Money and Banking: Chapter 12 (Financial Crisis)

NSFR

net stable funding ratio the percentage of the institution's short-term funding in relation to total funding

How are securities from shadow banking funded?

through REPOS short-term borrowing that uses assets like mortgage-backed securities as collateral

Asset-Price Boom and Bust (definitions) fundamental economic values

values based on realistic expectations of the assets' future income streams

Credit Boom

when financial institutions go on a lending spree (in the short-run) Lending consists of giving money to somebody with the intention of collecting back the original amount given and the interest

Higher Capital requirements (too-big-to-fail)

with higher capital, these institutions will have a larger buffer with which to withstand losses if they occur. reduce the subsidy to risk-taking for institutions that are too-big-to-fail

Debt Deflation ($100 million example)

1. A firm in 2016 has assets of $100 million (in 2016 dollars) and $90 million in long-term liabilities. $10 million in net worth. If the price falls by 10% in 20117, the real value of the liabilities would rise to $99 million in 2016 dollars, while the real value would remain unchanged at $100 million. Only $1 million in net worth The substantial decline in the real net worth of borrowers caused by a sharp drop in the price level creates an increase in adverse selection and moral hazard problems for lenders.

Three measures to solve the too-big-to-fail problem

1. Break up large, systemically important financial institutions 2. Higher capital requirements 3. Dodd-Frank

Three parts of the Initial Phase of a financial crisis

1. Credit Boom and Bust 2. Asset-Price Boom and Bust 3. Increase in Uncertainty

3 Causes of the 2007-2009 financial crisis

1. Financial innovation in the mortgage markets 2. Agency problems in the mortgage markets 3. Asymmetric Information and Credit-Rating Agencies

Dodd-Frank (too-big-to-fail)

1. Makes it harder for the Federal Reserve to bail out financial institutions, by imposing stricter regulations on SIFIs

Agency Problems in the Mortgage Markets

1. Mortgage brokers didn't make a strong effort to evaluate whether a borrower could pay off the mortgage, since they planned to quickly sell the loans to investors in the form of mortgage-backed securities 2. Risk-loving real-estate investors lined up to obtain loans to acquire houses that would be very profitable if the housing prices went up. "knowing they could walk away if housing prices went down." 3. principal-agent problem created moral incentives for mortgage brokers to encourage households to take on mortgages they couldn't afford, or to commit fraud by falsifying information. 4. Commercial and investment banks had weak incentives to make sure the ultimate holders of the securities would be paid off. (expanded more on the next card)

3 Stages of a financial crisis

1. Stage One: Initial Phase 2. Stage Two: Banking Crisis 3. Stage Three: Debt Deflation

5 factors that happened during the Great Depression.

1. Stock Market Crash 2. Bank Panics 3. Continuing Decline in Stock Prices 4. Debt Deflation 5. International Dimensions

Types of failures that occurred during the 2007 financial crisis.

1. Stock markets crashed worldwide (U.S. market falling by over 50% from its peak) 2. Many financial firms went belly up (commercial and investment banks for example) 3. A recession began in 2007 and the economy was in a tailspin

Ways the government intervened and created the recovery for the financial crisis.

1. U.S. Gov bailouts 2. TARP 3. Tighter fiscal policies

Global Financial Markets

1. europe also had a crisis European Central Bank began to horde cash, drying up credit led to the first major bank failure in the UK.

Financial derivatives Credit Default Swap

1. financial instruments whose payoffs are linked to previously issued securities, an important source for excessive risk taking. 2. a financial derivative that provides payments to holders of bonds if they default, AIG wrote billions of dollars worth of these risky contracts (credit default swaps)

Financial innovation in the mortgage markets

1. introduction to subprime mortgages (leading to an explosion in subprime mortgage-backed securities) 2. structured credit products - paid out income streams from a collection of underlying assets, designed to have particular risk characteristics that appealed to investors with differing preferences 3. CDO = most notorious structured credit product

Example of the asset-price bubble

1. tech stock market bubble of the 1990's 2. housing price bubble 3. credit booms (large increase in credit is used to fund purchases of assets, thereby driving up their price)

When did the financial crisis reach its peak?

