ECON 0620 Midterm 1

Kindleberger model/theory

Displacement (war, crop, policy, etc)
Credit Boom (money pour in)
Mania (overtrading, credit>economic growth)
Panic (rush to door)

Kindleberger on panic

markets are irrational
filled w/ fraud, scams
history based, tulipmania example, old-fashioned, understanding may benefit from historical perspective (based on 1929), part of econ. cycle & pendulum, panic = mimicing others = everybody wants OUT

Keynes

-sheep lack spirit
-ppl=sheep
-dont bet on beauty, bet on expectations of others (what others think is beauty)
-markets taken by irrational exuberance
BETTER FOR REPUTATION TO FAIL CONVENTIONALLY THAN SUCCEED UNCONVENTIONALLY

Minsky's 3 Players

Bubbles & irrational
Hedgers: (have resources to meet commitments)
Speculators: (ran math, have capital, think they are covered, speculate)
Ponzi (evil, devise system, attract people to keep playing, profits come from new investors, flow come down = crash

Minsky's Financial Instability Hypothesis

Financial crises happen in a capitalist economy, stability leads to instability internal dynamic and systems of interventions/regulations

Market fails on its own because of ponzi people; once people start to lose fundamentals & bet on future price movements, it travels across assets and they all decline

Speculation is the chief evil

Gorton

info insensitive -> info sensitive --> increase spending on learning resources --> increase speculation --> run
(no bubbles; world is rational; meltdowns are bank runs; must check fundamental; tulipmania explained by economics; money is info insensitive)

CDO (Collateralized Debt Obligation)

a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors

Why are info sensitive assets bad?

People dont have expertise on it, so they just sell them cuz they dont know how to deal w them

Tulipmania

- came to Europe from Turkey
- became very popular especially in Holland and Germany
- But supply of the tulips could not meet the demand and the prices rose
-aesthetic value for wealthy elites
- people started spending all their savings on bulbs and buying bulbs on credit
- left many Dutch families with lost property and bulbs that were worthless
-traded on forward contracts, traded in colleges (pools that set own rules), system of differences (between spot & forward price)
-no longer instrinsic tulip value, just speculative, conviction spread & prices fell

Earl Thompson Reading of tulipmania

We don’t know the full resolution of Tulipmania

forward contracts became like options, and since prices aren't clear & contracts not enforced we challenge the bubble view
governments intervene after crash

Peter Garber opinions

-traders either stupid or see something others dont
-says tulipmania not bubble and bubbles are myths
-Tulipmania observational equivalence (cant tell if its bubble or myth based on date) (you need a theory of what should happen rationally, but how to disentangle this from the fact that you got it wrong) (2 different ways of explaining the same thing and we don't know which one is correct)

Jonathan I Israel

connects amsterdam w/ diplomacy; maps interaction w/ netherland france and uk with what juries and traders were doing stuff; and how move of prices of East India company; and how that price & Amsterdam market was being influenced by geopolitical events; information cluster

De La Vega complete financial market

1. Princes
(buy & hold, dividends, wealthy, etc.)
2. Merchants
(invest liquidity, buy & sell on news, small profit)
3. Speculators
(trick and scheme, no cover, risky bets)
(foundation of behavioral finance)

De la vega vocab

Liefhebbern (lover(bull) purchase shares and bet on rise) praise & exagertae everything
Contremine(bear) sell shares and bet on fall, destoryers, ruled by fear

John Law and the Mississippi Bubble

-Law set up a national bank in Paris and printed money in order to increase the amount in circulation and to stimulate the economy
-Banque Generale is largely successful due to government eliminating competing currencies
-Shares can be bought through government debt, 1718 it is nationalized
-He organized a monopoly on Beaver Fur trade in Canada called the Mississippi Company on trading privileges with the French colony of Louisiana
-Acquires many overseas companies and increases tax farming activities.
-The Mississippi Company took over the management of France's debt and issued shares of its own stock in exchange for government bonds, which had fallen sharply in value
-The stocks soared in value and investors sold them for paper money to exchange for gold, however the French bank did not have enough gold to pay them
-Law was forced to flee France

Key words in mississippi

debt equity swap (through purchase of french debt you can get shares in Miss company)

Problems w/ mississppi

Shipped a bunch of women to french colonies; men in colonies were sex w/ native americans; they wanted more french women there; people were arrested to populate louisiana

Balance sheet during MISSISSPPI

Assets: French Debt
Liabilities: Shares

Bubble Companies Balance Sheet

Assets:
-Revenue from Colonial monopolies
-Tax revenues
-Government Debt
Liabilities:
-Capital
-Lease on tax revenues
-Debentures

Asset side contagion

When bank has its own assets & assets price to fall, goes to liability side, as people take out deposits, leads to insolvency, domino effects to other banks

asset side contagion victims

lenders, banks, insurance

Requirements for good acceptance seller

-good reputation
-insurance worth something
-must not default, so you must have capital & liquidity

Acceptance

-underwritten bill
1. Somebody wants to raise cash
2. They borrow money
3. They sign acceptance that says (I know I owe you money)
4. That acceptance is then traded
If Rothschild signs their name, they guarantee that money lending you will get back. They weren't signing all the acceptances, only the ones they knew were good. Mutually beneficial.

