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Posts tagged “GFC

Remember The Financial Crisis?! – Europe

The Euro: Background

  • Evolved from previous pan-European institutions, with its formal name change and major steps towards union from the Maastricht Treaty in 1993
  • Monetary union commenced in 1999 with the euro as an accounting unit, and was completed with the introduction of physical euros in 2002.
  • This single currency is managed by the European Central Bank As of January 1, 2015, there were 28 members of the EU, of which 19 use the euro (“eurozone”).
  • There are several other countries that are part of the “single market” of the European economic area (EEA), or that use the euro as their currency without being part of the EU.

 

Policy Response

  • Shortly after the Lehman failure, Irish banks were on the precipice, unable to fund the external gap built up during the boom.
  • In September 2008, the Irish government made the most powerful response of any nation during the GFC: guaranteeing all liabilities for seven “covered banks” – a total of €375 billion, or about two times Irish GDP.
  • It was clear to markets that €375 billion was just too big of a burden for the Irish government.
  • Ultimately, Ireland required an international bailout in November 2010.

 

Iceland: Background

  • Tiny country of about 320,000 people, less than 10% the population of Connecticut
  • Dominated by three banks: Glitinir, Landsbanki, and Kaupthing (collectively, “GKL”)
  • After the Northern Rock run of September 2007, there was increased pressure on GKL, and the online accounts began a slow run (jog?).
  • After Lehman, the jog turned to a sprint, and GKL were unable to keep up their short-term funding. Iceland nationalized all three banks over the week of October 6.
  • Iceland’s deposit fund was insufficient to pay everyone back, and so they made the controversial decision to pay back only domestic customers.
  • The UK and the Netherlands made their own depositors whole, but were not pleased.

 

Summary

  • The causes and immediate consequences of the GFC were similar between Europe and the United States.
  • Ireland had a lending boom leading to a domestic house bubble, and the government’s aggressive actions to guarantee Irish banks backfired into a sovereign debt crisis.
  • Iceland built a financial center on foreign lending. The scale of losses were too large for the government to guarantee the system, so Icelandic banks were nationalized and defaulted on foreign depositors.
  • After 2009, the eurozone countries lurched from crisis to crisis, with intertwined banking, sovereign debt, and growth problems.

 

 

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)