2008 $700 billion dollar bailout package proposed by the Bush administration. Emergency Economic Stabilization Act was finally passed nearly a week later.

Collateralized Debt Obligations

A collateralized debt obligation is a type of structured asset-backed security. Originally developed as instruments for the corporate debt markets, CDOs evolved into the mortgage and mortgage-backed security markets.

Volcker Rule (Dodd-Frank)

Banks are limited in the extent of their proprietary trading trading with their own money (the banks) are allowed to own only a small percentage of hedge and private equity funds

Failure of High-Profile Firms

Bear Stearns (invested heavily in subprime-related securities) was forced to sell itself to J.P. Morgan Federal Reserve $30 billion takeover to Bear Stearn's hard-to-value assets. Fannie Mae and Freddy Mac Lehman Brothers filed for bankruptcy AIG suffered an extreme liquidity crisis

How did subprime mortgages lead to the crash in 2007

Borrowers with weak credit records started to default their subprime mortgages. This led to the downfall of the financial markets, leading to the worst financial crisis since the Great Depression. Households and businesses found they had to pay higher rates on their borrowings -- much harder to get credit

Asymmetric Information and Credit-Rating Agencies

Credit-rating agencies (who rated debt securities when it comes to the probability of defaulting) caused asymmetric information in the financial market. These ratings were wildly inflated that enabled the sale of complex financial products that were far riskier than investigators recognized. Raters were subjected to conflicts of interest because the large fees they earned from advertising clients meant they did not have sufficient incentives to make sure their ratings were accurate.

Deterioration of Financial Institutions' Balance Sheets

Decline in the U.S. housing prices = rising defaults on mortgages Mortgage backed securities and CDOs collapsed Financial institutions started selling off assets The reduction in bank lending = financial frictions increased in financial markets

Debt Deflation (during the great depression)

Declining economic activity led to a 25% decline in the price level Net worth fell because of the increased burden by firms and households. Decrease in net worth = increase in adverse selection problems (unemployment rose 25%)

Stage Two: Banking Crisis

Deteriorating balance sheet and tougher business conditions lead some financial institutions into insolvency (when their net worth becomes negative) ^ unable to pay off depositors or other creditors (causes banks to go out of business)

Systemic Risk Regulation (Dodd Frank Act)

Dodd-Frank monitors markets for asset price bubbles and the buildup of systemic risk.

Derivatives (Dodd-Frank)

Dodd-Frank requires that many standardized derivative product be traded on exchanges and cleared through clearinghouses to reduce the risk of losses if one counter-party in the derivative transaction goes bankrupt. Banks are banned from some derivative-dealing operations (riskier swaps).

True or False? With fewer banks operating, information about the creditworthiness of borrowers-spenders are still retained.

False It starts to dissapear Increases adverse selection and moral hazard problems (deepens the financial crisis, causing declines in asset prices, and the failure of firms throughout the economy)

True or False? When banks have more capital, financial institutions become riskier

False With less capital, financial institutions become riskier. This causes lender-savers to pull out their funds. Fewer funds = fewer loans to fund productive investments for financial institutions ^ This leads to a credit freeze (which can turn a lending boom to a lending crash)

Continuing decline in stock prices (during the great depression)

Financial markets struggled to channel funds to borrowers-spenders with productive investment opportunities. outstanding commercial loans fell by half from 1929 to 1933 (investment spending collapse 90%) Resulted in credit spread

Stock Market Crash (during the great depression)

In 1928-1929 = prices doubled in the U.S. stock market Because of this, the Fed pursued a tightening of monetary policy to raise interest rates in an effort to limit the rise in stock prices. The Fed got more than they bargained for and the stock market fell 40% by the end of 1929

How did the credit boom lead to the financial crisis?

In a nut-shell, both financial innovation and financial liberalization promoted more capital allocation efficiency within the economy. In the short-run, it can encourage financial institutions to go on a lending spree. Thus, lenders (the person that lends money to borrowers) may not have the expertise or the incentives to manage risk appropriately in these new lines of business (due to financial innovation). Credit booms eventually outstrip the ability of institutions (and government regulators) to screen and monitor credit risks All of these factors cause overly risky lending.

