Economics Crises Final Flash Cards

What is the purpose of deposit insurance in reducing the likelihood of a crisis?

-Deposit insurance helps banks that are levered stay liquid by assuring that depositors will have their money, thus decreasing the risk of a bank run -However, insurance does not extend to things like MMMFs, which are still subject to runs (2008 & 2020)

What is credit risk? What are the two main metrics that characterize credit risk?

-Credit risk: the risk that an entity does not pay back its debt, thus causing the price of the underlying asset to fall 1. Expected cash flow - interest/loan payments 2. Discount rate - a base interest rate plus the spread to compensate for credit risk

From a high level point of view, in what sense is the Corona crisis fundamentally different from 2008?

-Corona was not a financial crisis like 2008, it does not fit into a banking, sovereign, or currency crisis definition → it was ultimately a health crisis -Rather, the real shock was shutting down the economy to slow the spread, which had repercussions for banks, currencies, and sovereign debt

How did the Fed and Treasury expand the traditional Lender of Last Resort (LOLR) role in the weeks following the Lehman bankruptcy?

-4 days after Lehman's bankruptcy, the Fed guaranteed all MMMF deposits to stop the run -Instead of their usual practice of only lending to banks (which would then lend to the market), the Fed lent strait to the markets as well

What is a credit default swap?

-A CDS is a mode of risk transfer whereby a bank sells the risk associated with a loan to a third party by paying them a fixed fee (i.e. the swap spread) -In return, only in the case of default, the bank gets paid from the third party who is receiving the swap spread

What is the Troubled Asset Relief Program (TARP)?

-A bill constructed by the Bush administration and the FED with the goal of stabilizing the financial system, restoring economic growth, and mitigating foreclosures in the wake of the 2008 crisis -TARP sought to achieve these targets by purchasing trouble companies' assets (MBSs) and stock -Essentially, the banks got all of the money from the Fed's purchases, and this capital restored confidence in the financial system -Was extremely controversial and hard to pass because people did not want to help the financial system

Why did the Fed bailout AIG but not Lehman?

-AIG was viewed as solvent but illiquid -Lehman was not solvent (not able to meet its long-term debt obligations)

What are the advantages and disadvantages of using VaR to measure market risk?

-Advantages: measures risk in a clear way; measures individual asset risk & firm-wide risk -Disadvantages: Given the confidence interval, VaR has no idea how much a loss will be during the 1% or 5% scenario (does not account for black swan events)

During booms, leverage tends to increase across financial and non-financial firms as well as households. Why does this make a crisis more likely than otherwise?

-An increase in leverage typically comes with an increase in ponzi finance, where households and firms become so levered that the only way they can pay off their debt is by taking on more debt (self-reinforcing cycle) -During booms, many countries have loose monetary policy (i.e. low interest rates). Low interest rates stimulate the economy by decreasing borrowing costs, which leads to a massive increase in leverage -In the case of households, banks did many things to ease the cash burden on home buyers - they would lock in mortgages with things like negative amortization and then refinance later (assuming that prices went up) -Refinancing during a boom: purpose is to decrease your interest payment -When housing prices go up, you are worth more & your income is expected to increase (during a boom), so your borrowing capacity is higher and at a better rate -Due to high leverage, liquidity in banks decline and they can only give out loans at very high rates (liquidity issue) -Leverage amplifies gains and losses - the larger the position on the losing trade, the larger the loss you will experience

Suppose A sets up an interest rate swap with B. A will receive the fixed rate. After the contract, interest rates rise. Which bank (A or B) made money? Which one faces more counterparty risk (A or B)?

-B makes money because the floating rate rose above the fixed rate, so now the value of B's contract is higher than A's (A has to pay B the difference) -B faces more counterparty risk - it relies on A to pay the difference

What is the evidence that markets were not paying attention to the risks of large banks during the years before the crisis? How did this change after the crisis?

-Bear Stearns and Lehman had high derivative exposure (couldn't tell who was exposed and who wasn't because there was no centralized clearing) and high leverage through the REPO markets leading up the crisis - this exposure was left largely unchecked -The Dodd-Frank act tried to implement several policies to avoid the next crisis. For one, the establishment of the financial stability oversight council sought to identify risks to the financial stability of the United States. -No regulation of the shadow banking system still → experienced a run in 2020 that was strikingly similar to the 2008 run -The Dodd-Frank act also said that the biggest banks have to hold more capital -Bank stress tests implemented under hypothetical scenarios designed to determine whether a bank has enough capital to withstand a negative economic shock -⅔ of the derivatives markets are now centrally cleared, so it is very easy to net positions and see who is exposed and who is not -TBTF is still a huge problem that has yet to be solved

Why did Bear Stearns fail?

-Bear held a ton of subprime MBSs (highly levered), mainly financed by the short-term, overnight REPO market -Their MBSs became very hard for outsiders to value -This made investors lose confidence in Bear, the investors in this case were the suppliers of funds in the REPO markets -Because they lost access to short-term credit, Bear couldn't roll over their debt -This lead them to having no cash and having to get bailed out by the government and J.P. Morgan to avoid huge fire sales

What are similarities and differences between the bank runs that occurred in the 1930s v. those that occurred in the recent crisis?

