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Level 15

Financial Crises


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Financial crises
Major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms
financial liberalization
the elimination of restrictions on financial markets and institutions , or when major financial innovations are introduced to the marketplace.
credit boom
when financial institutions expand their lending at a rapid pace. A rapid growth of credit will likely outstrip the information resources leading to overly risky lending.
deleveraging
a process that when financial institutions cut back on lending.
asset-price bubble
asset prices, in the stock market and real estate, can be driven well above their fundamental economic values by investor psychology "irrational exuberance"
debt inflation
occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firm's net worth because the increased burden of indebtedness
Subprime mortgages
are mortgages for borrowers with less than stellar credit records.
Alt-A mortgages
are mortgages for borrowers with higher expected default rates than prime (A-paper)
Securitization
Unbundling and repackaging of hard-to-trade financial assets into more liquid, negotiable, and marketable financial instruments (or securities).
originate-to-distribute
a business model for the subprime mortgage market in which the mortgage was originated by a separate party, typically a mortgage broker, and then distribute to an investor as an underlying asset in security.
financial engineering
the development of new, sophisticated financial instruments products
structured credit products
products that are derived from cash flows of underlying assets and can be tailored to have particular risk characteristics that appeal to investors with differing preferences.
collateralized debt obligations (CDOs)
paid out cash flows from subprime mortgage-backed securities in different tranches, with the highest-rated tranch paying out first, while lower ones paid less if there were losses on the mortgage-backed securities.
emerging market economies
economies in an earlier stage of market development that have recently opened up to the flow of goods, services, and capital from the rest of the world and are particular vulnerable
financial globalization
a process of liberating financial institutions and markets by eliminating restrictions on just serving domestically and opening up their economies to flows of capital and financial firms from other nations.
three stages of crises
stage one-initiation of financial crisis
stage one
initiation of financial crisis
stage two
banking crisis
stage three
debt deflation
increase in demand for credit
increase in interest rate caused by
increase in interest rate causes
# bad credit risks to increase
banks must raise funds externally
as interest rate increases and CF decrease
bank panic
multiple banks fail simultaneously
debt deflation
substantial unanticipated decline in price level sets in, leading to a further deterioration in firm's net worth because of the increased burden of indebtedness (because denominated in foreign currency)
shadow banking system
non-depository financial firms such as hedge funds, investment banks etc.
haircuts
lenders requiring larger amounts of collateral
decline in lending meant
both consumption expenditure and investment fell, causing a sharp contraction in the economy
stage one-initiation of financial crisis
stages of financial crisis in emerging market economies
currency crisis
stage two EME
stage three EME
full-fledged financial crisis
historically low interest rates
factors that led to home ownership mania
media said
flip that house
if people couldn't afford a house
if they couldn't make a down payment and/or couldn't afford to make payments, the idea "housing prices never fall" encouraged them to buy anyway
home ownership mania
idea that "housing prices never fall" led to
sub-prime loans led to
banks collecting bad loans which they pooled together and renamed them collateralized debt obligations which were then sliced and diced into more CDO's
overbuilding of homes
mania over home ownership led to
too many homes led to
housing prices falling, mortgages worth more than homes themselves, homeowners can't pay mortgage, default
because of default on homes
banks don't get paid and therefore fail (Lehman Brothers and Washington Mutual) or almost fail (gov buys FM&FM and AIG, Merrill Lynch bought by Bank of America, and Wachovia bought by Wells Fargo)
banks don't lend money
because banks don't get paid
Stage 1
Economic Boom: 1982-2007
Stage 2
Soaring Wealth
stage 3
greed and excess
stage 4
policy blunders
HUD
housing and urban development
community reinvestment act
enacted in 1977 by Jimmy Carter
Gramm-Leach-Bliley Act
financial services modernization act
commodity futures modernization act of 2000
exempted derivatives from regulation, supervision, trading on established exchanges, and capital reserve requirements for major participants
net capital rule
SEC regulation that requires broker-dealers to maintian "net capital" so that liabilities incurred by broker-dealer doesn't exceed a certain % of their net capital or of a specified % of the aggregate of transactional mo…
net capital
net worth adjusted by certain deductions for illiquid assets and reserves against possible market losses on securities positions
The Great Moderation
remarkable decline in the variability of both output and inflation
benefits of lower volatility
of inflation: improves market functioning, makes economic planning easier, and reduces resources devoted to hedging inflation risks
stage 5
financial innovation
subprime borrowers
heightened perceived risk of default because things like history of loan delinquency or recorded bankruptcy
loans are divided into
tranches (more senior ones being paid first)
adjustable rate mortgages
hit a record
stage 6
the bubble bursts
stage 7
reality hits
public and private
yields on 20 yr bonds
treasury's guarantee program
temporary guarantee program to protect SH of money market mutual funds
3 month interest rates: public and private
as recession hit, yields on short term debt fell sharply, but then started to climb back up and yield spread between commercial paper and t-bills widened, especially for financial commercial paper
QE1
FDIC invest up to 250 billion in banks
Stage 8
more bad policy
stimulus
unemployment with stimulus significantly higher than estimated unemployment without stimulus
thoughts on improving market
first factor behind improving market is sequestration(less gov spending)
federal gov debt
in 232 years-10.63 trillion
growing tax burden at top
poor now vote themselves money from the rich
government remedies
Sarbanes0oxley act: est oversight board to supervise, inc SEC's budget for supervisory activities, limited consulting rel b/t auditors and firms, enhanced criminal charges for obstruction, improbed quality of financial stmts and board
stage 9
sustained slump
employment
from 2007, it has taken 55 months for employment to recover
how long will it take us to get back to full unemployment
As pop grows, labor force tends to grow, we have more jobs just to keep unemployment rate from rising. If we added 503,000 jobs a month, we could get back to 5% unemployment in 2…
productivity growth
unemployment situation would be diff if productivity were still rising at healthy rates, then the fewer people at work each producing a lot more would be good for firms' profits. that's not the case. …
recovery
much slower today than after GD
stage 10
good times
Stock
Capital raised by a corporation through the issue of shares entitling holders to an ownership interest (equity).
