Lecture 1- Introduction and Overview of the Financial Crisis

Question 1

What is the LIBOR?

Answer 1

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%)

Question 2

What is Mark-to-market?

Answer 2

A way of valuing assets by their most recent market price

Question 3

What is a default?

Answer 3

Failure to repay a loan

Question 4

What are a bank’s reserves?

Answer 4

Part of a banks assets, they are a certain percentage of the deposits that are not lent out

Question 5

What is a bank’s capital?

Answer 5

The share holdings of the banks owners

Question 6

What are the 4 main types of financial crises?

Answer 6

• Banking crisis
• Banking crisis 2
• External debt crisis
• Domestic debt crisis

Question 7

Describe a banking crisis

Answer 7

Systemic failure of banking system, there is at least a run on one major bank leading to take over by the public sector

Question 8

Describe a banking crisis 2

Answer 8

Financial distress but no bank runs

Question 9

Describe an External debt crisis

Answer 9

When there is a Sovereign Default which is when the government fails to meet payments on its debts

Question 10

Describe a Domestic debt crisis

Answer 10

When the government fails to meet payments on its domestic debts

Question 11

What are the 5 main leading indicators of banking crises suggested by Reinhart and Rogoff?

Answer 11

• 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

Question 12

What is a Collateralised Debt Obligation (CDO)?

Answer 12

A mortgage backed security, which involves securitisation, where security purchasers are divided into different groups with different risks

Question 13

What are Credit Default Swaps (CDS)?

Answer 13

Forms of insurance taken out against holders of bonds, in which the bond holder receives payment in the event of the bond issuer defaulting

Question 14

How did the housing market contribute to the Global Financial Crisis?

Answer 14

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.

Question 15

How did monetary policy contribute to the Global Financial Crisis?

Answer 15

The fed cut interest rates to 1% in 2002 following the dotcom bubble and only increased them again in 2005

Question 16

How did regulations relax and in turn contribute to the Global Financial Crisis?

Answer 16

• Glass-Steagall act repealed in 1999 so banks could have investment and depositary businesses together
• The UK tripartite regulatory system

Question 17

What was the first effect of the Global Financial Crisis and why was it problematic?

Answer 17

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

Question 18

What is the moral hazard involved with banks being bailed out?

Answer 18

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

Question 19

What is the Troubled Asset Relief Programme (TARP)?

Answer 19

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

Question 20

What are the 2 types of default?

Answer 20

• Full default

- Haircut

Question 21

What is a haircut default?

Answer 21

When the debt is partially paid

Question 22

What’s a sub-prime mortgage?

Answer 22

Mortgage lent to people who held a sub level credit score and therefore a greater than average risk of defaulting on the loan

Question 23

What was securitisation?

Answer 23

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

Question 24

What are 3 main arguments for allowing Lehman Brothers to fail in 2008?

Answer 24

• Adverse selection
• Moral hazard
• Network effect

Question 25

Describe adverse selection in the context of Lehman Brothers failing

Answer 25

Any underwriting by the government means investors take less care

Question 26

Describe Moral Hazard in the context of Lehman Brothers

Answer 26

If firms know they will be bailed out then they will take on more risk for the return

Question 27

Describe the network effect in the context of Lehman Brothers

Answer 27

Lehman was part of a complex network-mark to market would ensure any failure would be transmitted quickly

Question 28

Why did Argentina default in 2001?

Answer 28

• 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