-Between 1930-33, about 9.000 banks failed because of people withdrawing their deposits on massive scale. In 2008, only Lehman failed, but the Fed initiated bailout of other banks / financial institutions. -In 2008, the runs were focused on the shadow banking system, rather than the traditional banking system (there is now FDIC insurance)

What is the difference between book value of capital, market value of capital and the capitalization of a firm's stock?

-Book value: the summation of all a firm's assets determined by regular accounting methods -Market value: value of assets determined by an open market (net worth on a market value basis is an accurate measure of solvency, negative if you are insolvent) -Market capitalization: stock price, based on future speculation (includes growth opportunities; stock price can be high at insolvent institutions if firm is perceived to be backed by the government/TBTF)

Why did the Fed focus on buying long-term MBS in its first QE program?

-Buying long-term MBS helps the economy be reducing long-term interest rates → this makes business and mortgage borrowing cheaper

What did the Fed hope to achieve by buying long-term assets in its three QE programs?

-By engaging in three QE programs (each bigger than the subsequent round), the Fed is hoping to decrease the long-term interest rate -The Fed also helped that its purchases would help stimulate the economy by increasing money supply / liquidity in the system

What are the costs of financing a home? Which cost factors could possibly have led to the sharp price run up between 2000 and 2006?

-Depreciation: physical upkeep, insurance -Taxes: property taxes (plus some tax benefits) -Interest expense: monthly mortgage payments, main cost -In the 2000s, interest rates fell, allowing the cost of home ownership to drop. This led to a widespread expansion of credit -Expected change (increase) in future prices: if homeowners think that their house will increase in value, they are likely to invest in property

"Since derivatives neither create nor destroy risk, they have no effect on financial crises." Comment on whether or not you agree.

-Disagree, just because they don't create nor destroy risk does not mean they don't increase the risk for individual parties -Derivates provide a way to move risk around, allowing for some firms to become overexposed to to certain risks, like AIG -The risk concentration in a single company can exacerbate the market during a crisis -With the over-the-counter derivative model, it is extremely hard to tell who is exposed an who is not → development of the central clearing house that can easily net derivative positions to discover underlying exposure

How do distorted price signals in credit markets, in turn, distort bank choices and bank competition?

-Distorted prices in credit markets lead to bonds yields that don't fully reflect risk; therefore, banks take on riskier positions and are incentivized to do so because they know that they will receive government bailout in the worse case scenario -There is also unfairness → small firms cannot compete with the large firms that are taking on large amounts of leverage

What does financial integration have to do with changes in currency values, both in booms and busts?

-During a boom, there is increased investment from abroad, which drives up the local currency's value -During a bust, foreign investors pull their capital out quickly, which lowers the currency value

How did buying stock on margin lead to forced sales and thus price declines in the 1929 crash?

-During the 1920s, more people wanted to buy stocks, but many people did not have the cash, so they bought stocks on margin with borrowed money -Buying on margin meant that people only had to put down 10%-20% of their own cash, borrowing the remainder -During a margin call, investors were forced to sell immediately (b/c their account was going to run out of money), driving asset prices down through the cyclical process of deflation

Why did we have a 'Great Recession' in the aftermath of the crisis?

-Even though the banking system was able to rebound quickly with the Fed's help, not much was done to help homeowners with underwater mortgages (i.e. their house was worth less than the mortgage) -This led to many people losing virtually all their wealth and a huge debt overhang problem, forcing people to unlever rather than buy the goods/services that drive the economy

What is the role of the GSEs in housing finance?

-Fannie May and Freddie Mac -They arrange mortgage-backed securities into large securities -Provide financing to lenders for nearly half of current U.S. mortgages by buying the mortgages from lenders and packaging and selling them to investors

What does the term shadow banking refer to?

-Financial activities that take place amongst non-traditional financial institutions -Not regulated the same way that banks are -Direct financing through the markets rather than through banks -Provides more liquidity to the market but also adds more liquidity risk (MMMFs)

How did the changes in the financial system (e.g., financial innovation, OTC derivatives, financial integration, securitization) that we studied in the first half of the course lead to an over-leveraged financial system prior to the crisis?

-Financial innovation: MMMFs collected deposits and made short-term, overnight loans via the REPO markets in exchange for collateral. These loans could dry up overnight if there is a run and quickly lead to the liquidity death spiral for financial institutions reliant on REPO for financing. -OTC Derivatives: The OTC derivatives market greatly increases leverage while making it extremely hard to net positions to determine who is exposed and who isn't. Derivatives greatly increase leverage because when the price of the underlying asset moves significantly in a favorable direction, options magnify this movement (can leverage positions at a fraction of the cost of the underlying asset) -Financial integration: There is a direct relationship between the level of financial integration and the amount of leverage. Financial integration leads to increased confidence, which allows for more debt -Securitization: securitization allowed IBs to diversify the risk of underlying assets and sell it into the market for people with different risk appetites; banks engaged in massive securitization and therefore increased their leverage massively

Why did bank lending growth explode in early March 2020?

