Lecture 2

• The 2008 Financial Crisis saw an increase in US mortgage delinquencies in 2007 and 2008, triggering financial crises
• Subprime mortgages were given out, interest rates rose, many borrowers began defaulting, and there was a sharp drop in the value of securities backed by these mortgages
  • The housing market boomed, driving up inflation, leading to an increase in the federal funds rate to control it
  • Mortgages with floating rate coupons became more expensive, leading to higher default rates

Market Freeze

• In 2008 financial markets froze
• The collapse of mortgage-backed securities and related derivatives led to significant losses for financial institutions worldwide
• Uncertainty grew and trust in financial institutions fell, leading to a liquidity crisis
• Institutions hoarded cash, unwilling to lend to each other, freezing financial markets

Corporate Paper

• Difficulty in rolling over corporate paper occurred
• Commercial paper is a type of short-term, unsecured debt, with a short maturity, issued by corporations to finance immediate financial operations
• This is typically a very liquid market
• Investors were wary about purchasing commercial paper, due to distrust in financial institutions and fear of solvency issues, leading to a credit crunch
• Even financially well companies faced difficulty in getting short-term funding

Disappearance of Credit Markets

• As the crisis escalated, broader credit markets contracted
• Lending standards were increased, resulting in little credit availability for consumers and firms, causing widespread economic fallout, layoffs, bankruptcies, and recession

Government Intervention

• Governments needed to bail out large companies, guarantee liabilities, and purchase struggling assets

Causes of the 2008 Financial Crisis

• Excessive optimism
• Financial institutions and investors were excessively optimistic about risk and asset prices
• The low-interest rate environment and changes in the financial landscape masked the extent of leverage and risk
• Lack of market oversight and sufficient supervision
• Excessive risk-taking or accounting of interconnectedness of regulated and non-regulated activity occurred
• Due to a fragmented regulatory structure and legal constraints on information sharing
• Weaknesses and differences existed in national and international solutions to the crisis
• Limitations of existing mechanisms for central bank liquidity support

Regulatory Reforms 10 Years After the 2008 Financial Crisis

• There was a forced overhaul of global financial regulatory architecture
  • New tools, standards, and practices were implemented
• A new global agenda emerged
• Less leverage, more liquid, and better supervision
• Basel III: capital and liquid accords, and the adoption of stress testing
• Shadow banking was curtailed with stricter regulatory oversight
• Shadow banking increased the spread of systemic risk
• Macroprudential authorities were established, responsible for the oversight of financial systems stability
• There was more intensive bank supervision and improved bank resolution regimes
• Lower government bailout expectations

Human Behavior & Home Values

• Risky financial practices happened under the assumption the market would continue its upward trajectory
• Complacency and optimism were prevalent
• Irrational exuberance caused investor enthusiasm to drive asset prices up to levels above fundamental value, leading to asset bubbles
• "Animal spirits" are the psychological drivers compelling individuals and markets to act irrationally
• Overly optimistic asset valuations and underestimation of risks
• There was herd mentality where institutions and investors kept investing in rising markets, despite warnings, due to the actions of others and fear of missing out
• There was a failure to anticipate risk
• Warnings were ignored, and ongoing successes led people to believe that growth was sustainable, underplaying associated risks
• There were Career concerns
  • Herd behavior
• Prioritizing short-term gains to conform with market trends
• Prioritizing reputation of success over prudent analysis

Politics

• Bond spread: the difference in yield between two bonds, indicating their relative risk
• Yield: the annual return on an investment, expressed as a percentage of the bonds current price (interest payments and difference between par value and principal)
• Euro zone bond spread: the introduction of the euro was expected to minimize the likelihood of default of eurozone countries
• Lower risk premiums were required for holding bonds from countries like Italy or Spain, narrowing the yield difference between German bonds and their bonds
• The financial struggles in Greece challenged these ideas and introduced systemic risk to the euro
• Political actions affecting the ability to pay back increased political risks
  • Increased spreads after the Lehman brothers' collapse

Share of Defaults per Country

• The default history of a country reflects its political willingness to honor debts
• Political crises can increase the probability of default
• Politics stability affects investor confidence, while policy decisions inherently affect the default risk
• The push for deregulation of the market by the Regan administrations increased excessive risk taking
• Leaders would make confident public statements, which were often overly confident leading to widespread perception of stability, making the public and markets more complacent
• Significant economic downturns happened even after reassurance from officials
• There was an effect on timely recognition of economic threats
• Credit default swap: a financial derivative that allows the transfer of risk of default on a debt to another party, acting as insurance against default
• Used accessibly for speculation, so when going unchecked it led to excessive leverage
• Institutions that sold CDS didn't have enough capital to cover them in case of widespread defaults, amplifying systematic risk

