain financial assets and raising questions about the overall value of the firms holding those assets
what does tarp stand for
troubled asset relief programme
what happened to oil prices during the financial crisis
rose from $20 a barrel in 2002 to $140 a barrel in the summer of 2008 before falling to $40 by the end of 2008
why did the price of oil rise and fall so sharply during the financial crisis
decline in oil consumption among oecd countries (usa) more than offset by increases in china, india and middle east, rising prices coupled with rising quantities
what is the effect of falling house prices
reduce consumers main form of wealth so reduce consumption,
negative equity where value of house is less than what they paid for it
short run output ________ during the financial crisis and unemployment _______
decreased,
increased
in a typical recession GDP falls by ___ however in the recent recession real GDP declined by ___
- 7%,
4. 7%
stat about unemployment rate in current recession
unemployment rate grew by 4.5 percentage points compared to 2.5 percentage points in the average recession
what do many observers refer to this recession as
the great recession
why did inflation rates rise sharply in the first half of 2008
high energy prices,
rise in the price of oil in first half of the year
what was the peak inflation rate in 2008
middle of the year 5.5%
was the financial crisis just in the us or did it affect the world
it was on a global scale, japan germany uk all suffered deep recessions
assets d
items of value that the institution owns
liabilities d
items of value that the institution owes to others
what does a hypothetical bank’s balance sheet look like
assets on the left, liabilities on the right (and equity)
what is an example of things that a bank would have in its assets column
loans it has made,
investments it has made,
cash and reserves,
(in order of value in this example)
what is an example of things that a bank would have in its liabilities column
deposits (that households and businesses have made),
short term debt,
long term debt,
(in order of value in this example (short term and long term debt the same))
where is equity on the balance sheet
under liabilities
equity d
represents the value of the institution to its shareholders or owners
what is a reserve requirement
mandates that banks keep a certain percentage (such as 3%) of their deposits in a special account with the central bank
what is a capital requirement
mandates that the capital (net worth (equity)) of the bank be at least a certain fraction of the bank’s total assets (such as 6%)
leverage d
ratio of total liabilities to net worth,
liabilities / equity (net worth)
how does leverage explain what happened to the banks
market prices fall so investments worth less than before, however due to leverage the bank’s equity would fall by more than this initial fall in market price
when a bank or firm is highly leveraged a given percentage change in the value of its assets has a ____ _______ proportional effect on its net worth
much larger,
this magnification is a result of leverage
explain how the leverage thing relates falls in price and equity
because of the ratio between liabilities and net worth a small change in price relates to a large change in equity
what happens when the assets owned by the bank are no longer large enough to cover the liabilities that the bank owes to others
bank is insolvent or bankrupt
did banks have low or high leverage leading up to the financial crisis
very high, bear sterns 35 to 1
why is lots of people demanding their money back from the banks at once a problem
majority of the banks assets are held in loans and investments, relatively illiquid forms that are hard to turn into cash quickly
how was the bank run situation different in the financial crisis to previous crises
normally bank does not have enough deposits to pay back customers demanding their money, this time the large amounts of short term debt that the bank was owed was not being paid
what did banks have to do to fund their daily operations during the financial crisis when their short term loans were not getting paid
banks were forced to sell some of their less liquid assets at ‘fire sale’ prices, reducing their net worth - potentially all the way to insolvency
what was the peak of the unemployment rate in the us during the financial crisis
10%
default risk premium d
higher interest rates because of toxic assets
overnight loans d
if one bank doesn’t have enough deposits at the end of the day and another has too much they will loan (need certain amount in deposits as defined by the central bank)
overnight market d
shortest term loan, lend borrowers funds only overnight to be paid back in the morning with interest