-Firms had to draw from their pre existing credit lines to help with the economic shutdown -Large Banks had the liquidity to fund this borrowing from their customers (large firms)

What are three ways that dealer banks manage counterparty risk in OTC derivatives markets?

-Interest rate swap example: dealer bank collects floating rate (liability) from one party and transfers it to another party with a fixed rate (asset) -The dealer bank is not experiencing any interest rate risk or market risk -They would experience risk if one side of the relationship was higher than the other, leading to an unmatched book and the potential for large losses (AIG) 1. Amount of exposure (measure potential future and current exposure) 2. Credit quality of counterparty (credit rating) 3. Collateral / margin (as exposure increases or credit quality decreases, collateral / margin increases)

Why are fiscal integration, economic integration and financial integration three important features of a well-functioning monetary union?

-Fiscal integration (eurozone does not have this): the integration of fiscal policy of nations and states (taxes and spending) -Economic integration (eurozone does not have this): arrangement among nations to reduce or eliminate trade barriers and coordinate monetary and fiscal policies -Financial integration (eurozone has this): the phenomenon in which financial markets in neighboring, regional, and/or global economies are closely linked together -The eurozone does not have fiscal integration or economic integration, meaning that member states have vastly fiscal and monetary policies; therefore, the eurozone does not represent an optimal currency area. The EU would have to have a tax authority for fiscal integration, and coordination of monetary policy for economic integration. There is no EU wide safety net (no FDIC insurance equivalent)

What is the role of banks in Germany and France in driving down sovereign spreads across the Euro?

-Germany and France were the strongest economic powers in the eurozone; therefore, when Greece issued debt, it was as though Germany and France were guaranteeing it. The backing of Germany and France drove a general decrease in bond yields across all member states in the eurozone (Germany and France seen as liable) -There was an increase in growth, spending, and foreign investment -Italy faced rising debt levels and increased borrowing costs to fund the difference between government spending and revenues

What is the difference between hedge finance, speculative finance and Ponzi finance?

-Hedge finance: having enough money/liquidity at the moment to pay what you owe right now -Speculative finance: the borrower does not have enough money at the moment, but the lender expects the borrower to be able to raise enough money to pay back in the future -Ponzi finance: the only way you can pay your debt is by borrowing more / taking on more debt (similar to what happened with housing)

What are the basic patterns in housing prices during the boom and bust?

-Housing prices typically increase much faster in a boom compared to the years before. From 2002-2006, prices rose at 15% per year, 50% faster than the prior 5 years -Discrepancies in housing prices across the country. Miami and San Francisco saw huge increases while other cities saw little movement -Increasing homeownership rates. Lower-income people have access to mortgages in order to finance their home

When a liquidity spiral begins in one asset class, why does it often have detrimental effects on other asset classes?

-If one asset experiences a negative price shock, the financial institutions that hold that particular asset class are forced to dump other asset classes to pay off their loans; therefore, the other asset classes that are dumped experience liquidity crises -A good example of this is the subprime MBSs - these securities led to a general distrust in even highly-rated securities, which ultimately led to deflation in highly-rated asset classes

Why are assumptions about the correlation structure of mortgages in an MBS pool so important?

-If returns are uncorrelated, then the pooling allows for a large fraction of the funding to go to the AAA rated bonds -There is the risk of the underlying assets in the pool, and the diversification risk of the assets as whole within the pool -The models that were used incorporated a large range of geographical diversity, but they did not take into account the correlation of housing prices across the market (the United States had become much more integrated)

How did the response of the economy in the 1930s differ from what happened after the 2008 crisis?

-In 1929, the Fed allowed banks to fail, in 2008 the Fed bailed out the banks (TARP) - this is what prevented the recession from becoming much worse -After 2008, the Fed lent very aggressively to banks and financial institutions -Loose monetary policy after 2008 to encourage borrowing, tight monetary policy in response to 1929 crash (set in motion the decline in prices) -Social programs created after 1929

What are some reasons why TBTF got worse during the years leading up to the crisis?

-In 1998, the hedge fund LTCM, was indirectly bailed out by the Fed. The Fed pooled together funding from top private banks to loan to LTCM → this set the precedent that the Fed was willing to fallout major financial institutions that would cause ripple effects in the economy if they failed -Because of securitization and tranching, many investment bankings offloaded as many loans as they could into the markets (was seen as acceptable because probabilities of failure of the individual loans were seen as uncorrelated)

Why do banking crises often lead to sovereign debt crises (and vice versa)?

-In a banking crisis, if the government bails out their banks, the government's position is hurt by the bank's losses (like when the Irish government committed to bailing out banks) -In a sovereign debt crisis, the main holders of government bonds are the banks of that country. If a government becomes distressed and its bonds fall in value, banks can also become distressed (depending on how many government bonds they hold)

Why are the recessions that follow financial crises typically longer and deeper than normal?

