Issues in Financial Markets Flashcards
How did Deregulation contribute to GFC?
1980s- Relaxed Rules + Regulations
- Technology- fuelled Innovation + New Financial Instruments
- Lending became more Risky
- Banks looked at New Markets to improve Returns after I.R cuts
- Building Societies stopped lending for benefit of Members
Financial Institutions changed Roles
How did Asset-Prices + Risk-taking contribute to GFC?
- Easier to get Mortgages –> Increased D for Housing –> Increased House Prices
- Higher Positive Equity + Higher Expectations for Prices to keep Rising –> Fuelled Speculation- Increased D
- Staff Bonuses in Investment Banking –> Encouraged Risk-seeking Mentality
- Pension Funds- eager participators- especially due to Lower I.R
Late 1990s-2000s: Debt Spiralled- House Prices kept rising due to Low I.R + Generous Loan to value Mortgages –> Existing owners- Higher Equity- borrowed for 2nd home
–> New Buyers keen to get on Property Ladder
What is the Sub-Prime Market?
US Banks + other Lenders- looked to Increase Lending beyond Prime Market
- Sub-Prime Market- Higher I.R + Greater Risk of Default
- -> Increased D for Housing –> Higher Prices
- Increased Speculation- main reason for higher D
- -> Key characteristic of Bubble
What is Securitization?
Packaging Mortgage-Backed Securities (MBS) into Pools of Debt + selling them
How did Securitization contribute to GFC?
Credit Agencies assessed Collective Debt as favourable- More attractive to Investors as Risk of Default assessed as Low
- Investors bought associated Bonds in form of Special Purpose Vehicles (SPV)- keeps Liability off Banks books
- Continued to Fuel Incentive to Increase D for Housing
How do SPVs work?
Receive Mortgage Payments + Cash Flow
- Used to pay Bond Interest + Principal
What are Tranches?
SPVs issued Bonds in Bundles- Tranches
- Tranches have different levels of Risk + rates of Return
What did Institutions use CDS for?
Credit Default Swaps
Insure themselves against Risk of Default
How was Systemic Risk increased?
Expansion of Securitization + CDS Market
- Many exposed to Same Losses
- Many Major Banks + Insurance Companies exposed to CDS: Lehman Bros. AIG. Barclays + RBS. Icelandic Banks
How was the Impact of GFC Offset?
2006-07: C.Bs Concerned about Inflationary Pressures
- -> Started gradually increasing I.R
- Increased I.R –> Increased Defaults on Sub-Prime Loans –> Fall in House Prices + Speculators tried to sell–> Downward Pressure on Prices
Why were there a Rise in Defaults- beside I.R?
- Many Borrowers signed up to Teaser Rates- Reset to Higher I.R–> Not affordable to Sub-Prime borrowers
- Some Borrowers tried to Sell Property–> Fall in Prices
- -> People caught in Negative Equity
How did the Banking System falter?
- Increased Defaults–> Banks forced to call in Debt + put SPVs back on Balance Sheets
- -> Increased Liabilities- Needed more Reserves to cover Liabilities–> Reduced Ability to Lend
- Before Sub-Prime Market collapsed- many banks reported significant write-downs + losses
- Confidence in Banking System began to Falter- Banks less willing/unable to lend to each other/anyone else- including businesses
What is the Mortgage Market?
Buy Mortgages from Lenders + Sell Debt to Investors
How did the Collapse start?
2008- Banks + Major players in US Mortgage Market in trouble
- Mortgage Market- Guaranteed Borrowing for millions of US Mortgage owners
- US Authorities stepped in to support them
What was the problem of Moral Hazard for the Gov. in the GFC?
Bail-out Banks for bad Practice or let them take Losses?
- Lehman Bros- at forefront of Sub-Prime + CDS Market
- NOT Bailed out- filed for Bankruptcy September 2008
What was the issue following Lehman Bros. collapse?
Billions of $ of claims on Lehman CDS- had to be paid out by those who sold protection
- Many other Banks exposed + in danger of failing as well
What was the general path to Global Recession?
- Mortgages harder to get- Reduced D for Housing–> Fall in Prices
- Negative Equity worry- Homeowners reduce Spending on non-essentials
- Businesses lost Sales–> Reduced Profit
- Tighter Credit- Businesses faced Cash Flow issues
- More Business Shutdowns
- Higher Unemployment
What is the Efficient Market Hypothesis?
Suggests Asset Prices reflect ALL Public available info about Value of an Asset
- So ALL Shares are fairly Valued
What is equal At Market Price?
No. of People who think Stock Overvalued = No. of People who think Stock Undervalued
- Stock Market- Informationally Efficient- reflects all info rationally
What changes when Information changes?
Stock Prices change
When do Stock Prices change?
New Info on Market’s Perception of Company’s value becomes available
Why is E.M.H limited?
NOT ALL info is discovered + understood by everyone at same time + same depth at same speed
- TIME LAG- can be exploited for Profits
What does the Basis of Regulatory Framework assume?
Markets are Efficient + Self-correct to reflect True Market Value
What is an Alternative view to Rationality?
Herd Mentality
What is Herd Mentality?
Irrational exuberance / Animal Spirits
What is the Evaluation of E.M.H with respect to GFC?
GFC shows Irrational Behaviour- contradicts E.M.H
- Part of Sub=-Prime problem- US Gov. Policy promoted home ownership among all society classes–> Economic issue caused by Gov.
How do supporters of E.M.H justify Financial Markets?
Financial Markets provide path from Saver to Borrowers
What is the main issue with Bailouts?
Moral Hazard- risk may continue if they know they will be Bailed out
