Tutorium 2 Flashcards
Define a credit crisis
Sharp reduction in lending, bc. financial institutions face difficulties
Credit crisis —> Housing sector
Hh. can‘t get loans –> can‘t buy houses
–> housing demand down
–> house prices down
Crisis: some borrowers might not be able to repay loans
—> have to sell their houses —> housing supply up
—> house prices down
credit crisis —> labor market
Firms can‘t get loans —> stop investing and hiring
—
Credit crisis —> public finance
unemployment up —> state has to pay social benefits
—> economic activity down and tax revenues down
—> uncertainty: interest rates on state debts go up
—> costs for the gov‘t up
—> Bailout of large companies
—> gov‘t has to rescue companies & economy
—> fiscal stimulus (subsidies for a new car, etc.)
Why: long-term unemployment worse than short-term ue.
Short-term:
• can be beneficial for the match between firms and employees
long-term
• long-term makes it harder to find a job (skills get lost)
• expected wages down
Definition: Recession (from NBER)
NBER= National Bureau of Economic Research
recession= GDP declines for at least 2 consecutive quarters
Definition: Asset price bubble
Prices of an asset (houses, stocks, gold) become over-inflated and are not supported by underlying demand
interest rate —> fundamental value of an asset
Negative correlation.
Interest rates tells, how much future payments are discounted. The more you discount them, the lower the fundamental value.
r(f) = 5%
house value = 100.000 $
What is the rental revenue?
5% * 100.000 = 5000/year
Definition: Asset price bubble
Prices of an asset (houses, stocks, gold) become over-inflated and are not supported by underlying demand
interest rate —> fundamental value of an asset
Negative correlation.
Interest rates tells, how much future payments are discounted. The more you discount them, the lower the fundamental value.
r(f) = 5%
house value = 100.000 $
What is the rental revenue?
5% * 100.000 = 5000/year
rents = 3.000 / year
r(f) = 0%
house value in t(1) = 100.000$
What is the NPV?
(3000/1,0^1) + (100.000/1,0^1) = 103.000
rents = 3000/year
r(f) = 3%
house value in t(1) = 100.000
What is the NPV?
(3000/1,03^1) + (100.000/1,03^1) = 100.000
Bond: T = 1 C = 10$ V = 100$ r(f) = 10% default rate = 1%
What is the NPV?
NPV = (10/1,1^1) + (100/1,1^1) - 100*0,01 = 99$
Bond: T = 1 C = 10$ V = 100$ r(f) = 10% default rate = 1%
—> trades at present value 99$
What is its return?
0,99 * (110-99) + 0,01 * (0-99) = 9,9
in %: (9,9/99) = 10%
Mortgage backed security:
T = 1
collateralized: only interest payments can be lost
based on 2 different mortgages: T = 1 rent = 10.000 value = 90.000 default rate = 10% r(f) = 5% —> risk uncorrelated
NPV of this MBS?
Case Probability
no default 0,9 * 0,9 = 0,81
one default 0,9 * 0,1 = 0,09
two defaults 0,1 * 0,1 = 0,01
expected payments:
0,81 * 2 * (90.000 + 10.000) —> no default
+ 2 * 0,09 * (90.000 + 90.000 + 10.000) —> one default + one d.
+ 0,01 * 2 * 90.000 —> two defaults
= 198.000
198.000 / 1,05^1 = 189.000
Mortgage backed security:
T = 1
collateralized: only interest payments can be lost
based on 2 different mortgages: T = 1 rent = 10.000 value = 90.000 default rate = 10% r(f) = 5% —> always default together
NPV of this MBS?
expected payoff:
0,9 * 200.000 + 0,1 * 180.000
= 198.000
198.000 / 1,05^1 = 189.000
Mortgage backed security:
T = 1
collateralized: only interest payments can be lost
based on 2 different mortgages: T = 1 rent = 10.000 value = 90.000 default rate = 10% r(f) = 5%
What is the probability of ending up with less money than invested?
(correlated and independent risk)
independent risk:
one default: 90.000 + 90.000 + 10.000 = 190.000 > 189.000
two defaults: < 189.000
—> 1%
correlated risk:
—> 10%
How can decrease in asset prices be amplified through borrower‘s balance sheet?
