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Family Office – Governance in an educational context

Education in the context of family governance is one of the major points that family offices and ultra wealthy families are currently dealing with. On the other hand it seems like a niche service provided by the family offices and service providers directly adressing the needs of this highly sophisticated clientele.

Looking back to my panel in New York it seems that people trying to simplify the topic as a whole instead of using a more holistic approach. There are so many different ways to deal with the topic and there is no such thing as one fits all.

One family for example is givng their kids some “pocket money” but they deduct 30% of it as taxes. (Money is than used to educate the kids in finance) – The son is aged six!

Another family opened a “gambling” account for their successor just to get him introduced to fund management, different styles  of how to select the right company, corporate finance, financial markets – supported from one of our seniors who is a successful manager of years. He could have kept all the money he made – beating the market and passing a hurdle rate.

One of our families choose the approach of integrating their successor in the company in various roles when he was still at school. He travelled the globe and gained experience in their hundreds of branches. He is now a board member at 25 owning a significant share of the company.

As you can see there is a rather individual approach how to deal with the immense wealth these families have accumulated. Kids are taught numbrs in school but most of them are unaware of finance – at least if it comes to real life matters.

Therefore I´ve chosen a different track to support the people we are responsible for – I took a three year track to became a teacher. Not do I only think we as individuals should be learning every day – I took courses from some of the best universities over the last 15 years or so but it is also a matter of how you transport this knowledge in an ever changing environment.

The children today are used to modern communication tools because they grew up with it whilst msot of us did not. So we need to adapt and make it appealing to them. If they are not interested in a topic it is not up to them, it´s upt to us to present it to them in a meaningful way. We as a family office introduced our own academy which best helps to foster the needs of the next generation of our clients.


Remember The Global Financial Crisis?! – Panic

Repo – A New Type of Banking

  • A sale and repurchase agreement (“repo”) is a deposit of cash at a “bank” which is short-term, receives interest, and is backed by collateral. Depositor takes legal ownership of the collateral.
  • Carved out of Bankruptcy Code; unilateral termination by non-defaulting party.
  • Two types of repo: bilateral and tri-party. Both types caused trouble in the crisis.
  • Collateral may be “rehypothecated”.
  • Collateral value typically exceeds the amount of cash deposited, this is called a haircut For example, deposit $98, receive a bond worth $100—a 2% haircut.

 

Lehman Brothers

  • As of March 2008, the situation at Lehman Brothers was just as precarious as it was at Bear Stearns, and perhaps Lehman only survived longer than Bear because some shady accounting made them look better than reality.
  • After the government-supported rescue of Bear Stearns in March 2008, the Federal Reserve created the Primary Dealer Credit Facility (PDCF) to provide liquidity to non-bank dealers like Lehman.
  • The PDCF was critical to Lehman’s survival over the next six months, as they tried to get rid of their worst assets and improve their capital and liquidity position.

 

Lehman Weekend – September 2008

  • On September 10, 2008, Lehman reported $28 billion in shareholder equity, $4 billion higher than a year earlier. But it was simply impossible to know if this equity cushion was accurate.
  • For one thing, Lehman reported $54 billion in real estate assets. Some market participants thought the true value was closer to half of that, which would effectively wipe out Lehman’s equity.
  • At the same time, Lehman’s counterparties in derivatives, commercial paper, and repo were pulling back, shortening terms, and demanding more collateral.
  • Most notably, JP Morgan, Lehman’s clearing bank in the tri-party repo market, demanded $5 billion and received $3.6 billion on 9/9, and demanded and received $5 billion on 9/12.

 

Lehman Weekend – September 12-14, 2008

  • Over the weekend of 9/12 – 9/14, the U.S. government tried unsuccessfully to arrange a private rescue for Lehman.
  • The government insisted there would be no public money spent on the rescue.
  • Bank of America chose to buy Merrill Lynch instead of Lehman.
  • On Saturday, Barclays agreed to buy Lehman, but by Sunday the deal was effectively blocked by UK regulators.
  • Without sufficient liquidity to operate the next day, and otherwise out of options, Lehman filed for bankruptcy early in the morning on September 15.

