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Lecture7-FinancialCrisis-Jun24.pptx

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Financial Institutions & markets

FIN 353 - Summer 2020

Snow Han

SFSU

Lecture 7 – Financial Crisis

Review

Central Bank – Federal Reserve System

Goal – Max employment, stabilizing prices, &moderating long-term interest rates

Independence of Central Banks

Why we have financial crisis?

Agenda

What is financial Crisis?

Why financial crisis occur?

Dynamics (theory) of Financial Crises

Why are financial crises almost always followed by severe contractions in economic activity financial crisis => economic recession

Are crisis so bad?

Bubbles are events where people get really excited about something., they drive the price really high

They have to break sometime

After 2003 ,On another boom , like on a roller coaster – and claps again

In 2007, failure of companies invested in home mortgages

Run of banks in the Britain, Bank runs in US, and then we see international cooperation, Government all around the world bail out all these institutions

Crisis – is not a single event, is a accumulation about a lot of events (small events)- big shocks

Financial Crisis - Introduction

Asymmetric information creates barriers between savers and firms with productive investment opportunities.

However, both moral hazard and adverse selection are still present, impact efficiency of the system!

When this problem accumulate, and get more severe, information flows in financial markets experience a particularly large disruption

Financial system could stop functioning – Economic contraction

This is financial crisis

Stage 1: Initiation of Financial Crisis

Lessons from the past~

Financial crisis can begin in several ways:

Credit Boom and Bust

Asset-Price Boom and Bust

Increase in Uncertainty

1. Credit Boom & Bust

A credit boom or "lending spree" is the rapid expansion of lending by financial institutions.

Mismanagement of financial liberalization

- elimination of restrictions (over-lending)

And/or Financial innovation:

-introduction of new types of loans or other financial products

Either can lead to a credit boom, where risk management is lacking

How?

1. Government safety nets (FDIC) - weaken incentives for risk management

2. With Financial Liberalization & Innovations , sometime we don’t have the necessary expertise to forecast/predict credit risk – we hedge

Eventually, over-lending problems – credit boom

Consequence – Bust: loan losses accumulate =>asset values fall, driving down financial institutions’ net worth

Probability is a mathematical concept that try to forecast a certain events – fancy models, but rely on the past

We have mathematical theories and laws, it is similar as weather forecast / hurricane forecast.

Continuing

leading to a reduction in capital – deleveraging

Eventually – credit freeze

No incentive to making loans &* no need to collect information

A. loans become scarce

B. Economic spending contracts

C. The financial system losses its primary incentive to address adverse selection and moral hazard

2. Asset Boom & Bust

A pricing bubble starts, where asset values exceed their fundamental values.

E.g.: Tech Bubble in the late 1990s – investment companies

When the bubble bursts, prices fall

Corporate net worth falls as well (similar as banks after credit booms).

Bubbles are events where people get really excited about something., they drive the price really high

They have to break sometime

Example: this is more like the financial crisis we have in 1997-2002 Tech Bubble

World.com

The Taxpayer Relief Act of 1997, which lowered the top marginal capital gains tax in the United States, also made people more willing to make more speculative investments.[10] Alan Greenspan, the former Chair of the Federal Reserve, allegedly fueled investments in the stock market by putting a positive spin on stock valuations.

https://en.wikipedia.org/wiki/Dot-com_bubble

Continuing

Moral hazard increases as firms have little to lose (less skin in the game).

Firms take risk, and eventually default

FIs also see a fall in their asset value & net worth (credit freeze & deleverage)

Asset Booms are often related to credit booms (not necessarily), in which the large increase in credit is used to fund purchases of assets, therefore, driving up asset prices

E.g.: housing crisis in 2008

3. Increase in Uncertainty

Periods of high uncertainty can lead to crises, such as stock market crashes or the failure of a major financial institution

E.g.: Great Depression (1929-1933)

Information flows in financial markets experience a particularly large disruption. Financial markets may stop functioning completely – can lead to Bank runs

Reducing lending and economic activity (credit freeze & deleverage)

Sum of Stage 1: Initiation

Credit Boom & Bust

Asset Boom & Bust

Deleverage, Credit Freeze

Stage 2: Banking Crisis

Deteriorating balance sheets of financial institutions (FI)

some Banks might become insolvency.

AND, the effect is contagious

If severe enough, these factors can lead to a bank panic, where several banks fail simultaneous due to depositor panic

Fire sale of banks’ assets (far below their value) – lead to the decline of other banks’ asset

=> full-pledged bank crisis (contagion the entire industry)

Adverse selection and moral hazard become severer, since fewer institutions are collecting information

Develop and exacerbate financial crisis

Sum of Stage 2: Bank Crisis

Deleverage, Credit Freeze

Stage 3: Debt Deflation

Sometimes, the crisis ends after stage 2. With bad firms/ institutions go out of business, uncertainty in the financial markets decline (restore people’s confidence and trust), stock market recover, and the balance sheet of financial institutions improve – usually take years.

