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Economic principles 2 > introduction to financial crisis and great recession > Flashcards

introduction to financial crisis and great recession Flashcards

1
Q

sub-prime d

A

credit or loan arrangement for borrowers with a poor credit history, typically having unfavourable conditions such as high interest rates

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2
Q

what does the phrase “financial crises are an equal opportunity menace” mean

A

hit small and large countries as well as rich and poor,
domestic or external origins,
different shapes and sizes,
large scale government

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3
Q

financial crisis d

A

extreme manifestation of interactions between financial sector and real economy

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4
Q

what do financial crises cause/result in

A

substantial change in credit volume and asset prices,
disruptions in financial intermediation and supply of external financing to various actors,
large government support

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5
Q

explain financial crisis (short)

A

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

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6
Q

what is a global savings glut

A

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

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7
Q

how did the financial crises of countries like Argentina and Brazil end in the 1990s

A

money stopped being lent,
have to support themselves domestically,
change to savings > investment,
(more funds so can lend abroad (capital outflows))

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8
Q

what is the technical term for money lent or borrowed from another country

A

capital inflows / capital outflows

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9
Q

capital inflows always _______ price of assets

A

increase

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10
Q

what is a chain of events following capital inflows increasing the price of assets

A

lower interest rate, in order to increase investment

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11
Q

how did the financial crisis start (why were there initial low interest rates)

A

government want to promote ownership because jobs in construction

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12
Q

explain the initial model of the mortgage market before the change

A

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

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13
Q

where is the secondary market in the mortgage market

A

where banks sell the mortgages to investors or investment banks

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14
Q

what was the change in the mortgage market from 1990 to 2000

A

1990 only banks and investors,

2000 banks and investment banks

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15
Q

investment banks are the _______ in the mortgage market

A

intermediary

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16
Q

bonds d (to do with mortgages)

A

multiple mortgages bundled into one,

investors now buy from investment banks

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17
Q

who creates the mortgage backed securities

A

investment banks (these are what is sold to investors when loads of mortgages are bundled into one)

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18
Q

how come loads of sub prime mortgages were given out

A

because strongly encouraged by the government in order to boost the construction sector

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19
Q

central banks are ______ of governments

A

independent

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20
Q

central banks decide how much ________, commercial banks need to keep on balance sheet

A

reserves

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21
Q

describe the model with central bank setting interest rate to consumer getting credit

A

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)

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22
Q

what is the libor rate

A

rate at which the commercial banks lend money to each other

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23
Q

why would banks use the interbank market (libor) as oppose to borrowing from the central bank who have a lower interest rate

A

in order to keep good relation with other banks,

if consistently borrow from central bank shows that bank has liquidity problems

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24
Q

describe the interest rates for these periods,
2000-2006
2006-2008
end 2008

A

2000-2006 low interest rates to encourage houses,
2006-2008 increase in interest rates to avoid inflation,
end 2008 fall massively to stimulate growth

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25
Q

how did a rise in interest rates from 2006-2008 cause inflation

A

i high to avoid inflation,
interest rate increase on loans so people default,
drives down investment and consumption,
takes economy into recession

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26
Q

as i increases the number of ______ on loans increases

A

defaults

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27
Q

what does an increase in the money supply always cause

A

fuels inflation

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28
Q

equation for risk spread

A

libor - base rate

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29
Q

why is the base rate not necessarily indicative of the rate

A

because of the risk spread

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30
Q

what is a government bond

A

pay the government money with a promise that they will pay you back + interest,
(riskless because government always pays debts)

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31
Q

are government bonds a safe investment

A

yes

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32
Q

what was government action after the financial crisis

A

bank of america buys $8.4 billion of merril lynch’s debt,
ben bernanke and tarp $700 billion bailout,
collapse of lehman brothers

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33
Q

unemployment rate equation

A

unemployed / labour force

34
Q

what was at the heart of the financial crisis

A

large decline in housing prices

35
Q

in the decade leading up to ____, housing prices grew rapidly before collapsing by __% over the next several years

A

2006,

40

36
Q

what was the increase in housing prices fuelled by

A

demand pressures of ‘new economy’,
low interest rates,
ever-loosening lending standards