 

MMMFs

  • Money-Market Mutual Funds (MMMFs) are a specific type of investment company that is only permitted to own a narrow range of securities. In return for accepting this narrow investment range, they had the right (at this time) to report “stable values” for their share prices.
  • On September 16, 2008, Reserve Primary Fund “broke the buck” due to exposure to Lehman Brothers commercial paper. This led to a run on many MMMFs – mostly by institutional investors – and then quickly to an explicit guarantee from the U.S. government.
  • We really should have seen this coming – but we did not. Because MMMFs had significant problems in August 2007 as a result of the Asset-Backed Commercial Paper (ABCP) runs.
  • McCabe (2010) shows that MMMFs assets under management grew during the ABCP runs of 2007, but that is because the implicit promises of many sponsors were honored: 43 MMMFs were bailed out by their sponsors/fund-families. This level of support was unprecedented.
  • In September 2008, this support was not possible, and the resulting runs transferred more than $400 billion from prime MMMFs (which support many components of private finance) to government-only MMMFs (which do not).

 

AIG

Main weaknesses:

  • Credit-default-swap (CDS) mark-to-market losses and collateral calls.
  • Cash collateral investment losses in securities lending business.
  • Funding pressure in CP and repo.
  • Ratings downgrade triggers additional collateral calls.
  • Liquidity puts on CDOs.

After Lehman, markets are in turmoil and no private rescue is possible.

Fed led rescue of $85 billion, later supplemented by more from Fed and TARP.

 

The Run on Repo

  • $350 billion of short-term funding ran away from ABCP.
  • From MMMFs, about the same amount.
  • Combine these drains with uncertainty about the subprime exposure on balance sheets, and there is massive pressure on repo markets.
  • This pressure manifests in spreads (on underlying ABS), repo rates, and haircuts.
  • The statistical evidence in Gorton and Metrick (2012) confirms a significant relationship between LIBOR-OIS and ABS spreads.
  • Regression evidence also suggests that the main driver of haircuts was uncertainty about future spreads on the ABS collateral.

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)


Currency War – Without Borders!

As written earlier this year the currency war is on with some countries trying to devalue their own currencies and thereby destabilizing nations that have pegged their currencies. The most influential currencies globally are still the USD and the EUR which roots go back to pegs of D-Mark times.

After Switzerland was forced to give up its peg in January eyes moved on to other smaller economies in Europe like Denmark that so far has managed to defend the Krone by repeatedly cutting interest rates. The question again is how long will hey maintain their “success” not becoming another Switzerland?

Since 2008 the number of currencies that are monitored by the IMF that are free floating (no intervention) has decreased from 40% to 34%. The problem with pegging currencies is simply that central banks rely on the mercy of anothers country fiscal and monetary policy. That gives them less freedom to respond to domestic goals such as jobs or containing prices.

How can we get back to normal?

 

If you are in the process of setting up aFamily Office or know someone who is going through the process and would like any advice or help with initial hires the please do not hesitate to get in contact with us via LNKD or follow us on TWTR Swiss Family Office.


Remember The Global Financial Crissis?! – Anxiety

Some Notable Events in 2007

April 2007

New Century: 4/2/07 (REIT with market cap of $1.75 billion on 1/1/07, delisted 3/13, filed for bankruptcy 4/2)

June 2007

S&P/Moody’s significant downgrades beginning in June 2007 Bear Stearns suspends redemptions: 6/7/07

July 2007

Bear Stearns liquidates funds: 7/31/07

August 2007

BNP Paribas funds: 8/9/07

 

ABX

The ABX-HE (or just “ABX”), is an index of credit default swaps (CDS) written on subprime mortgage securitizations. The price of the ABX index is essentially a measure of perceived value of subprime securities with various ratings; the return (or spread) on the ABX is essentially a risk premium for subprime.