Capital Gain
an increase in the value of an asset
Realized asset
the gain that occurs when the owner of an asset when the owner of an asset actually sells it for more than she paid for it
Dow Jones Industrial average
an index based on the stock prices of 30 actively traded large companies. The oldest and most widely followed index of stock market performance.
NASDAQ
An index based on the stock prices of over 5000 companies traded on the NASDAQ Stock market. The NASDAQ market takes its name from the national association of securities dealers automated quotation system.
Standard and Poors 500
an index based on the stock prices of 500 of the largest firms by market value.
stabilization policy
describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible.
Gramm-Rudman- Hollings Act
1986 Bill passed by congress and signed by Reagan to respond to the deficit. Set target for reducing deficit by a certain amount each year
Automatic Stabliizer
revenue and expenditure items in the federal budget that automatically change with the economy in such a was as to stabilize gdp
Automatic destabilizer
revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize gdp
Debt Crisis of the 1980s
in August of 1982 Mexico announced that it could no longer meet its debt obligations
Brady Plan
-Plan to approach 1980s debt crisis
debt reduction through the Brady plan
Factors that lead to the lending boom in the 1990s
What happens with sudden drops in KA in emerging markets?
With the sudden stops of these flows, there end up being a large selling of foreign exchange due to the equation
Generation 1 crises
excessive fiscal deficits that are money financed (or likely will be money financed in the future); monetary policy is inconsistent with a fixed exchange rate, leading to an eventual speculative attack
Generation 2 crises
models with self-fulfilling expectations (multiple equilibria)
Generation 3 crises
models of crony capitalism and moral hazard
Argentina Crisis of 2001
large rise in fiscal debt even during large rise in growth
contagion
crisis in one country spills over into the others
raise interest rates or devalue their currency
What to do when faced with a sudden stop in capital inflows
there is no perfect exchange Rate regime
What is the best exchange rate regime to avoid financial crises
currency board
like a central bank, but with only foreign exchange reserves on the asset side of the balance sheet
Strengthening of Financial Regulatory Policy
it is important to regulate banks such that they don't borrow in one currency (the dollar) and lend in another (the local currency). this can cause bank defaults when the currency depreciates or is devalued
Fiscal and Monetary Policy
the standard advise given by the IMF is conservative fiscal and monetary policy
Capital Controls
it may not be optimal to open up the capital account (remove controls particularly on capital inflows) when the domestic financial sector is not well regulated
risksharing across countries
Benefits from international capital mobility
Role of IMF
to lend to countries with "temporary" balance of payments problems and provide temporary liquidity
TARP
Troubled Asset Relief Program: Hastily built program to buy out toxic assets from banks but really just injected liquidity into financial sector.
Iceland Crises
Lots of borrowing and lending, international borrowing of Euros, currency transformation, run on icesave, it becomes nationalized
PILLAR I
No buckets, banks can use CRAs, international banks can assess own risk
PILLAR II
Regulators must review bank's self-assessed risk
PILLAR III
Banks must be transparent
Basel III
Flexible capital ratios, increased tier 1, macro prudential countercyclical buffer, short term and long term capital requirements
Problems with Basel II
Pro cyclicality and Easy to avoid with OBS and SIV, only microprudential
Counterpressure, avoidance, evasion
Ways Fed policy can be avoided
What was the stress test program called?
SCAP: Supervisory Capital Adequacy Program: see if banks have adequate capital, run scenarios, banks must correct, spanish banks failed, didn't do much to stock prices
Too Big to Fail
Mentality that banks are too big to not be protected by the government, regulatory forbearance, economies of scale
Regulatory Forbearance
Regulators' refraining from exercising their right to put an insolvent bank out of business, creating zombie banks
Zombie Banks
Failing banks that take risky loans, if they fail, they're gone anyway, if they're paid back they'll come back to life
Policies that tried to end TBTF
FI recovery, reform, enforcement act gave all duty to the FDIC. FDIC Improvement act ended regulatory forbearance, categorized banks. Yet this was all micro-prudential.
