Lecture 2 - Financial Market History

Question 1

What are the three kinds of financial crises?

Answer 1

Banking crises - erosion of capital in the system.
Financial market - stock market crisis, it falls in value.
Currency crises - forced change in parity, abandonment of a peg, or international rescue.
They are often intertwined.

Question 2

Why do financial crises matter?

Answer 2

• There are wealth effects (because of monetary losses).
• They cause inefficient use of resources (because prices are unreliable).
• They affect the real economy.

Question 3

What are the “costs” of financial crises?

Answer 3

Direct - costs of recapitalising a bank.

Indirect - costs of below trend growth (or falls) in GDP.

Question 4

Explain the effects of the financial crisis globally.

Answer 4

• Cumulative losses in GDP worldwide due to the 2007/08 crisis was $4,700 billion.
• The total worldwide reduction in stock market capitalisation was $26,400 billion.

Question 5

Explain the effects of the financial crisis in the UK.

Answer 5

GDP fell by 5.5% between 2008Q1 and 2009Q2.

Question 6

Explain the effects of the financial crisis in the US.

Answer 6

• GDP was falling at an annual rate of 7%.
• The S&P500 share index fell by 40%.
• Household wealth fell by $trillions.
• Was losing around 630,000 jobs per month.
• Money market liquidity dried up.
• 12 of the 13 largest US financial institutions were at risk of failure.

Question 7

Summarise the major financial crises.

Answer 7

• The 2007/2008 financial crisis.
• The 1987 stock market crash.
• The 1998 downturn in UK stock market.
• The early 21st century bear market (“dot-com crash”).

Question 8

The long term economic factors that caused the financial crisis of 2007/08 were…

Answer 8

• Perceptions that economic and financial risks had reduced.
• Global savings glut.
• Current account (BoP) imbalances.
• Low real interest rates.
• Housing market boom and increase in household indebtedness.

Question 9

The long term technological and deregulatory factors that caused the financial crisis of 2007/08 were…

Answer 9

• Behaviour of financial institutions.
• Financial innovation.
• Mispricing of risk.

Question 10

1) Perceptions among investors and economic agents from 2002 onwards that economic uncertainty and financial market risks, especially credit risk, had fallen.

Answer 10

• Most developed economies had relatively stable and growing macroeconomics outlooks post the millennium dot com bubble and the 9/11 attacks.
• Increasing globalisation increased opportunities for global sharing of risks.
• Financial market deregulations and developments contributed to an increase in financial market liquidity.

Question 11

2) Global savings glut.

Answer 11

• Increase in precautionary saving.
• A rise in savings ratios in emerging economies after the 1997/98 Asian crisis.
• Increasing oil prices boosting the wealth of oil exporting economies.
  The savings ratio in China was especially high due to:
• Reduced public spending on health and education.
• Low levels of social security provision.
• Increase in commodity prices boosting national income.
• Revenues from exporting to the world.

Question 12

3) Global current account (of balance of payments) imbalances.

Answer 12

The emerging economies, taking advantage of their low production costs, that were exporting goods to the developed economies built up huge current account surpluses (value of exports > value of imports). At the same time, the developed economies built up huge current account deficits.

Question 13

4) Low real interest rates.

Answer 13

The global savings glut in and the capital flows from emerging economies led to sustained downward pressure on interest rates.

Question 14

5) The housing market and consumer indebtedness.

Answer 14

Lower interest rates reduce the cost of credit and much of this cheaper credit was used to purchase housing. Between 2000 and 2005, US house prices (and indeed house prices in other developed economies) rose faster than they had done in the previous decade and a half. Since the 1990s, consumers had become more comfortable with being in debt and so spend now rather than saved to spend. Desire for new tech. Household debt in the US as a proportion of disposable income rose from 96% in 2000 to 128% by 2008. Mortgage debt averaged $91,500 in 2001 but $149,500 in 2007. Housing represented 30% of consumer wealth and consumption represents 70% of GDP (US data).