Example of debt deflation

In economies with moderate inflation (many advanced countries), many debt contracts with fixed interest rates are typically of fairly long maturity (10 years or more) Since debt payments are fixed, an unanticipated decline in the price level raises the value of borrowing firms and household liabilities (increases the burden of debt) but doesn't raise the real value of their assets

Dodd-Frank (consumer protection)

It has the authority to examine and enforce regulations on all business with more than $10 billion in assets. requires lenders to make sure borrowers can repay residential mortgages by identifying their income Bans payments to brokers for pushing borrowers into higher priced loans increased FDIC to $250,000

Haircuts

Lenders requiring larger amounts of collateral if a borrower took out a $100 million loan in a repo agreement, the borrower might have to post $105 million of mortgage-backed securities as collateral for a haircut of 5%.

Financial Crisis

Major disruptions in financial markets characterized by sharp declines in asset prices and firm failures.

too-big-to fail (break up large, systemically important financially institutions

Make sure a financial institution doesn't become so large that'll cause a financial system crisis if it gets shut down. Regulators will no longer need to bail out these institutions if they fail

Macro-prudential vs Micro-prudential Supervision

Micro-prudential Supervision = focuses on the safety and soundness of individual financial institutions Micro-prudential = looks at each individual institution separately and assesses the riskiness of its activities and whether it complies with disclosure requirements. Macro-prudential supervision = focuses on the safety of the financial system in the aggregate (migrate system-wide fire sales and deleveraging by assessing the overall capacity. Macro = financial systems as a whole

Dodd-Frank Bill

Passed in 2010 and addresses 5 main categories 1. Consumer Protection 2. Resolution Authority 3. Systematic Risk Regulation 4. Volcker Rule 5. Derivatives

Dodd-Frank (Resolution Authority)

Provides the U.S. government with the authority for financial firms (that are deemed systemic) systemic = firms that pose a risk to the overall health of the financial system because their failure would cause widespread economic damage

Run on the Shadow Banking System

Sharp decline in the values of mortgages and other financial assets triggered a run on the shadow banking system composed of: 1. hedge funds 2. investment banks 3. non-depository financial firms Not as tightly regulated as regular banks (shadow banks supported the issuance of low-interest-rate mortgages and auto loans)

SIFIs

Systemically important financial institutions firms are subject to additional regulation by the Fed, which includes higher capital standards and stricter liquidity requirements

The most significant economic crisis of debt deflation.

The Great Depression

Credit Boom and Bust (definitions) Financial liberalization

The elimination of restrictions on financial markets and institutions

How did the Asset-Price Boom cause a financial crisis?

The prices of assets (such as equity shares and real estate) can be driven by investor psychology well above their economic values (realistic expectations of the value of assets). Since the prices were much higher than their economic values, this caused an asset-price bubble. - When the bubble burst and asset prices started to realign with the fundamental economic values, stock and real estate prices tumbled. - Net worth started to decline and the value of collateral these companies can pledge (promise) - Because of their declining net worth, companies needed to make more risky investments since they had less to lose. (moral hazard)

Asset-Price Boom and Bust (definitions) asset-price bubble

The rise of asset prices above their fundamental economic values (tech-stock market in the late 90's and the housing price bubble)

Effects of the 2007-2009 Financial Crisis Part 1 = Residential Housing Prices (boom and bust)

The subprime morgage market became a trillion-dollar market by 2007. High housing prices meant that subprime borrowers could refinance their houses with even larger loans when their homes appreciated (recognized their full-worth). Because housing prices rised, subprime borrowers were unlikely to default since they could always sell their house to pay off the loan. As housing prices rose and profitability for mortgage originators/lenders grew higher, underwriting standards for subprime mortgages fell lower and lower. This caused the housing bubble to burst and eventually foreclosures on millions of mortgages.

