week 3: crises

Question 1

4 important financial criseses before 1900s?

Answer 1

• The Crisis of 33 AD
• The Great Debasement (1544-1551)
• Tulip Mania 1637
• South-Sea / Mississippi Bubbles (1719-1720)

Question 2

The Liquidity Crisis of 33 AD

Answer 2

In 33 AD, under Emperor Tiberius, regulatory measures on real estate loans and reduced public spending led to a money shortage and credit contraction, threatening Rome’s financial system. Banks, owned by the rich individuals, faced issues as borrowers sold land to comply with regulations, causing real estate prices to plummet. Runs on banks worsened liquidity issues. The economy was saved from total collapse by injecting interest-free loans.

Question 3

What is debasement?

Answer 3

intentionally devaluing currency

Question 4

The Great Debasement (1544-1551)

Answer 4

Throughout history, government have rely on debasement of their
currencies in order to financially gain at the expense of the citizens.

Governments historically devalued their currencies by reducing the precious metal content in coins, allowing them to produce more currency but diminishing its purchasing power. Henry VIII and Edward VI oversaw a series of such devaluations from 1544 to 1551, benefiting the government at the expense of citizens’ purchasing power.

Question 5

Tulip Mania 1637

Answer 5

Originally, demand for the flower picked up as a result of scientific
interest in the bulbs. However, from around 1630 bulbs became
attractive financially. In 1636 and early 1637 there was a frantic
trade in tulips.
Countless people with no prior interest in the flower invested in
tulips, some of them even putting up their homes as collateral so that they can get funds to finance their investment.

In February 1637 the market crashed with adverse consequences for many investors.

Question 6

South-Sea / Mississippi Bubbles (1719-20)

Answer 6

Both events were preceded by a new type of financial innovation; namely, the exchange of government debt for private equity.

In Britain, the South-Sea Company gained monopoly rights in South Seas trade in exchange for assuming government debt, while in France, John Law’s bank supported government finances by acquiring the Mississippi Company, which held exclusive colonization rights in Louisiana.

Both the South-Sea Company and the Mississippi Company issued shares to cover the corresponding government debts.
The shares of the former rose dramatically during the first half of 1720, remained flat till September and then crashed.
The shares of the latter rose fast in 1719 and early the following year. The bubble burst in the Spring of 1720.

Question 7

POST 1900 FC’s? [4]

Answer 7

• Crash of 1929 / Great Depression
• Black Monday, 19 October 1987
• Southeast Asian Twin Crisis 1997
• DotCom Bubble 2000

Question 8

What Happened Before the great depression?

Answer 8

In the 1920s, a speculative boom fueled by rapid economic growth led to a surge in all sectors of the economy.

Profits of 536 manufacturing and trading companies increased by 36% in the first half of 1929, enticing many Americans to heavily invest in the stock market.

With investors borrowing $8.5 billion to invest in stocks, share prices soared, creating a speculative bubble.

However, the stock market peaked on September 3, and as economic indices began to decline, investor confidence fell.

Question 9

Irving Fisher commenting on stock prices on 16 October 1929:

Answer 9

“…reached what looks like a permanently high plateau.’

Question 10

24 October 1929 – ‘Black Thursday’ the Dow Jones declined by _%

Answer 10

2%

Question 11

28 October 1929 – ‘Black Monday’ Dow Jones declined by __%

Answer 11

13

Question 12

29 October 1929 – ‘Black Tuesday’ Dow Jones declined by a further __%

Answer 12

12

Question 13

July 1932 – the market reaches its nadir; total decline __%

Answer 13

89%

Question 14

November 1954 – Dow Jones __________

Answer 14

November 1954 – Dow Jones reaches its 1929 peak

Question 15

What happened after the Great Depression?

Answer 15

A collapse in aggregate demand, driven by a lack of consumer + investor confidence and a drop in aggregate liquidity

The effect on the labour market was disastrous

More than 20% unemployment estimated

Question 16

What happened on Black Monday?

Answer 16

19 October 1987: BLACK MONDAY

**A decline of more than 20% in various U.S. stock market indices. **

Question 17

Causes of decline on Black Monday generally?