-In the 1930s, three things made the situation terrible 1. Banks failed - they could not supply capital and liquidity to help prop up the rest of the economy, reversing the credit dynamics of the manic period (cannot invest which lowers aggregate demand) 2. Debt overhang - economy gets really heavily levered leading to debt holders not being able to pay; this was not effectively solved until 2008; people respond to this by aggressively de-levering, which affects their ability to consume goods 3. Deflation - negative feedback loop, as falling prices incentivize people not to spend (pessimistic expectations), causing more economic pain and deflation

What is the upper limit on how much risks can be recycled in derivatives markets?

-There is no upper limit -Like saying what is the upper limit on how much you can bet on the Super Bowl

How is a long position in a risky bond or loan combined with a credit default swap similar to a risk-free bond? How is it different?

-It is similar to a risk-free bond because you sell away the excess risk -The difference exists in the counterparty risk present in the CDS. With a risk-free bond (e.x. treasury security), there is virtually no counterparty risk -For a CDS, the protection buyers pays a fee to the protection seller (AIG) in exchange for insurance in case of default. The problem AIG ran into was that too many insurance policies had to be paid out because of excessive defaults in subprime MBSs -The credit spread is the difference between the interest rate and the risk free rate

What is the role of securitization in shadow banking?

-It's the first step of shadow banking because it allows loans that are typically just for banks to enter the marketplace -This allows for regulatory arbitrage and increased liquidity for banks

What is the purpose of a lender of last resort in reducing the likelihood of a crisis?

-LOLR plugs the liquidity hole that banks will inevitably fall into during a crisis. The Fed injecting money into banks prevents the sale of assets and the liquidity death spiral -Establishes a period of stabilization in the midst of a crisis -Discount window facility - a central bank lending facility meant to help commercial banks manage their short-term credit (borrow directly from Fed at Fed funds rate) -The Fed controls the short term interest rate and can decrease this to encourage borrowing

Be able to explain the 'Financial Crisis Death Spiral'.

-Losses on subprime mortgages (bound to happen given bad credit) -Balance sheets get weakened, making firms question the solvency of counterparties -This leads to a decline in access to short-term credit and higher haircuts (spread/fees charged by IBs) -Fire sales occur to make up for losses (leading to deflation) -Repeat

What is the role of money market mutual funds in shadow banking?

-MMMFs play the role of a deposit provider in the shadow banking system (they buy securitized loans) -They offer reverse REPO financing to non-bank entities -The risk, then, strikes when MMMFs experience a run and can no longer offer liquidity in the REPO market that is serving as deposits for shadow banks -The shadow banks no longer have the liquidity necessary to support their balance sheet of securitized loans leading to a liquidity spiral and asset prices plummeting -Shadow banking is taking traditional banking (taking deposits which are liquid to make loans which are illiquid; fragility in the market) into its own hands away from regulation

Why was LOLR not sufficient to end the crisis?

-Many banks were insolvent because of their real estate exposures -This powerful, negative feedback loop was still too much to handle despite the Fed's funding

Why is it hard for many countries to borrow in international capital markets in their home currency?

-Many countries cannot borrow in international capital markets in their home currency because much of international trade is done in dollars. Therefore, these countries need to hold reserves to ensure a steady supply of imports during a crisis and assure creditors that their debt payments denominated in foreign currency can be made

What are the advantages of centralized clearing?

-Market risk: the CC has no market risk -Market transparency: a CC can see the positions of of players in the market, so they know if firms become too exposed to market risk -Counterparty risk is reduced because there is more netting of positions in a clearing house -The margin is conserved (smaller) relative to the underlying exposures -It's more efficient because of network effects, the same service for multiple transactions -Firms engaging with the clearing house have to pay collateral (maintain a margin account) with the clearinghouse in case of default

What is market risk? What is Value at Risk (VAR), and how is it related to the concept of a confidence level and holding period?

-Market risk: the risk that a firm will lose money if market prices change -VaR is a tool to measure market risk -VaR equals the maximum amount, within a given holding period, that may be lost within a given confidence interval -The VaR model will tell you how much you stand to lose 95% of 99% of the time. The higher the confidence level, the higher VaR because you have to be more conservative as you push into the tail end of the distribution -Much easier to get a good estimate of a 95% confidence vs. 99% confidence - there is less and less information about what is happening in the tail of the distribution

Why did housing finance start to look like Ponzi finance in the late-boom period?

-Mortgages were made to people who couldn't afford their future mortgage payments -If an individual only had to put 3% down, but then housing prices drop by 5%, it makes more sense for the owner to just leave the house

What happened to the US dollar during the crisis?

-There was a huge demand to hold U.S. treasuries, which were denominated by the dollar and seen as a safe investment -The dollar increased in value (not typical: global investors did not flee the U.S. in general, they dumped risky U.S. assets and instead bid up the value of U.S. treasuries & the dollar) -This shows the global confidence in the U.S. economy

How do ccps get rid of market risk and how do they allow for multilateral netting?