Question 15

Economic factors - encouragement to borrow.

Answer 15

In 2004, Bush’s “zero equity” mortgage proposals helping low income families to obtain mortgages.
The US government encourages consumer indebtedness to give consumers a feeling of increased wealth.
Mortgage interest payments in the US are fully tax deductible. The UK enjoyed this benefit from 1969 until 2000 when it was removed by the chancellor, Gordon Brown.

Question 16

Economic factors - subprime lending.

Answer 16

“Subprime” refers to mortgage loans made to home buyers with weak credit. Some of these loans were made to naïve buyers who faced severe difficulties in making interest and principal payments.
After 2000, lenders began to issue sub-prime first mortgages, by relaxing their lending standards. This increased the demand for housing, pushing up house prices. Rising house prices meant that lenders losses would be covered if borrowers defaulted. However, as house prices rose, lenders had to relax their lending standards still further so that borrowers could still afford to borrow. Research shows that mortgage borrower quality declined between 2000 and 2006. In 2006, there was $421 billion in new sub-prime mortgages granted. By 2007, the total of sub-prime mortgages was $1.4 trillion. However, this is only 20 percent of the total of US mortgages. This is not especially large a percentage, what made “sub-prime” an issue was the way in which the mortgages were securitised and distributed around the financial system.

Question 17

Technological and Deregulatory causes - Financial Institution Characteristics and Behaviour - income seeking and regulatory arbitrage.

Answer 17

During the 1990s, responding to the deregulation of financial markets, the nature of banking changed. Retail (deposit taking) and investment banking (IPO management) were increasingly within the same institution. In 1999, the previously enforced separation of retail and investment banking in the US was removed allowed US banks to compete strongly with their more deregulated European counterparts.
The focus in banking turned to maximising (their own) shareholder wealth, and banks began to do this through trading income (from buying) and fee income (from selling) newly created financial products.

Question 18

Technological and Deregulatory causes - Financial Institution Characteristics and Behaviour - leverage.

Answer 18

Rather than relying solely on securitisation fee income, IPO fee income and retail deposits to finance their trading activities (purchases of financial investment products, including the recently innovated ones), banks began to borrow heavily in the wholesale markets (market for short term money, e.g., LIBOR). So they had primarily long term assets (mortgage-products) financed by short term borrowing (LIBOR). This presents the risk of banks facing a liquidity shortage.
Pre-crisis levels of leverage had reached 97.5% (2.5% capital reserves) (a 40:1 ratio) for many financial institutions

Question 19

Technological and Deregulatory causes - Financial Institution Characteristics and Behaviour - interconnectedness.

Answer 19

Financial institutions were interconnected, because they were selling the securitised assets to other banks including overseas.
Financial flows became interconnected because of the integration of economies and the removal of capital controls. The interconnectedness spread the opacity of the balance sheets.
Even in 2014, 80% of global investment banks derivatives exposure was to other investment banks.

Question 20

Technological and Deregulatory causes - Financial Institution Characteristics and Behaviour - loose lending standards.

Answer 20

The availability of cheap borrowing, because interest rates were low, and the ability to securitise the loans, allowed a loosening of lending standards, which would then lead to an increase in fee income.

Question 21

Technological and Deregulatory causes - Financial Innovation - search for yield.

Answer 21

Increase in demand for safe assets with a rate of return greater than Treasury bonds, led to the creation of Asset Backed Securities.
Financial institutions liked them because of the fee income that they earned.

Question 22

Technological and Deregulatory causes - Financial Innovation - securitisation.

Answer 22

Fundamentally a good idea as it improves risk allocation, but
The complexity creates opacity. It reduces lending standards, because the risks could be sold on.

Question 23

Technological and Deregulatory causes - Financial Innovation - asset backed securities (ABSs).