37
Q

how did the global savings glut contribute to the rise in asset prices in the us

A

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)

38
Q

why did large numbers of borrowers take out mortgages and purchase homes between 2000 and 2006

A

low interest rates,
increasingly lax lending standards,
belief that housing prices could only continue to rise

39
Q

what does sub-prime borrower mean

A

borrower who’s loan application did not meet mainstream standards

40
Q

why did the fed increase the rate and what happened

A

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

41
Q

securitization d

A

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

42
Q

what does CDO stand for

A

collateralised debt obligations

43
Q

what type of securities would a hedge fund and a pension fund take

A

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

44
Q

what was the problem with combining large numbers of sub-prime mortgages

A

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)

45
Q

why was this financial crisis different from the dot com bubble of 2000

A

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

46
Q

how did the libor rate change as the crisis was starting

A

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

47
Q

liquidity crisis d

A

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

48
Q

what does tarp stand for

A

troubled asset relief programme

49
Q

what happened to oil prices during the financial crisis

A

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

50
Q

why did the price of oil rise and fall so sharply during the financial crisis

A

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

51
Q

what is the effect of falling house prices

A

reduce consumers main form of wealth so reduce consumption,

negative equity where value of house is less than what they paid for it

52
Q

short run output ________ during the financial crisis and unemployment _______

A

decreased,

increased

53
Q

in a typical recession GDP falls by ___ however in the recent recession real GDP declined by ___

A
  1. 7%,

4. 7%

54
Q

stat about unemployment rate in current recession

A

unemployment rate grew by 4.5 percentage points compared to 2.5 percentage points in the average recession

55
Q

what do many observers refer to this recession as

A

the great recession

56
Q

why did inflation rates rise sharply in the first half of 2008

A

high energy prices,

rise in the price of oil in first half of the year

57
Q

what was the peak inflation rate in 2008

A

middle of the year 5.5%

58
Q

was the financial crisis just in the us or did it affect the world

A

it was on a global scale, japan germany uk all suffered deep recessions

59
Q

assets d

A

items of value that the institution owns

60
Q

liabilities d

A

items of value that the institution owes to others

61
Q

what does a hypothetical bank’s balance sheet look like

A

assets on the left, liabilities on the right (and equity)

62
Q

what is an example of things that a bank would have in its assets column

A

loans it has made,
investments it has made,
cash and reserves,
(in order of value in this example)

63
Q

what is an example of things that a bank would have in its liabilities column

A

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))

64
Q

where is equity on the balance sheet

A

under liabilities

65
Q

equity d

A

represents the value of the institution to its shareholders or owners

66
Q

what is a reserve requirement

A

mandates that banks keep a certain percentage (such as 3%) of their deposits in a special account with the central bank

67
Q

what is a capital requirement

A

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%)

68
Q

leverage d

A

ratio of total liabilities to net worth,

liabilities / equity (net worth)

69
Q

how does leverage explain what happened to the banks

A

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

70
Q

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

A

much larger,

this magnification is a result of leverage

71
Q

explain how the leverage thing relates falls in price and equity

A

because of the ratio between liabilities and net worth a small change in price relates to a large change in equity

72
Q

what happens when the assets owned by the bank are no longer large enough to cover the liabilities that the bank owes to others

A

bank is insolvent or bankrupt

73
Q

did banks have low or high leverage leading up to the financial crisis

A

very high, bear sterns 35 to 1

74
Q

why is lots of people demanding their money back from the banks at once a problem

A

majority of the banks assets are held in loans and investments, relatively illiquid forms that are hard to turn into cash quickly

75
Q

how was the bank run situation different in the financial crisis to previous crises

A

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

76
Q

what did banks have to do to fund their daily operations during the financial crisis when their short term loans were not getting paid

A

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

77
Q

what was the peak of the unemployment rate in the us during the financial crisis

A

10%

78
Q

default risk premium d

A

higher interest rates because of toxic assets

79
Q

overnight loans d

A

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)

80
Q

overnight market d

A

shortest term loan, lend borrowers funds only overnight to be paid back in the morning with interest

Economic principles 2 (7 decks)

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