-No market risk because clearinghouses can't make a bet on anything (still counterparty risk but less with multilateral netting) -Netting out counterparty risk (will make the buyer whole in the case of default) -Multilateral netting is a payment arrangement among multiple parties that transactions be summed, rather than settled individually. The netting activity is centralized in one area, obviating the need for multiple invoicing and payment settlements among various parties

Why did the asset-backed commercial paper market unravel in the summer of 2007?

-Northern Rock Trust experienced a bank run -This suddenly leads to a huge increase in the TED spread (spread between treasury rate and LIBOR rate), basically measuring liquidity in the market -ABCP had special guarantees that made it so banks had to buy back the securitized assets from the SPV if the ABCP market froze -This lead to many banks buying back their securitized assets -Because they had to buy back their assets, banks didn't have enough cash on had to make loans -Economy gets hurt by the restriction of credit

What are the key parts of the Dodd Frank Act that address deficiencies uncovered during the crisis?

-Orderly Resolution Authority: government can take control of an institution and can continue to operate (as opposed to bailout and failure; never used) -Broad Regulatory Structure (not just for banks): establishment of Financial Stability Oversight Council (FSOC) to identify risks to the financial stability of the United States -FSOC can declare SIFI status: lots of regulatory oversight for banks (lost this battle in court → SIFI status removed) -Biggest banks have to hold more capital (goes against TBTF) -Stress testing: Define scenarios; determine future plan for capital distributions; using 1 & 2, with a forward-looking model, to forecast profits/loses & map losses into changes in capital -Consumer Protection: Consumer Financial Protection Bureau -Volcker Rule: traditional banking vs. proprietary trading (modern-day Glass-Steagall) → not that effective because hard to tell the difference between market-making vs. proprietary trading/speculation -Didn't unwind the QE problem of banks continuously increasing their balance sheets (as well as being vulnerable to interest rates) -Also failed to address the issue with shadow banking runs (MMMFs)

What are the advantages and disadvantages of the originate-to-hold model of lending?

-Originating to hold is the traditional process of making a loan. A local bank will lend by assessing the credit quality of borrower (income, property value, etc.). Once the lender makes the mortgage, they hold that loan for entire duration, receiving the payments over time -Advantages: Incentives alignment: the bank has more skin in the game. Makes them be more responsible in their lending practices. They know more about their market and risks of local players -Disadvantages: Local lenders have illiquid portfolios (mortgages are so long in maturity that it is hard to sell to other lenders). Prices are higher because the mortgage market is dominated by local lenders. There is less competition

What is the role of overly optimistic expectations in the crisis?

-Overly optimistic expectations ultimately lead to the manic phase of 2008 crisis. People saw the growth of the housing sector and continued to invest / ease the cash burden for new homeowners, which fueled growth to an unrealistic level. When the housing bubble burst, these overly optimistic expectations were revealed in subprime MBSs

Why do asset prices tend to increase sharply during booms? What is the role of expectations? What is the role of risk aversion?

-P = CF / R-G -During a boom, the G term (growth) in the Gordon Growth Model is higher, and the r term (risk) is often distorted and lower than it should be. A higher G and lower r ultimately leads to a smaller denominator, increasing asset prices -Investors can often be overly optimistic, leading to speculative asset prices with no justification for underlying growth ("asset pricing bubble"). Becoming overly optimistic goes hand in hand with a general decrease in perception of risk

How does Krugman use the contrasting responses of Nevada and Ireland to a housing collapse to illustrate features of an optimal monetary union?

-People in Nevada can move out; on the other hand, people cannot move out of Ireland on mass -Fiscally, Nevada's retirees can count on Washington to keep paying their social security and medicare (people in Ireland moving out cannot say the same). Many workers moved to Nevada during the boom years -Nevada and Ireland: similar populations; the housing bubbles were comparable in their extremity; both have similar unemployment numbers -The Nevada vs. Ireland example illustrates why Europe is having trouble with a single currency than in the United States (Nevada is fiscally integrated with the rest of the country)

In securitization, what is the purpose of pooling? What is the purpose of tranching?

-Pooling allows smaller credits to be arranged together and sold into the market as a larger asset (individual credits to small to be sold by themselves) -Tranching allows for structuring of the pool such that there are different categories of risk. Senior debt gets paid first but has the lowest return (& the biggest slice of the pie). Junior debt is riskier, but there is compensation in the form of a higher rate of return/yield (risk of default is greater)

How can you infer the market's assessed probability of sovereign default from bond yields?

-Probability of default = (i - i*) / (1 - RR + i), where: -i = yield on bond -i* = yield on a risk-free benchmark bond -RR = fixed recovery rate assumption

What are the motivations for securitization, from the point of view of the bank?

-Risk transfer: the risk of default is transferred to bondholders -Diversification: Banks can securitize different types of assets, while buying securitized loans on other assets, giving them a more diversified portfolio -Liquidity: banks create liquidity by pooling the illiquid loans into liquid securities -Regulatory arbitrage: by securitizing loans, banks are able to reduce their capital requirements (became an issue when banks had inadequate capital to repay the defaulted loans in the REPO market; loans did not adequately capture the risk of default due to perceived low correlation)

What is the role of asset-backed commercial paper and repurchase agreements in shadow banking?