The index was created by the firm Markit, and first released in January 2006 covering the 20 largest subprime securitizations that closed in the last six months of 2005. These indices were denoted as ABX-HE 2006-1. Subsequent releases were denoted 2006-2, 2007- 1, and 2007-2 before subprime activity became too small for index construction.

The launch of ABX in 2006 was a notable event, as it allowed everyone to see, speculate, and hedge – for the first time – market expectations about subprime.

 

How Could We Be So Wrong?

“… given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” – Chairman Bernanke in a speech on May 17, 2007

 

Anxiety Spreads

The bad news in subprime was well-known by the time of Chairman Bernanke’s speech. Indeed, the news events in the spring of 2007 seem uncorrelated with the movements in the ABX.

Instead, the problem became the uncertainty about the location of subprime risk. Which securitized bonds were exposed to subprime? Which financial institutions would need to support their investment vehicles?

The financial system is not equipped to analyze “safe” investments. The resources for deep analysis of information are not there.

Consider what you would do if you had uninsured deposits at a bank, and you became nervous about the bank’s solvency. Is it rational to analyze the bank’s balance sheet, or to just take your money out?

 

LIBOR-OIS

The London Interbank Offered Rate (LIBOR) is a measure of the interest rates that banks charge each other for unsecured dollar funding over various time periods (overnight, one-month, threemonth etc.)

The Overnight Index Swap (OIS) is a fixed-floating interest-rate swap for various time periods. Because the amounts owed daily are small and counterparties must continuously post collateral for expected payments, the fixed leg of this swap is considered to be a good proxy for risk-free interest rates.

The LIBOR-OIS spread is thus a good measure for the riskiness of banks’ unsecured borrowing. Historically, this spread was very small (around ten basis points).

 

Asset-Backed Commercial Paper

Asset-backed commercial paper (ABCP) is primarily a method of maturity transformation – funding a pool of long-term assets with short-term liabilities.

ABCP is designed to meet specific needs of investors (often money-market mutual funds), and includes credit enhancement and liquidity support to achieve this goal.

 

ABCP vs. Securitization

ABCP may appear similar to securitization, but there are many differences:

  • Investments can be revolving and fluctuate in size
  • Conduits may invest in various asset types
  • Typically engage in maturity transformation, with backup liquidity support
  • No scheduled amortization of assets and liabilities

 

ABCP Data

ABCP programs grew rapidly in the 1990s, and then again in the crucial 2003-2007 period.

As of 2007, ABCP programs took many forms, and were not dominated by any particular type of sponsor.

 

ABCP “Runs”

Covitz, Liang and Suarez define an ABCP “run” as a week when the program does not issue new CP despite having at least 10% of outstanding CP mature.

Runs became endemic in August 2007, and once a program experienced a run it was unlikely to ever leave that state. By December 2007 more than 40% of programs were in a run state.

 

Summary

The problems in subprime were clear to all market participants in early 2007.

These problems were not expected to infect the whole financial system, but uncertainty about the location of risks led to a spread of anxiety beginning in the middle of 2007.

The anxiety is driven by a financial system ill-equipped to analyze risks in seemingly “safe” assets. This sets the stage for a good oldfashioned bank run, but now taking place in the shadow banking markets.

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)


Family Office – Family Governance in a Nutshell

Family governance is the result of leadership by boards of directors, family councils, family offices, and professionalized top-management teams. The primary responsibilities of a board of directors include reviewing the financial status of the firm, deliberating on company strategy, looking out for shareholders’ interests, ensuring the ethical management of the business, being a respectful critic of management, reviewing CEO performance and holding top management accountable to the family.