BUT, if the crisis leads to a sharp decline of price level, then the crisis will continue to the third stage

(how to prevent…?)

This is also one reason sometime people think crisis is a way that the market try to regulate/ adjust itself

What will happen if price level decline?

Example:

Consider a firm in 2015 with assets of $100 million (in 2015 dollars), $90 million of long-term liabilities, and so $10 million in net worth.

Price levels fall by 10% in 2016. Real value of assets (in 2015 dollars) remains the same.

Real value of liabilities rise to $99 million (in 2016 dollars), and so net worth falls to just $1 million!

Mismatch of your income and liability

Stage 3: Debt Deflation

Debt deflation can occur, if price level falls, but debt levels (nominal) do not adjust, increasing debt burdens (real term)

Firms’ net worth will fall

Moral hazard or adverse selection become more severe less “skin” in the game

Economic activities will keep declining for a even longer time

What about our financial crisis in 2008 (the great recession)?

What about the Great Depression?

Which come with price deflation

Why the fed is important – try to keep the price level stable

Sum of Stage 3: Debt Deflation

The Great Depression

In 1928 and 1929, stock prices doubled in the U.S.

The Fed tried to curb this period of excessive speculation with a tight monetary policy.

This lead to a stock market collapse of more than 20% in October of 1929, and losing an additional 20% by the end of 1929. (altogether more than 40%)

Severe droughts in 1930 in the Midwest led to a sharp decline in agricultural production

Defaults on Agriculture Loans, combined with stock market collapse led to many bank failures (Nov & Dec 1930)

loan amount decrease by half, investment decline (Stage 2 -> bank crisis)

Roosevelt – Bank Holiday – March 1933

Famous talks – Roosevelt – The only thing we have to fear is fear itself

The Great Depression

Debt Deflation (Stage 3)

Price level fell by 25% during this period

Debt Burden increased.

Prolonged the Economic contraction.

- Internationally

the contraction of the U.S. economy decreased demand for foreign goods

The worldwide depression caused great hardship, and the resulting discontent led to the rise of fascism and WWII

Initiation of the recent financial crisis (07-09)?

Information asymmetry in the mortgage market

Principal-Agent Problem (moral hazard)

Adverse selection

Financial Innovation Leads to credit boom, then asset boom

*Credit Score (FICO score)-2000

Credit Default Swap (CDS) – AIG eventually in trouble

Mortgage Backed Securities (MBS) – securitization

Subprime Mortgages – borrowers with lower credit score

Conflicts of Interest in Credit Rating Agencies

Ben Bernanke try to refinance his house in 2013/2014 – can’t do that!

makes a reported $250,000 for giving a speech and has signed a book contract that is surely in the seven figures

Mortgage originators did not hold the actual mortgage, but sold the note in the secondary market

Mortgage originators earned fees from the volume of the loans produced, not the quality

In the extreme, unqualified borrowers bought houses they could not afford through either creative mortgage products or outright fraud (such as inflated income)

They can walk away with no hurt

Agencies consulted with firms on structuring products to achieve the highest rating, creating a clear conflict

Further, the rating system was hardly designed to address the complex nature of the structured debt designs

The result was meaningless ratings that investors had relied on to assess the quality of their investments

Collateralized Debt Obligations (CDOs) - MBS

First, a corporate called special purpose vehicle (SPV) is created to buy assets, create securities from those assets, and then sell those securities to investors.

based on default priorities, SPV separated these assets (loans) into different categories – called tranches

The highest rated tranches suffer defaults if most of the assets default, while the first defaults go to the lowest rated tranches.

Super senior, Senior, the mezzanine, … the equity tranch

There are even and

Too complicated to determine exactly what they are worth and who has the rights to what cash flows.

increased complexity of structured products can actually reduce the amount of information in financial markets

Before continuing with the crisis, let’s take a detour and see how Collateralized Debt Obligations (CDOs) played a role in the crisis

In a speech in the middle of the crisis, Ben Bernanke, the chairman of the Federal Reserve, joked that he “would like to know what those damn things are worth.

Effects of the Great Recession (07-09)

1. Housing Market

the housing boom was lauded by economics and politicians. The housing boom helped stimulate growth

However, underwriting standard fell. You can almost get 100% financing (CDOs, loan sold)

No down payment – once you default, you can just ‘walk away’ – foreclosure of loans

Part Business, Part Government

Goal – allowing lenders to reinvest their assets into more lending and in effect increasing the number of lenders in the mortgage market

Buying mortgages from banks and turns them into mortgage backed securities (MBS) and sell them to investors

Provide liquidity for banks

Fannie Mae- Commercial Banks; Freddie Mac – Thrift Banks

Thrift banks are also known as "savings and loan associations. They are smaller than major retail or commercial banks, and more community-focused. In practice, this means that thrifts place a greater emphasis on serving their customers, compared to major banking institutions that are more focused on providing returns for shareholders.

Thrift banks are structured either as corporate entities owned by shareholders, or as mutual associations owned by their customers, both borrowers and depositors. local, basic-service banking institutions. They do not typically offer the same range of financial services available from major money center banks, such as brokerage and investment services, wealth management and insurance products.