Answer 23

Instead of borrowing money directly, companies sometimes bundle up a group of assets and then sell the cash flows from these assets. This issue is known as an asset-backed security or ABS. Cash flows of ABSs are allocated into tranches. The ratings were negotiated with the ratings agencies, so the aim was to try to put as many of the underlying securities into the Senior tranche without it losing its AAA rating.
By mid-2008, 60% of all US mortgages were securitised.

Question 24

Technological and Deregulatory causes - Financial Innovation - collateralised debt obligations (CDOs).

Answer 24

Instead of issuing one class of bond, a pool of mortgages can be bundled and then split into different slices (or tranches) know as collateralised debt obligations or CDOs. Even the mezzanine grade CDO would have a “supposedly” senior (i.e., AAA rated) tranche. 
However, because their rate of return would be higher than other AAA rated instruments (presumably reflecting the added risks), they were extremely popular, because they continued to get a AAA rating. Safe assets with a high expected return!

Question 25

How did the senior tranches of mezzanine CDOs manage to get a AAA rating?

Answer 25

• Failure of ratings agencies to understand that a pool of mortgages does not represent diversification!
• Ratings models were based on expected loss (Moody’s) or probability of a given loss (S&P).
• In both cases, this ignores the full information about the distribution of potential losses. It is easy to “fix” an estimate of an average by manipulating the constituents of a sample.

Question 26

Technological and Deregulatory causes - Financial Innovation - credit default swaps (CDSs).

Answer 26

A credit default swap, or CDS, is an insurance contract against the default of one or more borrowers. The purchaser of the swap pays an annual premium (like an insurance premium) for protection from credit risk. These are an OTC (over-the-counter) derivatives contract based on a reference asset, for example, a mortgage-backed ABS or CDO.
CDSs and all OTC derivatives were exempt from regulation, which contributed to their popularity and huge growth. Even though CDSs are insurance contracts, by not calling them this, they became unregulated! They required little or no collateral, though usually it was posted. CDOs and CDSs were priced on the basis that changes in the value of the underlying assets were normally distributed when in fact the chances of extreme events were much higher. This meant that they were cheap, and continued to be cheap even after house prices began to fall.

Question 27

Technological and Deregulatory causes - Mispricing of Risk.

Answer 27

An AAA-rated instrument is supposed to have a 1 in 10,000 probability of default in a 10 year period. In 2008/09, over 50% of all AAA-rated sub-prime ABSs defaulted in whole or in part. There was asymmetric information (adverse selection), where sellers knew far more than buyers about the quality of the underlying assets. (The reverse for CDSs). Ratings agencies relied on the fees from providing ratings, and there was competition among them (better ratings awarded, more fee earned). The ratings agencies thought that a portfolio of mortgages brings diversification.
ABSs and CDOs are difficult to value, so risks were under-estimated.

Question 28

The Unfolding Crisis (Proximate Causes).

Answer 28

From early 2006, there are growing mortgage delinquencies, falls in house prices. The defaults reduced the value of the securitised assets. This reduces the value of the collateral that financial institutions are posting against the short term borrowing. To make up the collateral financial institutions have to sell more assets, reducing their price and reducing their value as collateral. Same assets held by other banks will decline in value too, which increases perceptions of counterparty risk in the system. The high leverage in the banks made them very vulnerable to the asset price falls and the drying up of liquidity. Also many of the same banks that had invested heavily in mortgage CDOs, were also willing to sell CDSs. Many banks began to sell assets to rebuild their capital ratios, which further led to asset price falls.

Question 29

What were the economic consequences of the crisis?

Answer 29

The financial crisis caused a global recession due to the drop in confidence and aggregate demand. The crisis reversed some of the forces that had led to the crisis.
- There was a repatriation of capital back to the emerging and oil exporting economies.
- The reduction in aggregate demand in developed economies reduced their imports. - House prices reduced.
- The savings ratios increased.
While a decline in the $ would have helped discourage the influx of foreign capital, the US $ increased in value, as US investors were also repatriating capital.
Falls in oil prices have also helped the global imbalances. However, in 2015, the largest 15 global investment banks still owned 90% of the open derivatives contracts.

