The Great Recession Flashcards
What is an economic bubble?
When prices of assets and securities rise above true/fundamental value
What happens once an economic bubble bursts?
Assets and security prices collapse
What is a sub prime?
A small part of US housing mortgage market intended for borrowers with a relatively high probability of not being able to pay out their loan
Explain the rapid rise in house prices after 2000.
- Long period of low interest rates incentivised house buying
- No need to raise interest rates as inflation was low
- Expectation that house prices would increase
What role did lending play in the rapid rise of house prices in 2000?
- Borrowing became easier as banks made mortgage approvals more lenient
- Households with high probability of not being able to repay gained access to loans through mortgages
Explain the origin of the recession.
- Started in the sub-prime mortgage market
- House prices stopped rising and there were increasing rates of defaults on mortgages in sub-prime markets
- When households default on mortgages the underlying properties are foreclosed and transferred to the banks
What is a solvency problem?
If the value of assets decline under the level of liabilities then banks become insolvent
What is a liquidity problem?
The bank has difficulty repaying its investors.
Describe the leverage ratio.
Assets/Capital
Describe the capital ratio.
Capital/Assets
Why is a high leverage ratio risky?
In the event of a drop in asset value, banks can become insolvent
Why did banks have such high leverage ratios prior to the crisis?
- Risk underestimation
- High bonus incentives for managers
- Regulation was lax - minimum capital ratio existed but banks found ways around it
What was securitisation?
The creation of securities based on a bundling of assets
Why wasn’t securitisation reliable?
- Diversified underlying assets should not be correlated
- Sub-prime mortgages were highly correlated - properties were located in similar bubbles and provided to borrowers with low credit ratings
- Securities were also rated very safe by credit rating agencies
Describe the shadow banking system.
- Leverage of the banking system as a whole was much higher than had been perceived
- Through SIVs banks managed to hide risks and exposure
- As of 2008, no SIVs were left
Who were American International Group?
Insurance company in the 2000s that began to sell insurance against default risk through the sale of credit default swaps
What was the benefit to banks of AIG?
Banks could now get insurance on securities they thought would potentially default
Describe how liquidity affected banks in the late 90s.
Borrowing from other banks and investors in short term debt to finance purchase of their assets.
What was wholesale funding?
Funding your purchases through short term borrowing from other financial institutions.
What occurred when housing prices declined?
- Mortgages declined
- High leverage implied a sharp decline in bank’s capital
- Banks started selling assets to rebuild capital levels
What effect did Fire Sale prices have?
- Lowered the value of other assets
- Levels of capital continued to decline
What was the credit crunch?
- Low solvency led to banks going bankrupt
- Banks that survived stopped lending to each other or anybody else
How did the financial crisis become a macroeconomic crisis?
Consumer confidence in the US declined greatly leading to a sharp fall in spending and credit
What were the three international spillover channels from the US?
1 - European banks directly exposed to the US housing market having bought securities with underlying MBSs and CDOs
2 - Trade flows contracted due to fallen demand and lack of trade credit
3 - Increased US interest rates led to increased European interest rates - firms found it difficult to borrow
What was the initial US monetary policy response?
- Cut interest rates
- Increased federal deposit insurance in order to prevent bank runs
- Provision of wide spread liquidity to the financial system
What was the initial European monetary policy response?
- Cut interest rates
- Unlimited liquidity for European banks at a fixed interest rate of maturities up to a year
- Purchase of covered bonds by the ECB
How did governments use fiscal policy in response initially?
- Replaced private demand with public demand
- Tried to replace the fall in private consumption and investment with higher gov spending
What were the limits to these policies?
- Central banks of major advanced economies has decreased interest rates to zero
- The Fed turned to credit/quantitative easing
Why was the recovery so slow on the supply side?
- The banking crisis had decreased the natural level of output
- The expectation was not to go back to the level pre crisis
Why was the recovery so slow on the demand side?
Policy interventions were limited