The family council is a governance body that focuses on family matters, frequently developing family policies in a family constitution. A family constitution is a
collection of family policies guiding the family–ownership– management relationship. It represents a great investment in governing the relationship between ownership, management and family membership and addressing liquidity issues and estate planning. In larger families, a family assembly creates participation opportunities for all members by meeting at least once a year. In third and fourth generation families it is a great venue for the inclusion and engagement of spouses who, because of sheer numbers, may not be included in the family council. Family meetings are a significant contributor to the unique resource that family firms enjoy: family unity. Family unity and commitment to continuity can be the source of strategies—such as managing for the long run—that differentiate family enterprises from others and endow them with unique competitive advantages.

A family office’s primary duties are to provide and organize a series of services for family shareholders, including legal and financial assistance with estate and tax issues, management of the investment portfolios of the family, promoting transparency by providing information of relevance to shareholders through meetings, e-mails, and newsletters, and fairly and equitably making family or shareholder benefits available to family members.

Key nonfamily managers in the top-management team help set high standards for work ethic, accountability, dedication, and expertise. By doing so they too help govern the family–business relationship in a family enterprise and family office.

Finally, trans-generational entrepreneurial activity and philanthropy are great elixirs for the prevention of affluenza and an entitlement culture in the family of wealth. They also often promote a leading family’s legacy and its continued spirit of enterprise.

The incumbent generation’s leadership and very concrete steps to promote family governance through the approaches and best practices presented, and the family cases from around the world discussed in this White Paper, are meant to inspire you to fulfill this final test of leadership greatness.

Despite the popularity of Thomas Friedman’s well-known book title, the world is not flat when it comes to family enterprises. Many of the challenges to family governance are global indeed. But regional and national cultures, and their influence on family dynamics, make custom-tailored implementation of family governance best practices essential.

In family-first countries, in Latin America, parts of Asia, Spain and Italy, for example, a systematic approach like the one suggested by drafting a family constitution and having a professional family office and a board of directors that includes unaffiliated independents is critically important. The systematic approach to family governance provides a discipline that may be absent in cultural environments where family obligations supersede a business-first focus.

In business-first countries on the other hand, these may include the United States, Germany and Switzerland, for example, nurturing the heart of the family in business through family meetings, family assemblies, much communication and trust-building, promotes the engagement of next generation members that otherwise would be threatened by the loss of family values. The demise of the non-economic legacy often precedes the ultimate loss of wealth and the spirit of enterprise in these cultural contexts, making it vital for family businesses to embrace governance practices that strengthen family bonds.

Trusted advisors and their network of knowledge resources can help tailor a unique approach to the universal challenges posed by wealth to family governance. The need for family enterprises to consult with their advisors on good governance practices should not be underestimated.

Please contact us directly for further information via LNKD or follow us on TWTR Swiss Family Office.


Remember The Global Financial Crisis?! – The Housing Crisis

What Caused the Housing Crisis?

Bad Behavior, Moral Hazard, “Inside Job”

  • Mortgage demand from confused/misled buyers, taking out mortgages that self-destructed.
  • Mortgage supply from conflict-ridden financial intermediaries with no skin in the game.
  • Facilitated by revolving door of go vernment/industry/academia.

 

Government Failure

  • Mortgage demand from explicit and implicit government subsidies trying to expand homeownership.
  • Mortgage supply from “government sponsored enterprises” (GSEs), eager to comply with affordablehousing goals and to exploit government guarantees.
  • Facilitated by ineffectual regulators and by regulatory arbitrage.

 

Bubble Thinking

  • Mortgage demand from consumers, who view houses as a great investment that never goes down in value.
  • Mortgage supply from cash pools and intermediaries, who view mortgage-backed securities as “safe assets” (because housing prices could never fall by very much!) that satisfy their increasing demand for such assets for investment and collateral.
  • This “bubble thinking” made possible by the long quiet period since the last financial crisis in the United States, and the stability of housing prices during this time.

 

Why did the bubble take hold in 2003-2007?

Housing bubbles are always lurking.

The precipitating force this time was the demand for safe assets coming from macroeconomic forces.