Question 30

What economic policy prescriptions were made?

Answer 30

• Boost aggregate demand.
• Build up FX reserves.
• Impose capital controls.
• Avoid protectionism and capital controls.

Question 31

What banking policy prescriptions were made?

Answer 31

• Prevent a banking collapse.
• Establish creditor coordination.
• Increase data disclosure and transparency.
• Introduce deposit guarantee schemes.
• Separate good and bad assets (within banks).
• Recapitalise good banks.

Question 32

Policy prescriptions - Financial Instruments and Institutions.

Answer 32

• Originators of ABSs and CDOs should be forced to keep a share of each tranche so that they understand the full extent of the risks and their interests are aligned with those who have purchased the tranches.
• ABS and CDO contracts should be defined using maths and numerical examples of potential scenarios as well as just with words.
• More research to build better pricing models for CDOs.
• Risk management models must recognise that correlations increase during stressed market conditions.
• All transactions should be collateralised.

Question 33

What happened to the UK?

Answer 33

• Recapitalisation of the banking sector.
• Unconventional monetary policy.
• Review of financial regulations.

Question 34

What was the Stock Market Crash of 1987?

Answer 34

On the 19th October 1987, one week short of the anniversary of the Big Bang (refers to the UK stock market deregulation in 1986), equity markets around the world began to fall sharply. In the U.K., the FTSE 100 index fell by 11% on the 19th and a further 11% on the 20th. However, the magnitude of such falls was not unusual; a fall in market values of 25% was experienced in 1974.
What was unusual was the speed with which prices fell and that the crash spread through the world’s equity markets.

Question 35

The background to the crash - the reverse yield gap.

Answer 35

Usually, shares, being more risky, secure a greater rate of return (yield) than bonds. Security yields are inversely related to their prices. The bullish market had caused equity prices to rise so much that their yields were now much lower than those on bonds.
The fact that rising equity prices were reducing the demand and hence the price of bonds, meant that simultaneously, bond yields were rising, compounding the problem.

Question 36

The background to the crash - the emergence of world wide ‘bull’ markets - UK.

Answer 36

The Big Bang refers to the UK stock market deregulation in 1986. Big Bang increases efficiency, lower costs, increases competition and boost volumes.
Wider share ownership, increasing competition, liquidity and “media” interest. British business was well out of the slump of the early eighties, profit forecasts were high and dividend payouts were meeting or exceeding expectations.

Question 37

The background to the crash - the emergence of world wide ‘bull’ markets - US.

Answer 37

A long run of low domestic interest rates boosted the attractiveness of shares.
The increase in mergers and leveraged buy-outs had pushed up share values. LBO refers to take-overs financed by borrowing secured on the (usually very risky) future profits of the captured firm. The low value of the dollar relative to the Japanese yen caused a considerable inflow of investment funds in the US from Japan.

Question 38

The background to the crash - the emergence of world wide ‘bull’ markets - Japan.

Answer 38

• The general buoyancy of the economy.

- The high propensity to save among the people of Japan.

Question 39

The background to the crash - the emergence of world wide ‘bull’ markets - Hong Kong.

Answer 39

At that time, the Sino-British agreement over the future of the colony was seen as sufficient to ensure the potential for rewarding long term investment.

Question 40

The events immediately before the crash.

Answer 40

The twin deficit problem (budget and current account) in the US. The consequence of running a payments deficit is downward pressure on the currency which made financing by the capital account more expensive. To avoid expensive capital account financing, the US had come to rely on foreign governments to buy dollars and US goods. If at any time this support was not forthcoming, the only strategy remaining to support the dollar was a rise in domestic interest rates. This would raise the cost of finance for US firms, reduce their profits and cause a reduction in expected dividends and hence share prices. Thus the US had become a barometer of the relationship between the US and other countries’ economic policies, rather than a barometer of US expected company performance. Any significant discord between the US and foreign governments was bound to be hazardous for US equity prices.

