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