Decline in asset prices —> worse balance sheet —> no chance to buy more assets —> demand for assets down —> asset prices decrease further
small shock to the balance sheet of the bank —> bankrupt
Creditors believe, that other creditors will be worried
—> stop funding this bank
—> bankruptcy
Definition:
The originate and distribute bank model
• banks do not keep the loans in their own balance sheet
—> sell them to e.g. funds
—> receive new money for new loans —> don‘t have to use own capital
• the funds package multiple loans to a portfolio, distributed by risk
How does the originate and distribute model affect the incentive of a bank, to monitor its borrowers?
They have less incentives to monitor,
bc. they won‘t be affected by failures of loans they originated
Advantages of repackaging loans into new securities
- enables banks to increase the diversification of portfolios
- increases capital ratio if the securities receive a good rating
- selling the securities makes new money, that can be used for safer projects —> diversification
- fit the products better to risk preferences of different investors
2 mortgages: each pays 100 every period default rate = 10% —> new security: junior tranche + senior tranche: each pays 100 defaults independent
What does a risk neutral investor pay?
junior tranche only pays out, when no mortgages default
—> probability 90% * 90% = 81%
expected payoff: 81% * 100 = 81
2 mortgages: each pays 100 every period default rate = 10% —> new security: junior tranche + senior tranche: each pays 100 —> default together
What does a risk neutral investor pay?
junior tranche pays out, when no mortgages default:
—> probability 90% (default together)
—> willingness to pay 90
senior tranche pays out, when no one defaults (bc. if both default, it does not pay out and they default together)
—> 90% —> willingness to pay 90
If investors think, risk is uncorrelated but they are correlated, they overpay for senior tranches and underpay for junior tranches
2 tranches, risk is correlated.
BUT: investors think, it is uncorrelated.
Who wins, who loses?
investor in the junior tranche wins. his asset is less risky than he initially thought. The investor in the senior tranche loses, the security is riskier than he thought.
How can securitization increase the leverage of a bank?
Securitization creates safer securities (e.g. AAA rated)
—> they have lower capital requirements
—> bank can increase its debt and thus its leverage
Definition: overnight repo
Security with one-day maturity. Owner of an asset sells his asset and promises to buy it back the next day at higher price
—> equivalent to short-term securitization loans
Pro‘s and con‘s of short-maturity financing
pro:
•cheaper
con:
•need to finance more often
—> higher risk that you will not be able to refinance and thus be short of funds (maybe in a crisis)
Why did rating agencies rate structured mortgages too optimistically?
- get higher fees for these products and so may give better ratings to ensure, they don‘t lose the business
- mortgages defaults were historically low (bc. the lending standards were better)
- they offered consulting services together with the ratings
—> incentives to give the grade they promised
-they believed that mortgage defaults were independent from each other
-high competition among rating companies —> rating shopping
housing boom –> erosion of lending standards
Why is this not sustainable?
banks believe that house prices are going to keep increasing —> can recover the amount lent by selling the built house later in case of loan default
sustainablity:
mortgages with teaser rates (subprime credits with high rates): borrowers will have to pay a higher interest rate & erosion of lending standards
—> likely to default —> more houses will be foreclosed (Zwangsvollstreckung) —> housing supply increases —> prices drop
—> the housing boom is creating a behavior among bankers, that can‘t sustain the housing boom
Bank buys:
100 assets with 80 debt and 20 equity.
Asset value drops to 90.
Banks want to keep leverage —> sell assets
Assets 100
Liabilities 80
Equity 20
—> Asset value decreases:
Assets 90
Liablilities 80
Equity 10
—> preserve capital ratio of 20%
sell 40 assets
Assets 50
Liablities 40
Equity 10
—> capital ratio: 10/50 = 20%
Bank buys:
100 assets with 80 debt and 20 equity.
Asset value drops to 90.
Banks want to keep leverage —> raise equity
preserve capital ratio of 20% —> raise 10 equity
Assets 90+10
Liabilities 80
Equity 20
Why do margins go up when asset prices drop?
asset prices drop –> higher volatility
—> investors are uncertain about the future value of the collateral (Gesamtheit)
—> lenders expect prices to further drop
—> higher margins (even though the low price could be seen as a buying opportunity)
small shock to asset prices —> gets bigger by increasing the incentives of bankers to hoard (anhäufen) liquidity
bankers anticipate future difficulties to obtain funds —> hoard liquidity
—> can‘t finance other profitable projects (bc. money is saved)
—> lower demand for assets —> prices decrease