Global Economy & Economic Indicators

• Purchasing Manager's Index is an economic indicator of the health of the manufacturing and service sector
• During the financial crisis PMI was low (red), after which there was a gradual return to green
• Central banks implemented strong monetary and fiscal policies, and quantitative easing during the recovery period, moving PMI from red to green
• Long-term investment can yield substantial returns despite periods of uncertainty and volatility, based on the fundamental strength of the economy
• Focus on long-term growth instead of short-term uncertainties
• Long Term Refinancing Operations (LTRO): a monetary policy by the ECB to provide liquidity to the banking system, providing long-term funding to struggling banks to stabilize the banking system and ensure liquidity
• Outright Monetary Transactions (OTM): A policy tool by the ECB, allowing for sovereign bonds of Eurozone member states to be directly bought by the ECB in the secondary market
• A commitment to do whatever it takes to preserve the euro
• These interventions helped lower yields in response to the euro crisis
• Core tier 1 capital: a measure of a bank's financial strength including common equity, retained earnings, and disclosed reserves. It is measure of banks' ability to withstand financial stress and absorb losses without collapsing
• Increased core tier 1 capital ratio, now banks have a higher ratio of equity and retained earnings relative to risk weighted assets
• They are able to withstand downturns better and reflects effective regulatory measures such as Bassel III
• There has been almost $30 Trillion in global stimulus, with the U.S. leading the charge this cycle versus China during the GFC
• Increasing global stimulus used, especially in the US, led to a significant growth in public debt
• The US faces high levels of national debt, which may contribute to inflationary pressures, raising interest rates
• The threat of interest payments becoming the largest part in the US budget, reducing financial flexibility and straining the federal budget
• Banks are buying more and more securities, highlighting the increasingly important role in financial markets through quantitative easing
• There is increased debt globally
• The Covid crisis causing a further sharp build-up of debt
• Inability to deal with economic shocks occurred where countries with high debt levels, may not be able to deal with economic shocks, such as rising prices or fall in revenue, as they struggle to meet debt obligations
• Reduced fiscal ability happened with more resources being used to pay debt obligations, leaving less to use in other fiscal matters
• Interest rate sensitivity increased where with high debt levels countries become more sensitive to interest rates, as an increase in interest rate can increase the coupon payments significantly
• Increased debt may crowd out private investments due to high borrowing costs or reduced credit access
• Crowding out is a decrease in private sector investments due to increased government spending, where the government borrows money, increasing the demand for loanable funds
• This increases interest rates, making it more expensive for private investors to borrow

Importance of Financial Interconnectedness

• These concerns are especially important with the growing interconnectedness of the globe, affecting debt obligations and global financial market ripples
• Markets need some fear of loss to work, otherwise we face issues of irrational exuberance and moral hazard, affecting banks and excessive risks

Inside Job

• Iceland privatized its economy and borrowed significantly more than the economy
  • Money used for yachts etc
  • Aaa credit rating given
• In 2008 the banks collapsed, tripling the unemployment, many people lost all their savings.

History of Deregulation

• During the Reagan administration in the 1980s there was deregulation of financial markets
  • Whistleblowers about the need for regulation in the financial derivatives market were shut down by the government and congress
• Commodity futures modernization act banned the regulation of derivatives Collateralized debt obligations (CDOs) allowed for lenders to be more reckless on who to give mortgage loans to involving home buyers
• Bubble:
  • Since anyone could get a mortgage, real estate prices skyrocketed and lenders Investment banks and investors gave high risk morgages to borrowers with bad credit
  • Credit rating agencies assigned high ratings to assets even though they knew they are bad
  • Financial institutes like investment banks would have large leverage borrowed to magnify results

Crisis & Accountability

• Credit default swaps were unregulated
• AIG would simply give out the money in bonuses instead of saving the money in case the CDO went bad
• Employees would be aware about these investments being bad but would still go forth with it
• Many industry experts were giving warnings and alerting of possible bubble burst, without the issue being taken seriously at the time
• The 2007 housing bubble burst and value of subprime mortgages plummeted, leading to major losses for financial entities
• Moody's gave many of these firms triple or double credit ratings days before their stock plummeted
• The collapse of Lehman Brothers marked the start of financial crisis and led to collapse of commercial paper
• All money invested in hedge funds was lost
• In 2006, Bush signed a 700 billion USD bailout bill
• AIG had to be bailed out, using billions of USD and Goldman Sachs had to be bailed out with tens of billions
• But this bill did little to address the underlying issue
• US cuts spending affected the entire world
• Chinese imports plummeted-
• Many US citizens lost their homes, jobs, savings.
• The ceo resigned and did not take responsibility
• Economists moving into other sectors created conflicts of intrest
• This system of conflicts of interest underminded the integrity of regulatory frameworks
• Average Americans became less educated and prosperous.
• Obama spoke of the need of increased regulation
• There ended up weak, especially in the areas of rating areas and swaps and reformers were already had involvement in the financial crisis
• Overall, there was no reform, and no criminal prosecutions towards the large players.