Proposed policies to end TBTF
Volker Rule: separate investment and commercial banks to prevent proprietary spending. Liikanen wants separate legal entities of same company. Vicor wants separate them within the same company.
2010 act to set pattern for financial system
Dodd Frank, Wall Street Reform and Consumer Protection Act
What did Dodd Frank try to promote?
Protect the consumer from predatory lending, protect the taxpayer from bailouts, financial stability, end TBTF, improved accountability and transparency
Name some minor provisions of Dodd Frank
Established Bureau of Consumer Financial Protection, Federal Insurance Office, government accountability office, increase FDIC protection, anti-predetory lending standards, eliminated TARP
Name some major provisions of Dodd Frank
Establishment of FSOC: Financial Stability Oversight Council, increased capital requirements, Living wills established, Volker rule, Collin's Amendment, CDS go through clearing houses first with open info, swap push-out rule, Skin in the game, Hedgefunds clo…
Collins Amendment
Major Provision of Dodd Frank: that says the Fed can supervise all Financial Institutions
Swap push-out rule
Major Provision of Dodd Frank: Fed will not bail out CDS
FSOC: Financial Stability Oversight Council
Major Provision of Dodd Frank: ID SIFIs and regulate them
Skin in the Game
Major Provision of Dodd Frank: Derivative issuers must maintain 5% interest in credit risk
Compensation reform
Major Provision of Dodd Frank: No bonuses rewarded that encourage excessive risk, clawback bonuses, bonuses give throughout organizations
Role of the board of directors
Provide vision, recruit and supervise executives, representation/networking, many talents
Qualities of a CEO
Vision, insight loyalty, decisiveness, insight confidence from the board
London Whale
JP Morgan trader who lost $6 billion hedging in a proprietary trading scheme that made no sense, no one questioned it.
Chief Risk Officer
Monitors risk, must have staff and compensation. Fuld (Lehman) was evil, never let CRO in meetings, overoptimistic, Blankfein (Bear Stearns) was great, listened to lower levels
Why did Canada Survive?
Had a financial oligopoly based on social norms, one regulator, large capital ratio wit no OBS items, people and banks didn't like risk or subterfuge, holistic approval of loans, mortgage interest not tax deductible, originate to hold
Why was management failing?
Board members and CEOs were ignorant, FIs too complex to manage, CROs ignored,
Is everything better now?
No. A lot of success based on luck, REMICS (BMS) being made, regulations just breed subterfuge
Southeast Financial Crises
Real estate bubble in Thailand, borrowing lots of Euros, lending Bhat bubble burst, people want Euros back, central bank didn't have enough ฿, People run on system, confidence contagion, Euros expensive, IMF bailout provided liquidity, created flexible credit line.
Northern Rock
England lending from non-deposit sources, securities not doing well, liquidity shortage, little deposit insurance, cause a retail run on the bank, BoE and Treasury announced deposit insurance and nationalized good assets.
Debt Flow
Debt flows smaller than domestic capital flows
Advantages of external debt:
Augment domestic savings to add to investment, quick, no foreign ownership issues, no profit repatriation, can stabilize balance of payments shocks.
Disadvantages of external debt
Debt must be paid even when a project is not profitable, too much debt can lead to foreign capital withdrawals and to financial crises.
Stock of debt:
value of debt outstanding
Debt service:
principal and interest due in a given period
GDP, exports, government tax revenue
Capacity to pay is indicated by:
External transfer problem:
generating enough foreign exchange to pay external creditors
Internal transfer problem:
collecting enough tax revenue to enable the government to pay the country's external debt
Debt overhang:
debt is so heavy that making payments on it reduces growth of the economy thus making it even harder to repay the debt
Refinancing:
replace old debt with better terms
Rescheduling:
change maturity date of existing loans
Reduction:
partial or complete forgiveness of debt
Buyback:
debtor buys back some of the debt at a discount over face value
Debt for Equity swap:
replace some debt with partial ownership of a firm by the creditor(s)
moral hazard
the risk that one party to a transaction will engage in behavior that is undesirable from the other party's point of view
Free rider problem among lenders
a borrower may be able to repay each lender a fraction of the amount owed but each lender will not agree to restructure the debt hoping to collect a higher fraction of the amount owed at
Brady Plan:
two options
Paris club:
informal group of creditor governments. Provided debt
The Highly Indebted Poor Countries (HIPC) initiative:
Reduction of debt of low income countries' debt to multilateral organizations (World Bank, IMF, African Development Bank) to NPV of debt/export ratio of 150% provided they met goals of pro-growth reforms and poverty reduction policies
Financial crises:
involve large sudden reversals of international capital flows (foreign capital flows out). When the crisis breaks out there is a
Rational panic:
investors withdraw their assets from an otherwise healthy economy if they believe other investors will do the same.