-These are used to finance the exchange between the firm and the MMMF -Both of these are short-term loans that come with a lot of liquidity risk

What is the role of credit rating agencies in the tranching process?

-They assign separate credit ratings to the tranches within the securitized loans -This distributes the risk, with junior, mezzanine, and senior liens on the bonds

How can a bank use securitization to transfer risk to investors? What risks are transferred? What risks remain with the bank? Be sure to be able to answer questions like this in the context of the example in the lecture notes - see specific example below.

-Securitizing loans is the most common way for banks to transfer the risk of default (credit risk) -Securitization happens when a bank takes a pool of assets (loans) off of its balance sheet and sells it to a conduit firm (a special purpose vehicle or SPV) -An SPV pays for the assets by issuing bonds (made up of the assets) to the capital markets, usually with varying levels of seniority (tranching) -After securitization, the bank is left with just residual risk (the most junior tranche stays as an asset on the balance sheet), no credit risk

How does short-term borrowing amplify the effects of a decline in asset prices? Be able to describe/understand a liquidity spiral.

-Short term borrowing: asset-backed commercial paper (ABCP), REPO, etc. -If investors finance their purchases / client purchases with short-term borrowing, and a particular asset class experiences a negative price shock, investors are forced to sell assets to pay off their loans. Selling assets drives down prices (deflation), which leads to insolvency. This insolvency leads to a further decrease in access to short-term credit, which leads to more asset fire sales, etc. -Insolvency (relates to long term debt): when your assets are worth less than your debt -AIG: unable to pay their short-term debt, but there assets were still greater than liabilities (can pay off their long-term debt)

What is unique about sovereign risk relative to normal credit risk experienced by companies?

-Sovereign debt has much weaker control rights than corporate debt, where the collateral is more likely to be seized by creditors -With sovereign debt, the issuer controls the F/X rate by running a central bank, so the debt buyer is always vulnerable to an ex-post increase in inflation and thus a devaluation of the currency -Both of these differences imply that the issuer reputation is key to low-cost access to the market

What metrics are typically used to assess the risk of sovereign debt?

-Sovereign risk ratings are based upon the an assessment of both liquidity and the willingness of a country to service its debt -The probability that the government will nationalize the banking sector (political risk) -Liquidity / solvency metrics like debt/GDP, interest coverage ratio, solvency ratio, etc.

How did different countries, such as Spain, Ireland and Greece, respond to rate convergence?

-Spain: invested heavily in housing and saw prices rise nearly 80% (fueled by rock-bottom interest rates). Because the banks were thinly capitalized, they experienced huge losses similar to those experienced by the U.S. banks in 2008 when the housing bubble burst. -Ireland: also experienced a housing bubble accelerated by cheap credit and excessive leverage. -Greece: went on a spending spree to finance the Olympic games, and consumer spending massively increased. Also engaged in securitization to realize future revenues

Do central clearing houses face any market risk?

-Structurally, the clearinghouse cannot make a bet on the underlying assets, meaning there is no market risk -What they do have is counterparty risk, the risk that one of the parties involved in the derivative contract goes bankrupt

How did the advent of new mortgage products allow low-income people into the mortgage market?

-Subprime mortgages could be made to borrowers with low credit scores, as the pooled securities can make up fo the risk -During the boom, the practice of proving your income became less important, as financial institutions had less skin in the game and just wanted to make loans so that they could sell them -Borrowers had to put up less cash for a mortgage -Adjustable-rate mortgages: allowed low-income borrowers to get a loan and refinance are two years as long as prices continued to rise

What is the fundamental assumption underlying VAR?

-That the holding period will behave similarly to the past - there is nothing special about the current environment

What were some reasons why 'bulls' like Fisher thought the stock market was reasonably priced even in 1929?

-That thought technological growth was so relevant that it was priced into the market (G the Gordon Growth model) -They thought that management practices and corporate responsibility had improved to such a degree where they would affect firm values -Peacetime after war made investments seem less risky, times were less volatile (r in the Gordon Growth model)

What happened in September of 2008?

-The Fed knew in September of 2008 that AIG, Merrill Lynch, and Lehman were all in big trouble due to their overexposure to the housing market -They found a buyer for Merrill Lynch, which was Bank of America -The Fed lent to AIG so that they could meet their margin calls (AIG was viewed as solvent but illiquid) -They let Lehman fail because they viewed them as insolvent, which legally barred them from offering funds

Why did the Fed believe that lowering the short-term interest rate to near zero was insufficient to stimulate the economy after the crisis? What is the role of inflation expectations in the Fed's thinking?

-The Fed knew that lowering the short-term interest near zero would cause deflation and the economy to stop -The Fed decided to buy long-term bonds at a large scale (QE) to increase the prices and decrease the yields → this ultimately helps to avoid deflation and the economy halting -QE was very controversial because people thought that the Fed buying up bonds at a large scale would lead to inflation. However, there is no inflation because the short-term interest rate is at 0 (not costly to hold onto liquidity, there is normally a cost due to interest)

What is the role of OTD in the development of these products?