1825 Debt Crises

1. Monetary expansion by bank of england

2. War of revolutions in Latin America, new political entities being born, spanish emprie collapsing

3. New territories developing trade w/ Britain (peace in Europe, war in latin Amrerica)

4. New countries wanted best underwriters for loans

5. New investment prospects in latin america

6. information difficult to obtain

7. Argentina new gov issuing debt to raise money, asks London

8. merchant london banks buy debt when liquidity was easy to obtain (low interest rates)

9. interest rates increase (less liquidity, investment banks don't borrow as much, capital of merchant banks decline, investments unsuccessful)

10. Bank of England restricts credit --> crash

Joan Dejean: Capitalist Violence

Shipped a bunch of women to french colonies; men in colonies were sex w/ native americans; they wanted more french women there
sending people over also signaled colony was doing well (when it rlly wasn't)
Women never went voluntarily to Louisiana, people would accuse them of being a "prostitute" and would ship them out to Lousinana
Women who dont want to marry the man that their family wants them to marry, her father declared she was a prostitute and would be shipped away
Police were paid for every women they brought in
John Law could do anything he wanted during this corrupt time

margin call

additional securities or cash to maintain collateralization of their loans
Margin = Security price - collateral

High vs low margin calls

High:
security >>> collateral
low:
security <<< collateral

Bagehot

when BofE interest rate decreasing, Bagehot says to have high interest rates so that people are incentivized to lend with each other rather than doing it at the Fed; its a "fine on unreasonable timidity"; households will not take out interest they think they cannot pay back. They are disincentivized to borrow and default, which in turn enables banks to build up reserves.

Bagehot rules

Lend freely & against good collateral & at super high rates
1st time using: 1866 (Lombard Street is bills of exchange: liquidity crisis; Gorton problem; lose confidence & rotten apple problem

panic of 1907

In 1907 there was a worldwide financial panic. NYC trust companies had most of their loans be collateralized loans, while US commercial banks did not. During this panic, liquidity dried up due to a variety of factors, such as the Bank of England raising interest, which made money fly to UK from US & made refinancing more costly. Top bankers, such as Heinze, tried to corner his company UC unsuccessfully, which burned his liquidity prior to getting margin calls as his collateral declined. This forced him into a margin spiral, where he and his speculators faced losses. Prices on the market declined, and the lending activity of trusts became contracted and they accumulated cash positions to strengthen reserves. Brokers couldn't find cash on the market to meet their liabilities, even though they had good collateral to offer, coining the phrase "they had the securities on which to raise money but there was no money to be had". It led to the creation of the Federal Reserve.

Saviors: Morgan organizes money pools (gather banks to raise cash to lend to NY stock exchange houses)

panic phase

real assets --> money w/ crash in price of commodities, houses, land, etc.

Wildcat Banks

The banks of the western frontier. These banks were hit hard by the Panic of 1819. The Bank of the United States' response to the panic of 1819 made the nationalist bank a financial devil in the eyes of wildcat banks.
(located in geographically inconvinient; difficult to present banknotes and get reimbursed)

Clearinghouses role

-suspend publication of individual bank balance sheet, only aggregate
-joint suspension of convertibility of deposits into currency
-issued loan certificates to public during panic
-Aldrich Vreeland Act (establishes national monetary commission)
-origin of central banking

Sequence of currency - banking crisis

Fiscal problem → currency problems
Currency problems → removals from banks (banks receive huge amount of foreign deposits)
Removal of deposits by foreigners
Collapse of banking system

Rating Agencies

Rose w/ Mercantile Agency system (credit system & dry goods trade), network of lawyers,
Poor's, Moody's, Standard Statistics

Was there a moral hazard for BofE loan recipients?

