Financial crises

Causes of 2008 financial crisis

Early 2000s, following the dot-com crash, central banks slashed monetary policy interest rates, triggering a search for higher yields among global investors

Commercial banks massively expanded their mortgage lending

When they ran out of highly creditworthy borrowers they relaxed lending standards and turned to the subprime market w/ poor credit histories

-Mortgages handed out with 0 down payments, low “teaser” interest rates and occasionally w/o verifying the borrower’s job/ income (NINJA loans)

-Flood of credit created artificially inflated demand for housing, causing property prices to soar and creating a speculative bubble, people assumed house prices would always rise so they could refinance their mortgages later

Securitisation?

lenders bundled thousands of mortgages together and sold them to investment banks, which sliced the bundles into complex financial derivatives called Mortgage-Backed Securities and Collateralised Debt Obligations

Tranching

The way CDOs were split by risk: top slices were paid out first when mortgage payments came in, so credit rating agencies stamped them with AAA ratings, as safe as govt. bonds

Asymmetric information is housing market

rating agencies & global investors didn’t know about the underlying risk of the subprime mortgage loans

How did the risk from bad loans spread through the global financial system

Pension funds, foreign banks and councils all bought the bonds which spread local US housing risk throughout the global financial system

Leverage

use of borrowed money to amplify returns

Why was leverage a factor of 2008 financial crisis?

Major investment banks were using leverage ratios of 30:1 or more, meaning if their assets dropped by 3.3% their equity would be completely wiped out and the bank would become insolvent

Systemic risk

the danger that the failure of one deeply connected financial institution will cause a domino effect, triggering the collapse of an entire financial system/market

Banks rely heavily on trust and short-term borrowing from each other so sudden defaults of banks freezes credit markets instantly, impacting the broader economy

Housing bubble burst after interest rates rose

Subprime borrowers, unable to meet higher mortgage payments or refinance their now depreciated homes, began defaulting and their CDOs became “toxic assets”

2007 collapse of U.S subprime mortgage market triggered a wave of foreclosures and losses in the banking sector

Bankruptcy of Lehman Brothers, a major global investment bank, sparked widespread panic, freezing credit markets worldwide

These assets were spread across global balance sheets causing a severe liquidity crisis as banks stopped lending to one another because they didn’t know who held the toxic debt and were on the verge of bankruptcy

Stock markets plummeted, leading to a global recession and emergency interventions 

Huge govt. Bailouts of financial institutions and monetary + fiscal stimulus packages

“Too big to fail” banks had to be bailed out by the govt.

Stats on mortgages and foreclosures

Foreclosures on subprime mortgages- 3.3% 2005

14.5% by 2010

Delinquency rates on residential mortgages went from under 3% 2007 to almost 12% 2010

Govt. Bailouts in US during 2008 financial crisis

The Fed initially slashed interest rates from 5.35% to 0.25% between 2007 and 2008 to stimulate borrowing and investment. This was insufficient to unfreeze credit markets so the Fed launched quantitative easing- buying trillions of dollars in long-term govt. Bonds and toxic mortgage-backed securities, which injected liquidity into the financial system and stabilised failing banks

45 billion in subsidies for bank of america

25 billion for JPMorgan

4.3 billion for Societe General

How was the UK affected by housing bubble burst?

Uk one of the first countries to experience financial panic after the US- Northern Rock became first bank to collapse in 150 years due to a bank run as the bank announced it would be seeking emergency support from the Bank of England

UK banks stopped lending to each other

UK bank stats

Barclays value fell by 24.6 billion 2007-8 but needed no govt. Bailout as it sought middle eastern investment

Royal Bank of Scotland received a 20 billion bailout, and value dropped by 30 billion

Moral hazard

When entities engage in riskier behaviour because they believe they won’t bear the full consequences of their actions (e.g government bailouts lead to moral hazard as it changes risk-reward calculus for banks, investors, and other financial institutions)

Factors behind the dotcom bubble

There was an abundance of venture capital during the 90s

-Start ups wanted to quickly get big and ignored fiscal responsibility

By 1999, 39% of all venture capital went to internet companies

Valuations were based on earnings and profits that wouldn’t occur for several years if the business model actually worked

Investors too willing to overlook traditional fundamentals

Companies with no revenue or sometimes even a finished product went to market with IPOs that quadrupled their stock prices in one day

Dotcom bubble crash

Nasdaq peaked at 5048 in 2000- almost double that of 1999

Several high tech companies like dell and cisco placed huge sell orders on their stocks when the market peaked, so investors panic sold and the stock market lost 10% of its value

Nasdaq fell to almost 20%