 

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)


Family Office – Erosion of the Entrepeneurial Culture

The entrepreneurial stage is widely recognized as one that endows the organization with the capacity to be nimble, largely because at that formative stage owners know that the essence of being successful is making the sale.

But it does not take long for successful family businesses to be expected to comply with standard accounting principles that promote greater transparency – and the accompanying paperwork – and to have to comply with a growing number of industry standards and government-initiated requirements. Increased regulation and the expanding need for coordination create the impetus for more meetings, more memos and more e-mail that make the business of the family naturally become more bureaucratic. Collectively, these multiplying requirements may contribute to the family enterprise or family office experiencing time delays that the founder’s business never experienced during its entrepreneurial phase.

More importantly, there is the possibility that the family itself may have become an important source of inward-focused time-wasters (like who gets to use the company plane or the country home for the holidays, both administered by a nonfamily staff member), in which case, the family begins to represent a cost to the enterprise rather than the resource that a family member in a combined owner-manager role represented
during the entrepreneurial stage. And, more importantly, by focusing inward, it can lose its ability to keep an eye on new competitive dynamics, the everchanging marketplace, and the financial landscape.

Ignacio Osborne, reflecting on this very development, commented:
“The biggest source of resistance to any change may have been that the family name is on every product label. So we had to try to explain to family members who have been managing the company that in business today you have to focus on the customer and you have to forget a little bit about the vineyards, the countryside and the craftsmanship in production and look more into the market and what is going on in the world. I think that was the biggest resistance. After all the company has been very successful with the original business model for many years, so why change?”

For a number of companies with entrepreneurial cultures the costs of losing this competitive advantage only become evident when their leadership transfers to later generations of the owning family. Ownership-transfer policies motivated by a founder’s desire to love and treat all heirs equally or, from the next generation’s perspective, expectations by family members of equal treatment, are likely to promote an impasse, to the detriment of continued agility and competitiveness. Distributing voting shares equally among a growing list of shareholders often erodes a next-generation owner-manager’s ability to lead. Stock ownership by complicated trusts can also create difficulties for successor generation leaders. Unless ownership and management have been sufficiently differentiated through the presence of nonfamily managers with a great amount of influence in the top management team, trustees, too, can second-guess a firm’s management into paralysis. Successors need to be able to manage the company with agility, flexibility, and speed, and have ample leeway, including freedom from family constraints such as those mentioned above, to sustain the entrepreneurial culture of the first generation.

Multigenerational family-controlled businesses, even those with some exposure to public markets, are largely illiquid enterprises. This lack of liquidity and need for selfless interest can be a burden for family members operating in a society that tends to focus on the short term, the last quarter, the day trade. They will bear this responsibility willingly only if opportunities to acquire information, to be educated, and to engage with important family values of stewardship are plentiful. Inclusion, affection, and mutual influence across generations and between active and inactive shareholders are an absolute necessity.
Investing sweat equity in disseminating information to family members and encouraging multiple avenues of participation gives rise to trust, a spirit of service, and a sense that everyone is in the same boat on the same long journey.

 

For further information please contact us via LNKD or follow us on TWTR “Swiss Family Office”.


Remember the Global Financial Crisis?! – Safe Assets and the Global Savings Glut

Shadow Banking

“Runnable debt” is effectively “money”, and it comes in many forms.

In its simplest form, such debt was produced by banks in the form of demand deposits.

 

Safe Assets

What Are Safe Assets?

Information Insensitivity

  • No incentive to produce information about the asset
  • Can also think of this as “no adverse selection”
  • Not the same thing as “risk free” — this is tricky!

Includes

  • Currency
  • Government bonds of stable countries
  • Insured deposits in banks

Excludes

  • Stocks
  • Private debt of third parties
  • Government bonds of unstable countries

 

Why do we need safe assets?

Investments

  • Investment portfolio for consumers, institutions, and other capital pools

Transactions

  • Collateral for financial transactions

These are the same functions we often ascribe to traditional money

 

The Global Savings Glut Hypothesis

Between 2003 and 2007, short-term interest rates in the United States increased, which would normally also increase long-term rates.

