Financial Crisis Theory Notes PDF

FIM THEORY SUMMARY Chapter 8: Financial Crisis Financial crises are major disrupBons in financial markets characterized by a sharp decline in asset prices and firm failures. The basis for understanding of a financial crisis is the study of moral hazard and adve...

FIM THEORY SUMMARY Chapter 8: Financial Crisis Financial crises are major disrupBons in financial markets characterized by a sharp decline in asset prices and firm failures. The basis for understanding of a financial crisis is the study of moral hazard and adverse selecDon. Although there are many regulaDons trying to eliminate both, they are sDll present. Sequence of events in a financial crises: 1. IniBaBon of Financial Crisis: DeterioraDon in Financial InsDtuDons’ Balance Sheets, Asset-Price decline, Increase in uncertainty 2. Banking Crisis: Economic acDvity declines, Banking Crisis, Adverse SelecDon and Moral Hazard problems worsen and lending contracts, economic acDvity declines 3. Debt DeflaBon: unanDcipated decline in price level, adverse selecDon and moral hazard problems worsen and lending contracts, economic acDvity declines A financial crisis can begin in several ways: è Credit boom and bust: due to mismanagement of financial liberalizaDon or innovaDon. The government safety nets weaken incenDves for risk managment, depositor ignor risk-taking and eventually losses accrue. Deleveraging starts. è Asset-price boom and bust: a pricing bubble starts, where asset values exceed their fundamental value. When the bubble bursts and prices fall, net worth falls as well. Moral hazard increases, deleveraging starts. è Increase in uncertainty: caused by f.eg. a stock market crash, the failure of a major financial insDtuDon Deleveraging: financial insDtuDons cut back in lending As a consequence of deleveraging, no one is lem to evaluate firms. The financial system loses its primary insDtuDons to address adverse selecDon and moral hazard. Furthermore loans become scarce. Financial insDtuDons start deterioraDng balance sheets and are caused into insolvency. If severe enough, this can lead to a bank panic and bank run. The insDtuDons must sell assets quickly, as cash balances fall, further deterioraDng their balance sheets. This can lead to a sharp decline in prices and debt deflaBon. ISCEB X STUDIST 28  FIM THEORY SUMMARY Debt deflaDon: asset prices fall, but debt levels do not adjust, thereby increasing debt burdens CASES: 1. The Great Depression StarDng from 1928/29 stock prices doubled in the US unDl the stock market collapsed by the end of 1929. A normal recession turned into a disaster, when severe droughts in the Midwest led to a sharp decline in agricultural producDon. In the following years many banks went out of business. Firms with prodcDve uses were unable to get financing, credit spreads and unemployment increased. Bank panics in the US spread to the rest of the world, decreasing the demand for foreign goods. Results were a rising discontent which led to the rise of fascism and WWII. 2. The Global Financial Crisis of 2007-2009 Financial innovaBon in mortgage markets: ->less-than-credit worthy borrowers found the ability to purchase homes through subprime lending Subprime lending: mortgage likely to get into into trouble Agency problems in mortgage markets: ->banks didn’t care if customers got into trouble: Mortgage originators did not hold the actual mortgage, but sold the note in the secondary market. The role of asymmetric informaBon in the credit raBng process: ->agencies didn’t wanna lose clients ->debt design was not addressable for raDng system, which resulted in meaningless raDngs which investors relied on CDO: Collateralized Debt ObligaBons: bad lending taken out of BS of the bank and sold to an SPV In a CDO securiDes/tranches are created based on default prioriDes, whereas the highest rated tranches suffer defaults last. The tranches are divided into: 1. Super senior: highest ranked 2. Senior 3. Mezzanine 4. Equity Note that in real life it is oren difficult to determine what a cash flow is worth. ISCEB X STUDIST 29  FIM THEORY SUMMARY SPV (special purpose vehicle): created to buy assets, create securiDes from those assets and sell those to investors -> company with special purpose; a kind of financial intermediary between investors and financial intermediary. Many suffered during the financial crisis of 2007-2009. We specifically consider: 1. US residenBal housing: the underwriDng standard fell, people were buying houses they could not afford. The lending standards allowed for nearly 100% financing, so owners had lible to lose by defaulDng when the housing bubble burst. Note: some experts argue that the low interest rates from 2003 to 2006 further fueled the housing bubble 2. FIs balance sheet: banks and other FI saw the value of their assets fall and the deleveraging process began. Banks started selling their assets and restrict the credit. A further fall in the stock market and rise in credit spread weakened the BS, finally causing a contracDon. 3. Shadow banking system: Shadow bank: company with oren a hedge or money market fund that provides loans 4. Global financial markets 5. Failure of major financial firms Sep 2007: Northern Rock: a bank relying on other FIs for funding, which was therefore ler without funding Mar 2008: Bear Sterns: failed and was sold to JP Morgan Sep 2008: Freddie Mac and Fannie May: both were semi US-government organizaDons which were listed on the NYSE Sep 2008: Lehman Brothers: filed for bankrupcty. This event took all the confidence in the Markets away. Sep 2008: Merrill Lynch: sold to Bank of America Sep 2008: AIG: liquidity crisis The Financial Crisis of 2007 caused the worst economic contracDon since WW2. It peaked in 2008. Eventually in March 2009, a bull market started, having the credit spreads fall and stock prices rising again. ISCEB X STUDIST 30  FIM THEORY SUMMARY 3. The European Sovereign Debt Crisis: The Eurocrisis Up unDl 2007, all countries that had adopted the euro found their interest rates converging to very low levels. At the same Dme, many countries were hit very hard, due to: è Lower tax revenue from economic contracBon è High outlays for FI bailouts è Fear of default causing rates to surge Greece was the first domino to fall. It was heavily affected by fraud in previous governments. As soon as the real numbers were published, the interest rates and the debt started rising due to fear of default. The country needed to be saved by the IMF, the EU, and the ECB. Yet unemployment rates climbed and the country was ler with huge bailouts to deal with. Other countries, such as Ireland, Portugal, Spain, and Italy followed pu}ng doubts on the survival of the EURO project. ISCEB X STUDIST 31