Bank Panics (during the great depression)

The weakness in the agricultural economy caused substantial withdrawals in banks. FDR temporarily closed all banks

How do government safety nets affect the credit boom? How does it affect the value of assets (loans) and liabilities of a bank

They increase moral hazard incentive for banks to take on greater risk than they otherwise would. Since lenders know that government-guaranteed insurance protects them from losses, they will supply risky banks with funds. This causes the value of the loans (assets for banks) to fall relative to liabilities.

What does authorities do with insolvent firms?

They sell them off (merger) or liquidate them.

TARP

Troubled Asset Relief Program The Troubled Asset Relief Program (TARP) was a group of programs created and run by the U.S. Treasury to stabilize the country's financial system, restore economic growth, and mitigate foreclosures in the wake of the 2008 financial crisis. TARP sought to achieve these targets by purchasing troubled companies' assets and equity. 1. Authorized the treasury to spend $700 billion purchasing subprime mortgage assets from troubled institution (or inject capital into those institutions) 2. raised the federal deposit limit from 100,000 to 250,000 3. FDIC was then taken place With these policies, credit spreads began to fall.

True or False? The asset-price bust also causes a decline in the value of financial institution assets, causing a decline in the institutions' net worth to deleverage.

True

True or False When financial institutions stop collecting information and making loans, financial frictions rise, this will prevent financial institutions to address asymmetric information and increase moral hazard

True This will cause fewer loans, thus borrowers-spenders won't be able to fund productive investment opportunities and decrease spending (contracting economic activity)

Increase in uncertainty

U.S. financial crises have usually begun in periods of high uncertainty 1. just after the start of a recession 2. a crash in the stock market 3. failure of a major financial institution With information hard to come by in a period of high uncertainty, financial frictions increase, reducing lending and economic activity

Fire sales

When a bank sells off its assets quickly to raise the necessary funds. Uncertainty about the health of the banking system can lead to runs on the bank, which may lead to fire sales. Fire sales may cause the prices of assets to decline so much that the more banks become insolvent, the greater the bank failures will be and the bank panic will be worse.

Stage Three: Debt Deflation Debt deflation

When a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firms' net worth because of the increased burden of indebtedness This is basically the way that a large amount of debt can lead to a rapid fall in asset prices as bankruptcy and falling prices lead to distressed selling on margin calls.

Credit Boom and Bust (definitions) Financial innovation

When an economy introduces new types of loans or other financial products (subprime mortgages is one of the financial innovations)

Deleveraging How does deleveraging effect capital?

When financial institutions cut back on their lending to borrower-spenders borrow-spenders = those who must borrow funds to finance their spending With less capital, banks and other financial institutions become riskier, causing lender-savers to pull out their funds

Contagion effect

When one bank failure causes a bunch of other banks to fail (due to asymmetric information, where depositors and creditors don't know the quality of banks' loan portfolios)

International Dimensions

Worldwide depression caused great hardship, wit millions of people out of work.

Subprime mortgage

a type of mortgage that is normally issued by a lending institution to borrowers with low credit ratings Before the 2000's, only the most credit-worthy (prime) borrowers could obtain residential mortgages Because of FICO scores, it became easier to assess the risk associated with a pool of subprime mortgages, thus you could bundle them into mortgage backed-security..

Financial Frictions (Also, what is capital allocation, and how does it relate with financial frictions)

asymmetric information problems that creates a barrier to efficient allocation of capital Capital allocation is a system of distributing financial resources to various sectors to increase efficiency and thereby maximize profits. When financial frictions increase, financial markets are less capable of channeling funds efficiently from savers to households and firms with productive investment opportunities. Economic activity declines

Leverage Cycle

A feedback loop resulted in a boom in issuing credit.

Haircuts during the crisis

Haircuts started at zero during the crisis, but then rose to nearly 50. financial institutions could borrow only half as much with the same amount of collateral. Because of the lowered value of collateral, as well as raising haircuts, forced financial institutions to scramble more for liquidity. Financial frictions increased and stock prices dramatically fell

Financial Crisis (definition 2 with financial friction)

Occurs when information flows in financial markets experience a particularly large disruption, with the result that financial frictions increase sharply and financial markets stop functioning. Then economic activity collapses.