Financial Crises: Consequences Flashcards
(24 cards)
Subprime borrowers
borrowers with poor creditworthiness, low income, and high LTV ratios
NINJA loans
a slang term referring to those with no income, no jobs, and no assets. Most loans require borrowers to show a steady income stream or post sufficient collateral, while NINJA loans ignore this verification process. Banks made these loans due to mortgage securitization
The originate and distribute model
Originator banks made loans to subprime borrower and wanted to free up capital so engaged in securitization.repackaged them into traceable bonds known as mortgage-backed securities (MBSs). They then sold these MBSs to investors
How did banks use securitization to theoretically reduce risk?
But the banks tried to reduce risk to individuals by pooling together all the interest and principal payments (in other words, the subprime loans) into a common pot known as a mortgage pool. The pool is divided up into thousands of pieces, which would then be used to create MBS bonds. Effectively, each of these pieces of the mortgage pool acts as the underlying collateral for the MBS bonds the bank is creating. The bank then sells these bonds to investors all around the world, so technically, even if a few borrowers default, the loss is spread over a large number of investors who all hold small bits of thousands of mortgages. Theoretically, the risk is spread over thousands of investors. the risk has been dramatically reduced because the MBS bonds are effectively made up of small bits of many different mortgages whose risks are theoretically uncorrelated
Tranching
Tranching was created because different investors have different tolerance levels for risk, so MBS bonds were sold as different varieties known as tranches (or flavors of risk), bearing different degrees of risk
What was the typical fate of the different tranches of bonds?
Investment grade bonds were thought to be solid investments and were taken by pension funds and investments banks. Equity grade bonds were thought to be far too risky and were just kept by originator banks. mezzanine bonds were better, but still too risky, so were put through securitization again and became CDOs
CDOs
Collateralized Debt Obligations – A CDO is essentially created through a second round of securitization. MBS mezzanine bonds originating from different tranche sets are bundled together in a common pool, are divided again, and then sold to investors
The key difference between MBS bonds and CDOs
This is the key difference between MBS bonds and CDOs –in MBS bonds, the underlying collateral were the mortgages themselves. Here, the collateral is a portion of these MBS bonds. Each piece of the CDO pool is itself made up of pieces of thousands of MBS bonds.
CDS
Firms sell corporate bonds to raise funds for investment rather than borrowing from the bank, but sometimes firms default so these bonds are risky. The risk of default is what is known as credit risk. As a result, when investors buy the bonds, they also often purchase a credit default swap –basically an insurance policy for if the firm defaults. The investor pays a monthly fee, CDS spread, to a bank to cover the principal payment in the case of default
How did MBS bonds change as a % of GDP between 2000 and 2007?
In the US alone, the amount of MBS and related securities reached 20% of GDP in 2007 compared to less than 5% in 2000
The two key reasons investors failed to understand the risks they were taking
- lack of transparency –securitization resulted in a major increase in the complexity of financial products, making it difficult to estimate the risk involved
- Moral hazard – Originator banks had little incentive to screen mortgage borrowers carefully because they would sell the loans shortly afterwards
define moral hazard
Moral Hazard is the lack of incentive to guard against risk when protected from the consequences
The two triggers for the crisis
○ Between 2004 and 2007, the US Fed increased interest rates by 4%. The mortgages were “adjustable rate mortgages,” meaning that if the interest rate rises, then contractually speaking, then mortgage interest rate rises as well. When the federal funds rate increased by 4% points, mortgage holders faced a 300% increase in interest payments and they could not afford to repay their loans and started to default
○ By August 2006, US house prices started to fall in annual terms
insolvency vs. liquidity shortage
- Insolvency happens when the value of a bank’s assets overtakes the value of its liabilities – it does not have the income to repay all its debts. A liquidity shortage is much less serious normally. It just means the bank is temporarily short of cash, but it can still repay its debts. The bank will usually take out a loan on the interbank market to make up the liquidity shortfall. If this option is unavailable, then it goes to the lender of last resort– the central bank – in what is known as “liquidity support”
fractional reserve banking
Banks keep only a small percentage of deposits as reserves, lending out the rest to firms and households
Process of a bank run
In summary, first reserves are depleted, then the loans and assets must be liquidated in a fire sale where the assets are sold far below market value since the assets are risky and banks need the money in a hurry. The bank cannot meet all withdrawal demands since the value of reserves and fire sale value of loans combined is less than the banks liabilities in deposits. Eventually the bank runs out of money and must be closed by a financial regulator
Why do banks hold capital?
- Banks hold capital to create a cushion against losses and thus reduce insolvency risk
A bank becomes insolvent when capital depletes to 0
what is capital for a bank?
assets – liabilities
The capital ratio
capital/assets
Deleveraging
selling assets and repaying debts.
How did capital deleveraging worsen the crisis?
It became a cycle, by which bank capital erosion leads to deleveraging, which causes asset prices to fall, leading to more capital erosion. This led to a financial meltdown, credit crunch, and global recession
The Liquidity Coverage Ratio
requires a bank to hold sufficient high-quality assets to cover its total net cash outflows over 30 days
Basel III Capital regulations
I.MCR increased from 2.5% to 4.5%
II. Capital conservation buffer of an additional 2.5% in which no dividends can be payed
III. Counter-cyclical requirement of 2.5% additional capital to be held during boom
The Volcker Rule
Bans commercial banks from trading on their own account (i.e.engaging in speculative activity for their own profit)