That didn’t happen. Ten-year rates stayed about the same.

Ben Bernanke proposed that one cause of this “conundrum” was a “global savings glut” (GSG) from emerging-market and commodity rich countries with large current-account surpluses.

 

Supply of Safe Assets

  • Precious metals
  • Debt and currency of stable countries: U.S., U.K., Germany

By 2007, we were running out of U.S. securities for to serve as safe assets.

  • Insured deposits in commercial banks can act like safe assets… but there aren’t enough insured bank deposits.

When there is excess demand for something, we can expect somebody to try to make it.

 

“Manufacturing” Safe Assets

  • The key principle is to use only part of an asset as collateral.
  • A house is purchased for $1 million in cash. How safe would a security be that is based on getting at least $1,000 on that property? How much work would you need to do to figure that out?
  • A large tech company has a market capitalization of $100 billion in equity, with zero debt.
  • How safe would be the first $1 million of debt? The key here is to set the debt to value ratio low enough that nobody has an incentive to analyze default probabilities.

This is not the same thing as “default is impossible”!

Why do it this way?

Agency Risk

  • Risk that bank’s management makes a mistake and harms the rest of their business operations
  • But since these assets don’t require maintenance – they just collect cash payments –you don’t need the bank’s management to be involved any longer

Market Risk

  • If the value of the assets fall far enough, the special purpose vehicle has unique bankruptcy rules which are much cheaper than usual bankruptcy costs

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)

 


Remember the Global Financial Crisis?! – Housing and Mortgages

Housing Bubbles and Financial Crises

Reinhart and Rogoff (2008) identify the “big five” crises since WWII – Spain (1977), Norway (1987), Finland (1991), Sweden (1991), and Japan (1992) – plus 13 other bank-centered crises in developed countries.

Housing price appreciations are a standard feature of financial crises, and as of 2007 the United States appeared to be in great danger.

 

Mortgages: Fixed and Adjustable

The standard mortgage in the United States has a 30-year term, with fixed interest rates. Every year you pay interest and an amortization of the loan.

Alternative structures have adjustable interest rates for all or part of the term (“ARMs”, 2/28, 5/25 or 5/1, 7/23 or 7/1 etc.), with the adjustable rate set to some spread above a reference rate. •

  • Initial fixed rate will typically be lower than for 30-year fixed mortgage, sometimes called a “teaser”.
  • These alternative structures are more popular outside the United States.

More complex structures allow for flexible payment sizes: negative amortization, balloon payments, pre-payment penalties, and other elements that can reduce payment sizes in early years.

 

Prime Mortgages

Conforming/Prime/Agency

This is the core category of mortgages in the United States, used for loans that “conform” to Government Sponsored Enterprise (“GSE”, or just “agency”) standards for:

  • loan-to-value (LTV)
  • credit score
  • maximum loan size
  • occupancy rules
  • income limits and documentation

Such loans are eligible to be purchased, guaranteed, and combined into agency Mortgage Backed Securities. Loans that would satisfy these criteria except for being too large are called “jumbo” or “super-jumbo” mortgages, and cannot be guaranteed by the GSEs.

 

Nonprime Mortgages

Subprime: “Although categories are not rigidly defined, subprime loans are generally targeted to borrowers who have tarnished credit histories and little savings available for down payments.” (Mayer, Pence, and Sherlund, 2009)

Near-prime or “Alt-A”: “Near prime mortgages are made to borrowers with more minor credit quality issues or borrowers who are unable or unwilling to provide full documentation of assets or income …” (Ibid)

Together, subprime and Alt-A are known as “nonprime”. Nonprime mortgages are not new products, but their use in the United States increased dramatically in the 2000s.

 

Are Subprime Mortgages “Designed to Fail”?

In a typical subprime mortgage, an initial “teaser” rate will be set to adjust after two or three years, usually to be much higher than the original rate.

