Week 11- Financial crisis Flashcards
What is the long-term context of the financial crisis (in which it developed)?
- gradual liberalisation and globaisation flows starting in mid-1970s
- development of new financial instruments anfd new banking model starting in the 1980s
- Light financial regulatory regime and shadow banking starting in 1980-90s
What is the medium term context of the financial crisis (in which it developed)?
1) The “Great moderation” period
‐ A period of stable macroeconomic conditions by
historical standards: stable growth, low inflation and low
interest rates
‐ This prolonged stability fuelled expectations of
continued stability boosting supply and demand for
credit in developed countries
‐ Also contributed to the continuation of a “relaxed”
regulatory environment, trusting the self‐regulation of
the financial industry
2) Global imbalances
• Large US current account deficit, large external debt and weak
dollar
• Low savings rates in the US and high in Asian countries
• Large China and oil exporting countries’ current account surpluses and related substantial accumulation of reserves (assets)
What led to the global credit boom? What is the credit boom?
- very low US interest rates and low inflation
- rising Us house prices and stock prices (bubblle)
‐ Large increase in leveraging and borrowing in industrialised countries
‐ Large increase in households’ debt
‐ Increase of global liquidity
=> created a greater global financial interdependence (free flowing capital)
What is customer funding gap?
The customer funding gap is the difference between customer lending and customer deposits. In this context, “customer” has a wide meaning, referring to all non-bank borrowers and depositors. This gap as fallen by over £600 billion since the onset of the crisis. It has also fallen as a percentage of customer loans
What was the consequence of the credit boom?
-Credit boom leads to “search for yield”
Consequences:
A. Leverage to obtain higher returns and greater dependence on overseas funding (ore riskier instruments to increase yield and returns together with a lot of leverage)
B. Excessive risk taking
• Reckless lending (US sub‐prime mortgages)
• Securitisation and mispricing of risk
C. Compounded by inaccurate ratings by credit rating
agencies
What are subprime mortgages?
- low credit-quality mortgages (risky)
- no documentation
- teaser rates (to encourage first few years very cheap, then becomes variable interest rate that can be very high) and interest rates only (all the remaining capital at the end)
- “no income, no job, no asset” mortgages
Note: in the US, mortgage interest rates are tax deductible, but rent is not, this is an incentive to borrow for housing
Other factors leading to the crisis?
- rapid expansion of banks’ balance sheets
- “originate and distriute” banking model: securisation and structured products (incentives to create new instruments)
How is the traditional banking model like?
• Bank collects deposits and lends
• Loans held by banks until maturity
• Loans with either:
– Fixed interest rates: high interest rate risk for lender
as interest rates may increase
– Flexible interest rate: lower interest rate risk for lender, but higher credit risk (borrower may become unable to repay)
What is the originate and distribute model like?
Securitization
• Rather than deposits, source of funding is borrowing from other banks (high leverage)
• Rather than keeping and monitoring mortgages and other debt contracts, these are sold to other institutions who pool them and create new securities ‐ collateralised debt obligations (CDOs)
• In turn these securities are “sliced”into tranches with different risks and sold as new securities
What are the consequences of the bursting bubble?
‐ Defaults in US sub‐prime mortgages
‐ Breaking down of securitisation markets
‐ Uncertainty in valuations due to complexity and
opaqueness of instruments and interdependence of
financial institutions
‐ Trust breaks down, fear of counterparty (default) risk,
loss of confidence in credit ratings
‐ Banks stop lending to each other, liquidity dries up
Describe the beginning of the crisis
July– August 2007: German bank IKB and BNP Paribas reveal difficulties related to US subprime
market
‐ September 2007 bank run on UK bank Northern Rock, nationalised in Feb 2008
‐ Governments intervene to provide funds and liquidity and to guarantee deposits
Site the major events of 2008
‐March: Bear Stern defaults and is bought by JP Morgan for $10/share
‐September:
‐ Fannie Mae and Freddie Mac effectively nationalised
‐ Lehman Bro defaults and is not rescued
‐ Merrill Lynch defaults and is bought by Bank of America
‐ Sharp drop in banks’ stock prices
‐ Stress transmitted to money markets and credit derivatives contracts
‐ International system‐wide “fragilities”
‐ Widespread government interventions to provide liquidity, recapitalise
banks and lower interest rates to mitigate deep recession
What are the 6 functions of the financial system?
- Transferring resources across time and space
- Managing risk
- Clearing and settling payments
- Pooling resources and subdividing shares
- Providing information
- Dealing with incentive problems
Explain the mis-functioning of the functions during 2007-2009
- Easy geographical transfer of resources enhanced interdependence and
“contagion” - Excessive risk‐taking and mispriced risk
- With fear of counterparty risk, gridlock of clearing and settling of payments
- Pooling of instruments, e.g. loans, resulted in opaque instruments and
mispriced asset‐backed securities - Information may be difficult to extract if trading and pricing not possible
- Incentive problems arose with respect to large financial institutions;
uncertainty on how much weight to give to moral hazard, e.g. Lehman
Bro’s default
How is the traditional housing financing?
surplus units / saver => banks => deficit units / borrowers
• Mortgages held by banks until maturity
– Fixed interest rates loans
– Flexible interest rate loans