-The OTD model incentivized banks to engage in practices that eased the cash flow burden on the borrower (teaser rates, negative amortization: okay if prices are rising, can refinance or sell) -Banks wanted originate as many mortgages as possible so that they could offload the risk into the market and off of their balance sheets

Be able to explain how an increase in 'haircuts' in the Repo market puts pressure on financial institutions to sell assets.

-They are equal to the value of collateral less the amount borrowed all over the value of the collateral -Haircuts = equity / assets -If a haircut increases, the assets must decrease in order to hold the same proportion with the equity. This creates negative price pressure b/c the IB must dump its assets into the market -Haircut = equity / assets (established before)

What happened to the Reserve Primary Fund in the wake of Lehman's bankruptcy? Why was this so important in spreading the crisis?

-The Reserve Primary Fund is one of the largest MMMFs -It had huge exposure to Lehman's bankruptcy -It "broke the buck" when it announced that it could only pay 97 cents on the dollar -This led to a massive withdraw of funds from all MMMFs -MMMFs are the main buyers of commercial paper and REPOs, which are used by banks to to finance their securitized loans -This leads to a fire sale, as banks/firms have to sell their assets to meet debt obligations -This creates more volatility in the market, more price declines, and higher haircuts

Why do the arrangers of MBS want as much financing as possible in AAA rated tranches?

-The arranger's profits are directly related to the level of the rating that their loans receive -The AAA tranche is the most senior; hence, it is the most likely tranche to payout every time (very low risk of default). By increasing the slice of the pie you have in the AAA tranche, your profits directly increase

Why would a bank which securitizes a pool of loans prefer to have more funding financed in the AAA-rated tranche, relative to lower-rated tranches?

-The banks makes more money on the higher rated debt because it makes up the majority of the pool (even though it has a lower return because there is a lower risk of default)

What evidence that TBTF is better now than before the 2008 Crisis?

-The biggest banks have to hold more capital → goes against TBTF -The implementation of stress testing described above (to determine if a bank has enough capital to survive a negative economic shock)

How did the behavior of the rating agencies help expand credit to the subprime mortgage market?

-The business models used by the rating agencies were easily manipulated by the banks. The banks wanted good credit ratings for their loans, so if the credit rating agency wouldn't give them a good rating, they wouldn't get paid, and the banks would just go to another rating agency -Credit rating agencies would deviate from their traditional models in order to favor big banks which brought them a lot of deals

What was the turning point that cooled the market's panic?

-The capital infusion of the TARP program -Right after this, the TED spreads decreased dramatically, signifying a more liquid market

What typically happens to a currency during a boom?

-The currency generally appreciates due to an increase in capital flow from abroad - when foreign investors invest in a country, they drive up demand for that county's currency -Important to note that as currency appreciates, growth is slowed because investments in that county's currency look less attractive (more expensive)

How did the Fed's actions regarding the Bear situation potentially affect the behavior of the other large banks during the months that followed?

-The full bailout of Bear set a precedent that the firm was TBTF → this ultimately distorted credit risk and encouraged other banks to lever up, knowing that the Fed would step in to help in the worst case scenario. Lehman Brothers was also highly levered through the REPO markets; however, they ultimately did nothing to offload their risk - they expected a Fed bailout. The failure of Lehman Brothers led to excessive losses both domestically and abroad - had the Fed not set the precedent of government bailout, then maybe Lehman could have acted to help its situation

How did TARP's implementation deviate from its original concept? Why was this changed? How did it unwind?

-The initial idea was to buy the toxic assets (MBSs) to relieve their solvency problems -This caused a problem there could be adverse selections (buyers and sellers have different information) in structuring an auction for these toxic assets -So instead, TARP's aim was modified slightly to buy equity in banks / financial institutions (U.S government bought preferred stock in 8 banks) -The TARP funds were repaid over time by the banks

What is the relationship between the proper holding period used to measure VAR and the underlying liquidity of the positions?

-The longer the holding period the greater the risk (VaR assumes all positions are freezed -Illiquid assets require longer holding periods because there is less flexibility to trade assets on a timely basis - this ultimately leads to a larger VaR (more things can change over time) -VaR assumes market conditions do not change. The longer the holding period, the less plausible the premise of sustained market conditions becomes

How did the first Stress Test of the large banks help end the financial crisis?

-The main goal of the first stress test was to inject private capital to replace public funds in the banking system -The banks that passed the stress tests did not have to raise private capital, the ones who failed did -All but 1 bank, GMAC, were able to secure private funds, making the stress tests successful in getting private capital back into the banking system

What is the Too Big to Fail problem?

-The too big to fail problem is the expectation that governments will bail out huge firms in the event of a financial crisis. Because these firms are so large and have so many counter parties, their failure can be detrimental to the whole economy. However, if investors expect that a large firm is implicitly backed by the government, that safety is reflected in their borrowing costs, which takes into account the fact that they can get bailed out. This gives large firms an opportunity to borrow too much and take too much risk.

