Fundamentals of Financial Markets, Institutions, and the 2008 Crisis - PDF

**Fundamentals of Financial Markets and Institutions** **09.01.2025 -- Lecture 2** [The 2008 Financial Crisis:] 1. **In 2007 and 2008, there was an increase in US mortgage delinquencies (the inability to make payments on time) -\> triggered financial crisis.** - Subprime mortgages...

**Fundamentals of Financial Markets and Institutions** **09.01.2025 -- Lecture 2** [The 2008 Financial Crisis:] 1. **In 2007 and 2008, there was an increase in US mortgage delinquencies (the inability to make payments on time) -\> triggered financial crisis.** - Subprime mortgages given out -\> interest rates rose -\> many borrowers began defaulting -\> sharp drop in value of securities backed by these mortgages. - As the housing market boomed, it drove up inflation, to control these federal funds rate increased. - Mortgages with floating rate coupons consequently became a lot more expensive leading to higher default rates. 2. **In 2008 the financial markets froze.** - The collapse of mortgage-backed securities and related derivatives led to significant loses by financial institutions worldwide. - As uncertainty grew, trust in financial institutions fell. - This led to a liquidity crisis, where institutions hoarded cash and were unwilling to lend to each other -\> freezing of financial markets. 3. **Difficulty in rolling over corporate paper** - Typically, this is a very liquid market. - Investors were wary about purchasing commercial paper due to distrust in financial institutions and fear of solvency issues -\> credit crunch, where even financially well companies faced difficulty in getting short-term funding. 4. **Disappearance of credit markets** - As the crisis escalated, broader credit markets contracted, lending standards were increased, and there was little credit availability for consumers and firms. -\> widespread economic fallout, layoffs, bankruptcies and recession. 5. **Government intervention** - Governments would need to bail out large companies, guarantee liabilities, purchase struggling assets. [Why did it happen?] 1. **Excessive optimism** - Financial institutions and investors were excessively optimistic about risk and asset prices. - The low-interest rate environment and changes in financial landscape masked the extent of leverage and risk. 2. **Lack of market oversight and sufficient supervision** - Allowed for excessive risk-taking or accounting of interconnectedness of regulated and non-regulated activity. - Due to fragmented regulatory structure and legal constraints on information sharing. 3. **Weaknesses and differences in national and international solutions to the crisis.** 4. **Limitations of existing mechanism for central bank liquidity support** [Regulatory reforms 10 years after] - Forced an overhaul of global financial regulatory architecture. - New tools, standard, practices implemented. - New global agenda: less leverage, more liquid, better supervision. - *Basel III*: capital and liquid accords, adoption of stress testing. - *Shadow banking curtailed*: stricter regulatory oversight on shadow banking. - Shadow banking increases spread of systemic risk. - *Macroprudential authorities*: bodies responsible for oversight of financial systems stability. - *More intensive bank supervision*. - *Improved bank resolution regimes*. - Lower government bailout expectations. [Why did nobody notice it?] A graph showing the value of home values Description automatically generated 1. **Human behaviour** - Complacency and optimism. - Risky financial practices were continued under the assumption the market would continue its upward trajectory. - Irrational exuberance: investor enthusiasm drives up asset prices up to levels above fundamental value, leading to asset bubbles. - "animal spirits", the psychological drivers compelling individuals and markets to act irrationally. - *Overly optimistic asset valuations and underestimation of risks.* - Herd mentality. - Institutions and investors kept investing in rising markets, despite warning, due to the actions of others and fear of missing out. - Failure to anticipate risk. - Ignored warnings, due to momentum mindset -\> ongoing successes led people to believe the growth was sustainable -\> underplaying associated risks. - Career concerns. - Herd behaviour. - Prioritizing short-term gains to conform with market trends. - Prioritizing reputation of success over prudent analysis. 2. **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 likelihood of default of eurozone countries. - Lower risk premiums were now required for holding bonds from countries like Italy or Spain. Narrowing the yield difference between German bonds and their bonds. - These ideas are however challenges by for example the financial struggles in Greece. -\> also introduced systemic risk to euro. - During the financial crisis, political actions which affect ability to pay back, increases this spread. (As seen by increased spreads after the Lehman brothers' collapse). A screenshot of a computer Description automatically generated Default history: - The default history of a country reflects its political willingness to honor debts. - Political crisis can increase probability of default. Politics stability affects investor confidence, while policy decisions inherently affect the default risk. In relation to the financial crisis, we can look at the Regan administrations effect on regulation of the financial markets. - The push for the deregulation of the market, increased excessive risk taking. 3. **The "official truth"** - Leaders would make confident public statements which were often overly confident. - Lead to widespread perception of stability, making the public and markets more complacent. - Even after reassurance from officials, there was significant economic downturn. - Affect 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 an insurance against default. - Used in the GFC 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 -\> amplified systematic risk. [How do we get out?]  