A borrower can get out of this higher rate by refinancing, but this action may incur a pre-payment penalty.

This sounds like a horrible trap, like a financial product that is “designed to fail”.

A subprime mortgage only makes sense if everyone expects housing prices to rise.

In this case, it can be a useful financial innovation, allowing borrowers to share the potential upside of their housing investment to get a lower overall rate.

 

Foreclosure: Localized But Global

In the United States, foreclosure was a national phenomenon, but was worst in the “sand states” of: Arizona California Florida Nevada

In the United States, foreclosure was a national phenomenon, but was worst in the “sand states” of Arizona, California, Florida, and Nevada.

All types of loans had elevated foreclosure rates in the crisis, with subprime loans and ARMs performing worse.

The United States had the worst foreclosure crisis, but some (not all) other developed countries also had problems.

 

Crisis Terminology

Some sources will refer interchangeably to the “housing crisis”, the “financial crisis” and the “Great Recession”, especially in the United States.

To be more precise, we should say that the housing crisis was a primary driver of the financial crisis, and that both were major contributors to the Great Recession.

To see how the housing crisis was a primary driver of the financial crisis, we must shift attention over to the “demand” side for mortgages.

Together, the crises in housing and in the financial sector deepened the real economic effects of what would later be called “The Great Recession”.

 

Summary

Housing crises and financial crises are intertwined, but are not exactly the same thing.

In the United States, foreclosure was a national phenomenon, but it was significantly worse in some regions and for some types of mortgages.

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)


Remember the Global Financial Crisis?!

What is a Financial Crisis?

  • Almost all wealth is embodied in long-lived assets that pay off slowly over time.
  • Some fraction of that wealth is needed to back short-term safe assets used in transactions (“money”).
  • Collectively, we cannot all convert our long-term assets to money at the same time.
  • A “panic” happens when enough people get nervous and try to convert.
  • A “financial crisis” occurs when a panic (or fear of panic) affects the functioning of the financial system.

 

Why Study the Global Financial Crisis?

  • It is an important part of history, by far the most important economic event since the 1930s, and crucial for understanding the world that followed.
  • It could happen again.
  • We would like to prevent it from happening again.
  • If it happens again, we need to be prepared to fight the fire together.

 

Asset Bubbles

  • “This time is different …” (Reinhart and Rogoff, 2008).
  • Prior to all financial crises, there is a large increase in the price of at least one asset class. When this price later falls, we retroactively label the original increase to be a “bubble”.
  • In the Global Financial Crisis, the bubble was in housing.
  • Housing bubbles have been associated with every major financial crisis since WWII.

 

New Kinds of Money

  • Through most of the history of civilization, our monetary needs were met primarily by metal-based currencies.
  • The rise of the modern state has allowed for sovereign-backed “fiat” money.
  • But … even stable governments have limits and the demand for money can exceed the supply of metal and sustainable fiat money.
  • Additional monies are then “manufactured” by the financial system, using private debt backed by collateral.
  • The history of financial crises is a tour through sad stories of new monies gone bad.

 

The Anatomy of a Modern Panic

  • For hundreds of years, panics were easy to spot: depositors would “run” to banks to exchange their banknotes for gold, or to remove their deposits.
  • The Global Financial Crisis was different, with the panics occurring out of public sight, in the non-bank part of the financial sector. This area of the financial system is often called the “shadow banking” system.
  • To fully understand the Global Financial Crisis and the efforts required to fight the panic, it is important to understand the mechanics of this modern system.

 

Fighting the Panic

  • Going into the Global Financial Crisis, governments all over the world were underprepared, with the available tools built for fighting an old-fashioned bank run, not a modern crisis.
  • To fight this crisis, these tools – emergency lending, guarantees, capital injections – were extended to creative new uses.
  • The evidence shows that this panic-fighting was a success, but this success came at the cost of political backlash, in some cases reduced our firefighting capabilities for the next crisis.

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)