Crisis

Part Government – meet government requirement – increase loan amount to below-median household, and subprime household

Part Business – compete for profits with investment banks

Lower underwriting standard.

a lawsuit has been filed against the federal government by the shareholders of Fannie Mae and Freddie Mac, for creating an environment by which Fannie and Freddie would be unable to meet their financial obligations

Bailouts – Fannie & Freddie

By 2008, the two had purchased or guaranteed over $5 trillion in mortgages or mortgage-backed securities

As these mortgages defaults, large losses mounted for both agencies.

Fannie Mae received $117 billion in bailout, Freddie Mac received $72 billion in bailout (Sept. 2008, Conservatory)

In 2013, Fannie Mae repaid $59.4 billion. In 2014, repaid another $20.6 billion. Through December 31, 2014 a cumulative total of $134.5 billion in dividends.– approximately $18 billion more than Fannie Mae received in support

Freddie Mac has paid back about $37 billion of the $72 billion it received, completely paid back in 2014.

2. Financial Institutions

Default loans lead to the deterioration of financial institutions balance sheets

Net worth declines

Deleverage – Credit Freeze (Stage 2)

3. Shadow Banking system

Hedge funds, investment funds, non-depository financial institutions

Those hold MBS have their asset value dropped significantly

Fire sale of their assets, Reduce their activities – contagious

Effects of the Great Recession (07-09)

4. Stock Markets

Effects of the Great Recession (07-09)

The decline in investment activities and consumption, along with fire sale of assets, leads to great economic contraction

5. international financial market

Following the downgrade of MBS ($10 bil), the shadow banking systems in the Europe began to fail

Major bank failure in UK – Northern Rock

Government bail out financial institutions

Eventually, leads to European Sovereign Debt Crisis (e.g. Greece)

Effects of the Great Recession (07-09)

Greece with huge cost of bailing out financial institutions, but lower tax revenue, post deficits in 2009, and a debt-to-GDP ratio of 100%

In October, 2009, new government was elected and find the situation was even worse , actually double deficit, and more debt than GDP

Greece was forced to write-down its debt (partial default)

Civil unrest broke out as unemployment rates climbed

The prime minister was eventually forced to resign

Ireland, Portugal, Spain, and Italy followed

Governments forced to embrace austerity measures to shore up their public finances (increase tax, but cut spending)

Interest rates climbed to double-digit levels

Severe recessions resulted, despite assurances from the ECB to help

Unemployment rates rose to double-digits (25% in Spain)

6. Failure of High-Profile firms

March 2008: Bear Sterns fails and is sold to JP Morgan for 5% of its value only 1 year ago (hold MBS)

September 2008: both Freddie and Fannie put into conservatorship after heaving subprime losses (provide insurance to MBS)

September 2008: Lehman Brothers files for bankruptcy.

September 2008: Merrill Lynch sold to Bank of America at “fire” sale prices.

AIG also experiences a liquidity crisis (government bail out)

Effects of the Great Recession (07-09)

Financial services firm Lehman Brothers filed for Chapter 11 bankruptcy protection on September 15, 2008. The filing remains the largest bankruptcy filing in U.S. history, with Lehman holding over $600 billion in assets

Lehman borrowed significant amounts to fund its investing in the years leading to its bankruptcy in 2008, a process known as leveraging or gearing. A significant portion of this investment was in housing-related assets, making it vulnerable to a downturn in that market. One measure of this risk-taking was its leverage ratio, a measure of the ratio of assets to owners equity, which increased from approximately 24:1 in 2003 to 31:1 by 2007.[2] While generating tremendous profits during the boom, this vulnerable position meant that just a 3–4% decline in the value of its assets would entirely eliminate its book value of equity.[3] Investment banks such as Lehman were not subject to the same regulations applied to depository banks to restrict their risk-taking.[4]

In August 2007, Lehman closed its subprime lender, BNC Mortgage, eliminating 1,200 positions in 23 locations, and took a $25-million after-tax charge and a $27-million reduction in goodwill. The firm said that poor market conditions in the mortgage space "necessitated a substantial reduction in its resources and capacity in the subprime space"

plan for Barclays to acquire the core business of Lehman Brothers (mainly Lehman's $960 million Midtown Manhattan office skyscraper), was approved. Manhattan court bankruptcy Judge James Peck, after a 7-hour hearing, ruled: "I have to approve this transaction because it is the only available transaction. Lehman Brothers became a victim, in effect the only true icon to fall in a tsunami that has befallen the credit markets. This is the most momentous bankruptcy hearing I've ever sat through. It can never be deemed precedent for future cases. It's hard for me to imagine a similar emergency."

The GREAT RECESSION

Stock market keep falling, almost 50% during 2007-2009

The fall in real GDP and increase in unemployment to over 10% in 2009 impacted almost everyone.

The recession that started in December 2007 became the worst economic contraction in the United States since World War II, and is now called the “Great Recession.”

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