What happened to the yields on sovereign bonds issued by European governments after the EU adopted a single currency?

-The yields on sovereign bonds dropped massively because of microeconomic benefits such as exchange rate certainty, price transparency, increased financial integration, etc. -People perceived the bonds of countries in the eurozone to be backed by the "European guarantee"

How does asymmetric information affect the OTD model?

-There is a huge disconnect between the entities that make the loans/credit decision for individual mortgages, and the entities that end up bearing the risks of those decisions (the ones who hold the securitized pool)

The fundamental assumption underlying the use of statistical models for risk management is that past data represents risk in the future. How did the models used by rating agencies reflect a failure of this assumption?

-They had the assumption that there were low correlations between housing markets across the country -The United States had become much more integrated; therefore, the individual risks of default for each of the loans within the securitization pool were more correlated than the credit rating agency's thought.

Why did the Fed intervene when Bear got into trouble? What did the Fed do?

-They had to intervene because there are laws that allow REPO counterparties to sell the collateral if the borrower (Bear) fails -The Fed made the decision to subsidize the purchase by J.P. Morgan because if there was a fire sale of the collateral, they feared Bear's bankruptcy would spread throughout the market -The Fed did a full bailout (first ever) by guaranteeing $29 billion of Bear's MBSs to J.P. Morgan -Bear was involved in many financial markets: REPO, subprime MBSs, OTC derivatives, etc. The Fed was ultimately worried about contagion -The firm had enough collateral for the loans that they needed, there was just a massive decline in access to short-term credit

Suppose JP Morgan has a 1-day VAR with 99% confidence of $50 million. One day during the year, however, the bank lost $300 million. What does this one loss imply about the quality of the VAR model used by Morgan?

-This does not say much about the model -The VaR model says 1/100 will have a loss greater than $50 million -The model does not say how much will be lost during that 1%

What are the advantages and disadvantages of the originate-to-distribute (OTD) model of lending?

-This is the modern method of mortgage lending business -Mortgages are originated by some entity, either local lenders or mortgage brokers, which are then sold to investors in the broader capital markets, usually to be pooled -Advantages: mortgages become liquid, lowering interest rates and increasing the availability of credit. Good for lenders, as they do not need to worry about local funding -Disadvantages: Less incentive to careful lending practices, as mortgages become more and more sellable, banks can take on bad mortgages just so they can sell them. Predatory lending: making loans to people you know can't pay off their debt

The article by Joe Nocera describes VaR as a 'peacetime statistic". What does this mean?

-This means that VaR is dependent on historical data, meaning that VaR calculations that are based on the assumption that future events will match historical events -This completely disregards the potential for black swan events and uncertain future events that occur outside the data -Also, fundamentally, VaR only accounts for 95% or 99% of the potential losses, not accounting enough for catastrophic events

What occurred that allowed the 1929 crash to worsen and then become the Great Depression?

-Tight monetary policy set in motion the decline in prices → liquidity death spiral (cost of borrowing up, decline in access to short-term credit, sell assets, prices down) -Consumer spending and investment dropped, as people focused on repaying their debts → led to steep declines in industrial output and employment as failing companies laid off workers

How does the Euro Crisis illustrate the feedback loop between sovereign crises and bank crises?

-When Greece entered the eurozone, yields on the country's bonds dropped massively due to perceptions of lower risk. This incentivized the Greek government to go on a borrowing spree to fund economic growth (took on massive debt to do this). Because the majority of Greek bonds were held by Greek banks, when Greece defaulted on its debt, panic quickly spread to the baking sector

What is the role of banks in Germany and France in providing the credit behind the real estate booms in Spain and Ireland?

-When Spain and Ireland joined the eurozone, they enjoyed low, stable interest rates. These lax borrowing standards fueled property bubbles that eventually led to banking crises in each country -The Spanish housing boom was financed in large measure by investments from German banks

How does TBTF distort price signals in credit markets?

-When people see large financial institutions / banks are TBTF, there are credit market distortions → bond yields don't fully reflect risk because of weakened incentives to price risk accurately -When you don't have skin in the game → leverage increases → incentivized to take riskier positions

What are the similarities and differences between what the Fed did regarding Bear v. what they did regarding LTCM?

-With Bear they organized a full bail out by guaranteeing $29 billion in Bear's MBSs to J.P. Morgan -With LTCM, the Fed organized / helped facilitate the conversation for other banks to bail out LTCM (they put up no money themselves) -

How did they solve the challenges of the stress tests?

1. Fed chair publicly stated that banks would not be nationalized 2. If private capital couldn't be raised, the Fed would add the necessary funds to the TARP funds 3. The stress tests of the 19 largest banks were publicly disclosed to the market in a credible manner, which gave investors confidence that they would get their fair return on investment

What were the three main challenges that the Fed faced in designing these stress tests?

1. Private investors worried about potential nationalization, meaning if they put their money into banks, they were scared it would just be taken over by the government later 2. Will banks that fail stress tests cause instability to the system? 3. Asymmetric information: Investors didn't know the value of the large banks so they didn't want to invest