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Financial crisis

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michael kang

on 8 June 2011

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Transcript of Financial crisis

2008 Financial Crisis Causes Consequences Conclusion The Trigger - The Subprime Mortgage Crisis Fundamentally flawed rating agencies' business model Asymmetric information Ratings only represent default risk Conflict of Interest All risk sold by someone is bought by someone As housing prices increased, and borrowing was cheap, financial institutions and households leveraged up,
Then bought more CDOs. Capitalism is not a fail safe system - the economy will behave cyclically, even if all appropriate recommendations are implemented. Based on greed, private property rights, and decentralised decision making. The dominant strategy is for the individual to be concerned only about his own gain, not the state of the global economy. The last time we tried an alternative to capitalism, we got central planning. More intergovernmental regulation Adjustable-rate, subprime and other mortgages were packed into mortgage-backed securities of significant complexity. Government Interventions Global Impact Misdiagnosed as a liquidity crisis, the Fed created the Term Auction Facility (TAF), aimed to reduce interest rate spreads and increase the flow of credit. $100 billion was distributed to individuals and families in the hopes that this would jump-start consumption and the economy It was not a liquidity crisis, and TAF failed to make much of a difference Milton Friedman's Permanent Income Theory Economic Stimulus Act of 2008 Term Auction Facility (TAF) Temporary increases in income do not lead to significant increases in consumption - People did not spend much of the stimulus, consumption did not jump-start About Capitalism Investment Banks used special purpose entities in order to create Collateral Debt Obligations(CDOs) Banks also bought these securities in addition to selling them, creating further complexity and a web of interrelated obligations between financial instituations, all dependant on Asset-Backed Securities, resulting in most of the risk being concentrated in banks. - Confidence in the housing market,
- High expected returns,
- Over-speculation, and
- Cheap loans. Housing Bubble Troubled Asset Relief Program (TARP) A program that allowed the Treasury to buy back illiquid assets from banks and other financial institutions, based on a Recommendations Taylor (2008) suggests the following;
A return to the set of principles for setting interest rates that worked in the great moderation and Banks gave out loans easily to capitalize on speculators in the market, with excessive faith that the borrower would make a return from resale and thus have no problems paying back the loan, or successfully refinance their loan. Base any future government interventions on a clearly stated diagnosis of the problem and a rationale for the interventions Create a predictable exceptional access framework for providing financial assistance to existing financial institutions. An expanding market for financial products tied to short-term, adjustable interest rates backed by mortgage (CDOs) emerged. Dollar Value of Mortgage Debt (2008) Provided Credit Default Swaps to financial firms that used off-balance-sheet entities, in the event of a systemic decline in the overall economy Greed Bankers - short-term bonuses based on marked-to-market (current market price) profits, regardless of the liquidity of assets. A large portion of bank assets could only become CDOs
E.g. Union Bank of Switzerland's (UBS) CDO group noticed that their risk-management systems treated the AAA-rated CDOs as near riskless, whilst they still yielded a risk premium. Fannie Mae and Freddie Mac essentially created the "secondary market for mortgages" which allowing banks to sell their loans to this market. Government sponsored entity (GSE) status Competitive Advantage Credit Default Swaps (CDS) CDS behave like insurance, but were used like bets by speculators.
One party in a CDS agreement makes regular payments to another that offers a contingent payment that is triggered by a credit event CDOs no longer produced returns, as the underlying mortgage payments were no longer met and the collateral (homes) were plummeting in value. Banks had bought this form of insurance from other institutes such as JPMorgan and AIG for default risk protection from their mortgage backed securities, resulting in another complicated web of payment obligations between financial institutions As financial institutions failed, others needed to collect on their contingency payments, they found that the institutions they were supposed to collect from had failed too - there were no funds to pay off their own contingency payment obligations. Overdependence on a single, high return high risk market Looking at it simply, a combination of risky lending and financial innovation resulted in the perception of global risk sharing. In effect, however, the risk was neither diversified or diffused away from banks, and depended heavily on U.S. home prices. Tranches The impact of this crisis is far reaching... Scarcity of Jobs
E.g. Hardly a month after Lehman Brothers had declared bankruptcy, British unemployment had increased half a percentage point to 5.7% Lower production and productivity Banks failed. ... and bought more. They have the dubious honor of being the biggest bankruptcy case in history, at $600 billion. Two days after Lehman Brother's went bankrupt, AIG was on the edge with $400 billion in credit default swaps outstanding.
Unlike the Lehman Brother's case, Paulson decided AIG was too interconnected to fail. What followed was a series of chain reactions as investor confidence plummeted and a cascading effect on U.S. and international markets It can be said that this day marks the start of the financial crisis proper Speculators and banks could no longer find buyers, and home prices plummeted. The bubble had burst. Individual investors and financial institutions around the world that had invested in the U.S. housing market saw a sudden decrease in the value of their assets. Lehman Brothers was extremely leveraged - only 3-4% of its assets were owner-equity financed. Government The need for a better understanding of financial products Adjustable-Rate Mortgages Lehman Brothers filed for bankruptcy at 1pm on 15 September, 2008 Credit Crunch Decline of U.S. superpower status Less financing for poorer nations Thank You Paulson, saving the world I R Regulator
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