Topic 6 - International Banking and Money Market Flashcards
What is the difference between the Euronote market and the Eurocommercial paper market?
Euronotes are short-term notes underwritten by a group of international investment or commercial banks called a “facility.” A client-borrower makes an agreement with a facility to issue Euronotes in its own name for a period of time, generally three to 10 years. Euronotes are sold at a discount from face value, and pay back the full face value at maturity. Euronotes typically have maturities of from three to six months. Eurocommercial paper is an unsecured short-term promissory note issued by a corporation or a bank and placed directly with the investment public through a dealer. Like Euronotes, Eurocommercial paper is sold at a discount from face value. Maturities typically range from one to six months.
Discuss the regulatory and macroeconomic factors that contributed to the credit crunch of 2007-2008.
The origin of the credit crunch can be traced back to three key contributing factors: liberalization of banking and securities regulation, a global savings glut, and the low interest rate environment created by the Federal Reserve Bank in the early part of this decade. The U.S. Glass-Steagall Act of 1933 mandated a separation of commercial banking from other financial services firms—such as securities, insurance, and real estate. The repeal of Glass-Steagall caused a blurring of the functioning of commercial banks, investment banks, insurance companies, and real estate mortgage banking firms. Since the repeal of GlassSteagall, commercial banks began engaging in risky financial service activities that they previously would not have and which contributed to the credit crunch. The Commodity Futures Trading Commission (CFTC) was created in 1974 to oversee futures trading to guard against price manipulation, prevent fraud among market participants, and to ensure the soundness of the exchanges. Credit default swaps (CDSs), a type of OTC credit derivative security, were not regulated by the CFTC. The CDS market grew from virtually nothing a half dozen years ago to a $58 trillion market that went largely unregulated and unknown. CDSs have played a prominent role in the credit crunch. In the years leading up to the crisis, the world was awash in liquidity in recent years, much of it denominated in U.S. dollars, awaiting investment. As a result, the United States was able to maintain domestic investment at a rate that otherwise would have required higher domestic savings (or reduced consumption) and also found a ready market with central banks for U.S. Treasury and government agency securities, helping keep U.S. interest rates low. The Fed Funds target rate fell from 6 ½ percent set on May 16, 2000 to 1.0 percent on June 25, 2003, and stayed below 3.0 percent until May 3, 2005. The decrease in the Fed Funds rate was the Fed’s response to the financial turmoil created by the fall in stock market prices in 2000 as the high-tech, dot-com, boom came to an end. Low interest rates created the means for first-time homeowners to afford mortgage financing and also created the means for existing homeowners to trade up to more expensive homes. Low interest rate mortgages created an excess demand for homes, driving prices up substantially in most parts of the country, in particular in popular residential areas such as California and Florida.
What is a structured investment vehicle and what effect did they have on the credit crunch?
A structured investment vehicle (SIV) is a virtual bank, frequently operated by a commercial bank or an investment bank, but which operates off balance sheet. Typically, an SIV raises short term funds in the commercial paper market to finance longer-term investment in mortgage-backed securities (MBSs). SIVs are frequently highly levered, with ratios of 10 to 15 times the amount equity raised. Structured investment vehicles have been one large investor in MBS. Since yield curves are typically upward sloping, the SIV might normally earn .25 percent by doing this. SIVs are subject to the interest rate risk of the yield curve inverting, that is, shortterm rates rising above long-term rates, thus necessitating the SIV to refinance the MBS investment at short-term rates in excess of the rate being earned on the MBS. Default risk is another risk with which SIVs must contend. If the underlying mortgage borrowers default on their home loans, the SIV will lose investment value. Nevertheless, SIVs predominately invest only in high-grade Aaa/AAA MBS. By investing in a variety of MBS, an SIV further diversifies the credit risk of MBS investment. The SIV’s value obviously derives from the value of the portfolio of MBS it represents. To cool the growth of the economy, the Fed steadily increased the Fed Funds target rate at meetings of the Federal Open Market Committee, from a low of 1.0 percent on June 25, 2003 to 5 ¼ percent on June 29, 2006. In turn, mortgage rates increased and home prices stopped increasing, thus stalling new housing starts and precluding mortgage refinancing to draw out paper capital gains. Many subprime borrowers found it difficult, if not impossible, to make mortgage payments in this economic environment, especially when their adjustable-rate mortgages were reset at higher rates. As matters unfolded, it was discovered that the amount of subprime MBS debt in structured investment vehicles was essentially unknown. While it was thought SIVs would spread MBS risk worldwide to investors best able to bear it, it turned out that many banks that did not hold mortgage debt directly, held it indirectly through MBS in SIVs they sponsored. To make matters worse, the diversification that investors in MBS and SIVs thought they had was only illusory. Diversification of credit risk only works when a portfolio is diversified over a broad set of asset classes. MBS and SIVs were diversified over a single asset class—poor quality residential mortgages! When subprime debtors began defaulting on their mortgages, commercial paper investors were unwilling to finance SIVs and trading in the interbank Eurocurrency market essentially ceased as traders became fearful of the counterparty risk of placing funds with even the strongest international banks. Liquidity worldwide essentially dried up, creating the credit crunch.
What is a collateralized debt obligation and what effect did they have on the credit crunch?
A collateralized debt obligation (CDO) is a corporate entity constructed to hold a portfolio of fixed-income assets as collateral. The portfolio of fixed-income assets is divided into different tranches, each representing a different risk class: AAA, AA-BB, or unrated. CDOs serve as an important funding source for fixed-income securities. An investor in a CDO is taking a position in the cash flows of a particular tranche, not in the fixed-income securities directly. The investment is dependent on the metrics used to define the risk and reward of the tranche. To cool the growth of the economy, the Fed steadily increased the Fed Funds target rate at meetings of the Federal Open Market Committee, from a low of 1.0 percent on June 25, 2003 to 5 ¼ percent on June 29, 2006. In turn, mortgage rates increased and home prices stopped increasing, thus stalling new housing starts and precluding mortgage refinancing to draw out paper capital gains. Many subprime borrowers found it difficult, if not impossible, to make mortgage payments in this economic environment, especially when their adjustable-rate mortgages were reset at higher rates. As matters unfolded, it was discovered that the amount of subprime MBS debt in CDOs and SIVs, and who exactly owned it, were essentially unknown, or at least unappreciated. The diversification that investors in CDOs and SIVs thought they had was only illusory. Diversification of credit risk only works when a portfolio is diversified over a broad set of asset classes. MBS, SIVs and CDOs, however, were diversified over a single asset class—poor quality residential mortgages! When subprime debtors began defaulting on their mortgages, commercial paper investors were unwilling to finance SIVs and trading in the interbank Eurocurrency market essentially ceased as traders became fearful of the counterparty risk of placing funds with even the strongest international banks. Liquidity worldwide essentially dried up, creating the credit crunch.
What is a mortgage backed security?
A mortgage-backed security is a derivative security because its value is derived from the value of the underlying mortgages that secure it. Conceptually, mortgage-backed securities seem to make sense. Each MBS represents a portfolio of mortgages, thus diversifying the credit risk that the investor holds.
Euronote Market
Euronotes and Euronote Facilities, Euro-Commercial Paper, Euro Medium-Term Notes
Eurocredits
bank loans to MNEs, sovereign governments, international institutions, and banks denominated in Eurocurrencies and extended by banks in countries other than the country in whose currency the loan is denominated