Answer 17

Problems with the microstructure (organization, operations) of these markets and not with economic fundamentals.

Question 18

What were the three main problems identified with the microstructure causing the Black Monday decline?

Answer 18

1. Margin Calls
2. Program Trading
3. Information Acquisition

Question 19

What are Margin Calls, why was it a problem?

Answer 19

Investors can borrow funds to buy shares by posting the shares as collateral. When there is a drop in the price of shares the value of the collateral decreases. Lenders will then ask borrowers to repay part of the loan. During a crisis margin calls can exaggerate any already in place liquidity problems.

Question 20

What is Program Trading why was it a problem?

Answer 20

A great bulk of trading is automatically done by computers that have been programmed, for example, to sell after prices have dropped below a certain level.

Question 21

What are Information Acquisition Problems?

Answer 21

Markets work efficiently when trades reflect new information. However, during a panic traders follow the actions of other traders thus reinforcing the decline of prices which thus cease to reflect economic fundamentals.

Question 22

Southeast Asian Twin Crisis | 1997

Answer 22

For several decades before the crisis, economies in Southeast Asia experienced high economic growth + moderate inflation.

From second half of 1980s, also had increases in stock prices and land values.

Furthermore, many banks and corporations in the region relied on short-term foreign loans for financing their operations.

Question 23

What was the Crisis in Thailand?

Answer 23

As a result of a series of external shocks, e.g. the devaluation of the Chinese remnimbi and the Japanese yen and the sharp decline in semiconductor prices → export revenues sharply dropped → led to slowdown of economic activity + severe declines in asset prices.

In Thailand, these developments put downward pressure in the
foreign exchange market ending with the collapse of the Thai baht in July 1997.

Question 24

What does regional contagion have to do with the thailand currency crisis?

Answer 24

The events in Thailand were followed by a wave of currency depreciations and stock market declines affecting the other economies in the Southeast Asian region.

Question 25

1998 → value of most affected East Asian currencies fell ______ % against the $, and the most serious stock declines were
as great as 40-60%.

Answer 25

35-83%

Question 26

The adverse effects on bank and firm balance sheets in Thailand (currency mismatch and maturity mismatch) led to..?

Answer 26

to widespread bankruptcies and a sharp decline of credit flows.

→ economic activity in the region collapsed.

Question 27

Answer 27

Question 28

What happened before the DotCom bubble?

Answer 28

Before
Well-established corporations are listed on the New York Stock
Exchange (NYSE). Young, innovative and promising firms have
their shares traded at NASDAQ.

The prices of the shares of many companies listed in the latter
started growing in the late 1990s. At that time access to the
internet was greatly expanded and offered new opportunities to
companies to do business (online retailing).

It generated expectations of high future profits ⇒ thus a large demand for the shares of such companies which inflated their share prices.

Question 29

The stock values of many large tech companies grew from around
_______ points in 1995 to more than ______ in 2000.

Answer 29

1,000 -> 5,000

Question 30

The increased stock values and prices also encouraged firms to ‘_________’

Answer 30

go public;

(to enter the stock market by issuing stock and offering it for sale;
initial public offerings (IPOs)).

Question 31

Internet companies are able to raise funds by what?

Answer 31

Selling their stock at prices above the initial valuations.

Question 32

2000 was a decade of______ inflation, ___ interest rates _______ growth

Answer 32

Low inflation, low interest rates, steady growth

Question 33

But what happened in 2008 leading to the financial crisis?

Answer 33

• Savings Glut (accumulation of reserves by China, Japan and oil-exporting countries)
• Foreign Capital Inflows financing the U.S. Trade Deficit
• Credit Boom (excessive lending supported by a loose monetary policy)
• U.S. Saving Rate fell from 6% to 1% of Disposable Income
• U.S. Debt-to-Disposable Income Ratio rose from 75% to 120%
• Housing Bubble

Question 34

‘Too Big to Fail?’ A very concise history of financial (de)regulation: [3]

Answer 34

1933 | Glass-Steagall Act
1986 | ‘Big Bang’: Complete deregulation of the UK financial system
1999 | Abolition of the Glass-Steagall Act

Question 35

What was the 1933 Glass-Steagall Act?