Question 41

Theories to explain the Stock Market Crash.

Answer 41

There are two main elements of the crash to explain:

• The speed with which prices fell on stock exchanges.
• The fact that stock markets fell world-wide.

The reasons and theories to explain the crash can be categorised into 3 groups:

• The previous rise in stock market prices, especially during the first half of 1987, represented the expansion of an unsustainable speculative bubble that burst on October 19th in the aftermath of severe down-turns on the New York Exchange during the previous week.
• Information changed rapidly. This explanation is based upon the efficient markets hypothesis, and implies that sufficient “bad” news accumulated over the weekend and during the 19th to explain the decline.
• That there was some internal market failure arising from an interaction of portfolio insurance driving down futures markets in Chicago, together with some failure of insufficiently capitalised market makers in the New York spot market.

Question 42

The 1998 downturn in the UK stock market.

Answer 42

The FTSE100 index peaked at 6197 on July 20, 1998, following 3 years of increasing rate of return, which accelerated after April 1997. The index fell 450 points across the week commencing October 20, 1997, but thereafter continued to rise. Index fell by 25 percent between July 20 and October 5, 1998.

Question 43

The 1998 downturn in the UK stock market - UK interest rates.

Answer 43

Low and lowering domestic interest rates had caused investors to switch from bonds into the shares, so pushing up their prices. The low interest rate regime came to an abrupt end with four consecutive 25 basis point rises between May and August 1997, and an additional 25 basis point rise in November 1997.

• Raised corporate cost of capital.
• Raised probability of default (FTSE100 dominated by banking sector).

Question 44

The 1998 downturn in the UK stock market - other UK economic factors.

Answer 44

• Improved capital account on balance of payments.
• Worsening current account, exports more expensive.
• Output growth began to fall, falls in unemployment began to stall.
• Inward FDI was re-assessed.

Question 45

The 1998 downturn in the UK stock market - stock market structure.

Answer 45

• Introduction of SETS on October 20, 1997.

- Much uncertainty following less than smooth trials.

Question 46

The 1998 downturn in the UK stock market - economic and monetary union.

Answer 46

• Government disagreement regarding timing of UK participation in EMU.
• Applicability of convergence criteria.
• Chancellor’s speech, “Brown Monday”.

Question 47

The 1998 downturn in the UK stock market - foreign political events.

Answer 47

• Potential presidential impeachment in the US increased general economic uncertainties.
• Political fragility in Russia, presidential ill health and government sackings.

Question 48

The 1998 downturn in the UK stock market - foreign economic events.

Answer 48

• As weaknesses were identified in the rapidly developing economies of South East Asia during the course of 1997, their currencies came under speculative attack.
• Indonesia, Thailand and Korea experienced substantial falls in real GDP, making foreign debt repayment difficult. Thai baht, the Philippine peso and the Indonesian rupiah fell, along with Korean won.
• Devaluation of the Russian rouble in August 1998, as foreign investors pulled-out.
• Capital began to leave Latin American countries, particularly Brazil and Venezuela, as fears of contagion increased.
• Even the safe haven economies were not immune from the mounting financial and economic crises as, in August 1998, LTCM a US hedge fund collapsed.

Question 49

The Pre Millennium Boom.

Answer 49

• Appreciation of the Yen, unwinding of Yen financed high risk investment following Russian Crisis.
• Falling interest rates, cuts in US, three successive cuts in the U.K. and cuts in Eurozone in anticipation of Euro.
• Technology stock boom.
• Short-run effect of rising oil prices.

Question 50

The Early 21st Century Bear Market.

Answer 50

• Technology stock valuations questioned - “Tech” indices fell up to 30 percent in early 2000.
• Long run effect of rising oil prices.
• Weakening US economy from 2000.
• Increasing profit warnings in UK from 2001 - sustained impact (9/11)
  and uncertainties relating to Iraq from 2002.