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. - During the recovery period central banks implemented strong monetary and fiscal policies, and quantitative easing -\> moving PMI from red to green. Warren buffet's perspective. - Long-term investment can yield substantial returns despite periods of uncertainty and volatility, based on the fundamental strength of the economy. - It suggests we should have a steady consistent approach to investing - Focus on long-term growth instead of short-term uncertainties. A graph of a graph of the crisis Description automatically generated with medium confidence Long Term Refinancing Operations (LTRO): a monetary policy by the ECB to provide liquidity to the banking system. - 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. - Able to withstand downturns better. - Reflects effective regulatory measures such as Bassel III. [Issues we are facing today] A graph of the global stimulus Description automatically generated with medium confidence Increasing global stimulus used, especially in the US -\> significant growth in public debt. - Is the current economic growth sustainable? - If debt is cut, how does it affect consumer spending and asset prices -\> could it cause another recession.  - The US faces high levels of national debt, these may contribute to inflationary pressures -\> raising interest rates. A graph of a graph showing the amount of debt Description automatically generated with medium confidence - Threat of interest payments becoming the largest part in the US budget. -\> reducing financial flexibility, straining federal budget. Global trends:  Banks are buying more and more securities, highlighting the increasingly important role in financial markets through quantitative easing. - Increased debt globally. - Covid crisis causing a further sharp build-up of debt. Why are these concerns? 1. Inability to deal with economic shocks. - 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. 2. Reduced fiscal ability. - With more resources being used to pay debt obligations, it leaves less to use in other fiscal matters. 3. Interest rate sensitivity - With high debt levels countries become more sensitive to interest rates, as an increase in interest rate can increase the coupon payments significantly. 4. Inflationary pressures 5. Economic growth constraint - Increased debt may crowd out private investments due to high borrowing costs or reduced credit access. - Crowding out: a decrease in private sector investments due to increased government spending. - Governments borrows money, this increases the demand for loanable funds, this increases interest rates, making it more expensive for private investors to borrow. These concerns are especially important with the growing interconnectedness of the globe. Where if one country is unable to pay debt obligations, it may have ripple effects on the global financial markets. Markets need some fear of loss to work, otherwise we face issues of irrational exuberance and moral hazard. Where banks take excessive risks knowing they will be bailed out in case they fail. [Notes on Inside Job] Iceland privatized its economy and borrowed significantly more than the economy. - People would use the money for personal use, like buying apartments, yachts, etc Auditors gave it a triple Aaa credit rating. In 2008 the banks collapsed, tripling the unemployment, many people lost all their savings. [Part One: How We Got Here] - During the Reagan administration in the 1980s there was deregulation of financial markets. - There were whistleblowers about the need for regulation in the financial derivatives market, however these 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. - Home buyers -\> lenders -\> investment banks -\> investors [Part Two: The Bubble] - Since anyone could get a mortgage, real estate prices skyrocketed. - High risk mortgages were given to poor credit borrowers. - Credit rating agencies assigned high ratings to assets even though they knew they were toxic. - Financial institutes like investment banks would take on large amounts of leverage (borrowing to amplify results). - Credit default swaps were unregulated; therefore, AID would simply give out the money in bonuses instead of saving the money in case the CDO went bad. - Investment banks would bet against their customers, by buying credit default swaps. They would even sell bad CDOs, the more went bad the more money they would make. - Employees would be aware about these investments being bad but would still go forth with it. [Part Three: The Crisis] - Many industry experts were giving warnings and alerting of possible bubble burst and recession but somehow it seemed to not be taken seriously. - In 2007 the housing bubble burst, value of subprime mortgages plummeted, leading to major losses for financial institutes invested in them. - Moody's gave many of these firms triple or double a credit ratings days before their stock plummeted. - The collapse of Lehman Brothers marked the start of financial crisis. - Led to collapse of commercial paper - All money invested in hedge funds, etc was lost - In 2006, Bush signed a 700 billion USD bailout bill. - AIG had to be bailed out, using billions of USD, 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 plummet, many migrant workers became unemployed. - Singapore had an amazing previous year, then imports plummeted. - Many US citizens lost their homes, jobs, savings. - Many of the CEOs were able to resign and were able to walk away with millions of USD. [Part Four: Accountability] - Many of those responsible for the crisis do not take accountability, even though there is clear evidence. - There are close ties between Wall Street and policy makers. - There is also an issue of economists moving into lucrative roles in the private sector or taking on additional consulting roles. - This systematic conflict of interest undermined the integrity of regulatory frameworks [Part Five: Where We Are Now] - There were some reforms such as tax cuts but being a real estate tax cut, mainly benefiting the top 1%. - Inequality of wealth in the US has only gone higher. - Average Americans became less educated and prosperous. - Obama spoke of the need of increased regulation, but the reforms ended up being weak, especially in the areas of rating areas and credit default swaps. - He ended up picking people who were all involved in some way in causing the financial crisis. - Overall, there was no reform, and no criminal prosecutions towards the large players.