Lecture 1- Introduction and Overview of the Financial Crisis Flashcards
What is the LIBOR?
London Interbank Offered Rate; the main benchmark short-term money market interest rate. Loans are often in the form of LIBOR plus, i.e. LIBOR plus 10 basis points (0.1%)
What is Mark-to-market?
A way of valuing assets by their most recent market price
What is a default?
Failure to repay a loan
What are a bank’s reserves?
Part of a banks assets, they are a certain percentage of the deposits that are not lent out
What is a bank’s capital?
The share holdings of the banks owners
What are the 4 main types of financial crises?
- Banking crisis
- Banking crisis 2
- External debt crisis
- Domestic debt crisis
Describe a banking crisis
Systemic failure of banking system, there is at least a run on one major bank leading to take over by the public sector
Describe a banking crisis 2
Financial distress but no bank runs
Describe an External debt crisis
When there is a Sovereign Default which is when the government fails to meet payments on its debts
Describe a Domestic debt crisis
When the government fails to meet payments on its domestic debts
What are the 5 main leading indicators of banking crises suggested by Reinhart and Rogoff?
- Sharp rise in asset prices; particularly houses
- Sharp rise in domestic credit
- Capital flows from abroad increase
- Public borrowing increases
- Sovereign debt rises both during and after the crisis
What is a Collateralised Debt Obligation (CDO)?
A mortgage backed security, which involves securitisation, where security purchasers are divided into different groups with different risks
What are Credit Default Swaps (CDS)?
Forms of insurance taken out against holders of bonds, in which the bond holder receives payment in the event of the bond issuer defaulting
How did the housing market contribute to the Global Financial Crisis?
The housing markets in the US and UK grew very quickly in the early 2000s which lead to a speculative bubble putting house prices far above their long-term equilibrium. Much of the lending was through mortgage backed securities and held off the balance sheet. Much of the lending was to sub-prime borrowers who couldn’t afford the mortgage interest.
How did monetary policy contribute to the Global Financial Crisis?
The fed cut interest rates to 1% in 2002 following the dotcom bubble and only increased them again in 2005
How did regulations relax and in turn contribute to the Global Financial Crisis?
- Glass-Steagall act repealed in 1999 so banks could have investment and depositary businesses together
- The UK tripartite regulatory system
What was the first effect of the Global Financial Crisis and why was it problematic?
A substantial rise in LIBOR interest rates, which is the rate at which banks lend to each other, meant that banks did not wish to lend as they believed the other banks held large amounts of worthless sub-prime debts, meaning they were close to bankruptcy
What is the moral hazard involved with banks being bailed out?
If banks are lead to believe the authorities will always rescue them, there is no incentive for them to do appropriate risk management, they will lend to ever more risky ventures, with the consequent higher return, until a crisis, then rely on support from the government
What is the Troubled Asset Relief Programme (TARP)?
Introduced after the failing of Lehman brothers, the scheme involved the US authorities buying toxic assets and equity from the banks to improve their balance sheets
What are the 2 types of default?
- Full default
- Haircut
What is a haircut default?
When the debt is partially paid
What’s a sub-prime mortgage?
Mortgage lent to people who held a sub level credit score and therefore a greater than average risk of defaulting on the loan
What was securitisation?
Securitisation meant that the sub prime mortgages were pooled together and re-scored by rating agencies, to then be marketed as strong credit score assets. When they defaulted, the securitised assets collapsed
What are 3 main arguments for allowing Lehman Brothers to fail in 2008?
- Adverse selection
- Moral hazard
- Network effect
Describe adverse selection in the context of Lehman Brothers failing
Any underwriting by the government means investors take less care
Describe Moral Hazard in the context of Lehman Brothers
If firms know they will be bailed out then they will take on more risk for the return
Describe the network effect in the context of Lehman Brothers
Lehman was part of a complex network-mark to market would ensure any failure would be transmitted quickly
Why did Argentina default in 2001?
- There was a lot of borrowing in dollars
- There was a pegged exchange rate of peso to dollar
- The economy was in recession and there was depreciation pressure on the currency