No because of BoE risk management
-registries

Interest rate difference

Arbitrage Interest rate of market SHOULD be lower than bank because if it wasn't you would just go to the Bank

When Bank lends freely, ibank lower than imarket, doesn't reject many bills

Why Rothschild was such a good underwriter

1) prudent
2) retain dominant position in market
3) name & rep
4) two tier market structure
They gave more loans but never defaulted

Fiscal-Financial System (John law & France)

Tax farmers (system of collection of funds to private individuals)

How do sovereigns fund their treasury

money, tax, debt

Prices driven by

fundamentals f(t) (intrinsic) & bubbles b(t)
b(t)>0 means people are buying because they expect prices to increase thru time (excessive expectations)

repo haircut

the difference between the initial market value of an asset and the purchase price paid for that asset at the start of a repo

Repo Market Downturn

secured lending; bank lend to bank, bank posts collateral, collateral is structued (e.g. CDO), low housing = low collateral, collateral becomes info insensitive, bank removes deposits backed by repo

We use Gorton & Kindleberger to answer:

what is a market, why do people trust one another, what makes a market liquid

difference in underwriters then v now

rothschild used to be way bigger than anybody
-now JPMorgan, but more balanced
-used to be more spread = more turnover, now not
-way more speculative bonds now than before
-investment banks today less powerful, only underwriters, other institutions do what IB used to do
-certification & crisis lending outsourced
-more diversification & educated investors

asset side contagion elements

1. joint liability
2. credit chains
3. forced sales

Public expectations of future price increases cause

prices to be temporarily elevated even if fundamentals remain the same

Wheat futures

Planting months: fall for winter wheat, strong demand in crops that were harvested during the previous season, rising prices
Harvest months: typically july for winter wheat, the newly harvested crop comes to market (supply is higher, falling prices)
-Global supply of wheat decreases, therefore, the price drastically shoots up because demand does not decrease

3 Classes of Men on Amsterdam

1. Big capitalists
-long term spots, reap dividends
2. Merchants
-buy & sell shares according to news
3. Speculators
-risky, take short & long positions,

Margin Call Example

1. Bank believes Asset will increase
2. Bank invests in Asset on margin (broker spots him)
3. Initial margin requirement is set by Fed (now 50%)
4. Bank invests in Asset on margin (has equity & debt)
6. Say asset declines in value, then Bank get a margin call
7. Asks Bank to post more capital to compensate for loss (needs equity/valuation to be > something)
8. Margin call happens until they meet maintenance margin

tulipmania elements

colleges: pools of traders who set up own trading rules

system of diffeeences (pay spot-forward price)

Opsies

De La Vega emphasizes importance bc they limit losses

Amsterdam 2 options

1. Episode of mania (de La Vega behaviorist)
2. Information crisis (de La Vega insider)

Market in amsterdam

not where info processed. where info is made.
-organized trading "First Stock Exchange"
-rules and intermediation
-instruments (East india tea comp. & debt of provinces traded)
-derivatives (vanilla trades, forward
-trade in coffee houses

Tulipmania Aftermath

Dutch Government intervenes

• Amsterdam: all contracts before November 1636 are enforced, all after can be forfeited after paying 10% to seller

• Haarlem: Moratorium on contracts, 1638 possible to nullify contracts by paying premium

Mississippi Bubble Contexts

War - After war of Spanish Succession, colonial expansion spreads from europe to Americas and results in difficulties for public finances

Ancient Regime Finance - Sovereigns fund treasury through money, tax, and debt, tax farmers form the fiscal-financial system by contracting with state

Government Equity -

Fundamentals of Bubble companies (South Sea)

-South Sea Company: given monopoly by UK to trade in South Seas, an area controlled by Spain, argue that bubble companies are machines to defraud investors

• Prices manipulated, insider trading opportunities are created - informed agents have advance knowledge of when company buys bonds, then buy bonds

John Law System

-Taking over tax farming renders service of government debt more reliable, encourages holdings at a lower interest rate
-Low interest rates encourage investment and new activities
-promoting new activities creates new revenues

Unfeasible, results in speculation, little investment, expropriation of creditors and outsiders by debtors and insiders

Lending of Last Resort

In period of distrust no one lends, thus create value be lending in “last resort”

Money Market - Acceptors

Merchant banks that underwrite bills,

Three Rates

Deposit rate - rate at which discount houses take deposits of the public
Lending rate - rate at which discount houses and other investors place their funds
Bank of England “Rediscount”
Arbitrage: Market Rate has to be below Bank rate, otherwise you go to the Bank

New York Bankers

Bank of deposits: Issue of US dollar limited to back in US bonds, internationalization of the dollar, creates a sustained demand for bonds

Midwestern Urban Bankers

Banks of note issue: Increase influence on the issuance of currency to expanding volume of domestic commerce
Commercial Bills currency: include short-term commercial papers for backing of dollar notes

Federal Reserve Act

Election of 1912: Opposition to the proposal was a plank in the democratic platform
-Still support for central bank