Answer 35

In 1933, the Glass-Steagall Act separated commercial banking from investment banking. This meant that banks couldn’t do both types of banking at the same time. The reason behind this was to make sure that people who put their money in banks felt safe. Commercial banks take people’s deposits and lend them out, so if they also took on risky investments like investment banks do, it could put people’s money at risk. By keeping them separate, the government could protect people’s deposits.

Question 36

What are the 4 main components of a firm, financially?

Answer 36

o Balance Sheet
o Income Statement
o Cash Flow Statement
o Retained Earnings Statement

Question 36

What does ‘too big to fail’ mean?

Answer 36

“Too big to fail” is a concept referring to financial institutions that are deemed so large and interconnected with the broader economy that their failure could have catastrophic consequences for the financial system and the economy as a whole. The notion suggests that because these institutions are so big, their collapse would cause widespread disruptions, leading governments to intervene to prevent their failure.

During the global financial crisis of 2007-2008, several banks and financial institutions were considered “too big to fail,” and governments around the world provided bailouts and other forms of support to prevent their collapse. This included institutions like AIG, Citigroup, and Bank of America in the United States, among others.

Question 37

What does a typical firm balance sheet look like?

Answer 37

Question 38

What does a bank balance sheet look like?

Answer 38

Question 39

What is insolvency?

Answer 39

Total assets are less than liabilities - equity.

or Negative equity

Question 40

What is the leverage ratio for some major companies?

Answer 40

Leverage ratio: Liabilities/Equity

• Apple Computers: <1
• RBS: 18.8
• Barclay’s 61.3
• US Banks: 35
• UK Banks: 41

Question 41

On average (US) it takes _______ of a bank’s assets go bad, for the bank to go bust.

Answer 41

1/35

Question 42

On average (UK) it takes _____ of a bank’s assets go bad, for the bank to go bust.

Answer 42

1/41

Question 43

Incentives and bail-outs

Answer 43

1. Depositors vs Shareholders

Depositors, concerned about the safety of their money.
Shareholders, focused on maximizing profits.

2. Upside risk vs Downside risk and moral hazard

Upside risk for shareholders and downside risk for depositors.
Moral hazard, where bailouts can encourage risky behavior.

3. Management compensation (bonuses)

Management compensation, which can incentivize short-term gains over long-term stability.

4. Political risks – TBTF

Political risks, particularly with institutions deemed “too big to fail,” where governments may bail them out to prevent systemic collapse, despite the potential for moral hazard.

Question 44

what was the US bail out cost after financial crisis?

Answer 44

7.76 trillion

Question 45

break down the 7.76 trillion us bail out

Answer 45

Marshall Plan: The Marshall Plan was a U.S. initiative to aid Western Europe economically after World War II. Its cost, adjusted for inflation, was around $150 billion.

Louisiana Purchase: The acquisition of the Louisiana Territory from France in 1803. Adjusted for inflation, its cost was approximately $15 million. This is an incredibly small fraction of the bail-out cost.

1980s Savings and Loan Crisis: The Savings and Loan Crisis in the 1980s cost taxpayers around $124 billion (adjusted for inflation). While significant, it is still substantially less than the bail-out cost.

Korean War: The Korean War, fought from 1950 to 1953, cost the U.S. government approximately $67 billion (adjusted for inflation). Again, this is significantly lower than the bail-out cost.

New Deal: The New Deal, a series of programs and reforms implemented during the Great Depression, cost the U.S. government around $500 billion (adjusted for inflation). While sizable, it is still much smaller than the bail-out cost.

Invasion of Iraq: The cost of the Iraq War, including both direct and indirect costs, is estimated to be around $2.4 trillion. This is a substantial amount but still less than the bail-out cost.

Vietnam War: The Vietnam War, which lasted from 1955 to 1975, cost the U.S. government approximately $1 trillion (adjusted for inflation). Again, this is much lower than the bail-out cost.

Total Cost of NASA: The total cost of NASA from its inception to the present day is estimated to be around $1.2 trillion (adjusted for inflation). While significant, it is still considerably less than the bail-out cost.