The Great Recession

Question 1

What is an economic bubble?

Answer 1

When prices of assets and securities rise above true/fundamental value

Question 2

What happens once an economic bubble bursts?

Answer 2

Assets and security prices collapse

Question 3

What is a sub prime?

Answer 3

A small part of US housing mortgage market intended for borrowers with a relatively high probability of not being able to pay out their loan

Question 4

Explain the rapid rise in house prices after 2000.

Answer 4

• Long period of low interest rates incentivised house buying
• No need to raise interest rates as inflation was low
• Expectation that house prices would increase

Question 5

What role did lending play in the rapid rise of house prices in 2000?

Answer 5

• Borrowing became easier as banks made mortgage approvals more lenient
• Households with high probability of not being able to repay gained access to loans through mortgages

Question 6

Explain the origin of the recession.

Answer 6

• Started in the sub-prime mortgage market
• House prices stopped rising and there were increasing rates of defaults on mortgages in sub-prime markets
• When households default on mortgages the underlying properties are foreclosed and transferred to the banks

Question 7

What is a solvency problem?

Answer 7

If the value of assets decline under the level of liabilities then banks become insolvent

Question 8

What is a liquidity problem?

Answer 8

The bank has difficulty repaying its investors.

Question 9

Describe the leverage ratio.

Answer 9

Assets/Capital

Question 10

Describe the capital ratio.

Answer 10

Capital/Assets

Question 11

Why is a high leverage ratio risky?

Answer 11

In the event of a drop in asset value, banks can become insolvent

Question 12

Why did banks have such high leverage ratios prior to the crisis?

Answer 12

• Risk underestimation
• High bonus incentives for managers
• Regulation was lax - minimum capital ratio existed but banks found ways around it

Question 13

What was securitisation?

Answer 13

The creation of securities based on a bundling of assets

Question 14

Why wasn’t securitisation reliable?

Answer 14

• Diversified underlying assets should not be correlated
• Sub-prime mortgages were highly correlated - properties were located in similar bubbles and provided to borrowers with low credit ratings
• Securities were also rated very safe by credit rating agencies

Question 15

Describe the shadow banking system.

Answer 15

• Leverage of the banking system as a whole was much higher than had been perceived
• Through SIVs banks managed to hide risks and exposure
• As of 2008, no SIVs were left

Question 16

Who were American International Group?

Answer 16

Insurance company in the 2000s that began to sell insurance against default risk through the sale of credit default swaps

Question 17

What was the benefit to banks of AIG?

Answer 17

Banks could now get insurance on securities they thought would potentially default

Question 18

Describe how liquidity affected banks in the late 90s.

Answer 18

Borrowing from other banks and investors in short term debt to finance purchase of their assets.

Question 19

What was wholesale funding?

Answer 19

Funding your purchases through short term borrowing from other financial institutions.

Question 20

What occurred when housing prices declined?

Answer 20

• Mortgages declined
• High leverage implied a sharp decline in bank’s capital
• Banks started selling assets to rebuild capital levels

Question 21

What effect did Fire Sale prices have?

Answer 21

• Lowered the value of other assets
• Levels of capital continued to decline

Question 22

What was the credit crunch?

Answer 22

• Low solvency led to banks going bankrupt
• Banks that survived stopped lending to each other or anybody else

Question 23

How did the financial crisis become a macroeconomic crisis?

Answer 23

Consumer confidence in the US declined greatly leading to a sharp fall in spending and credit

Question 24

What were the three international spillover channels from the US?

Answer 24

1 - European banks directly exposed to the US housing market having bought securities with underlying MBSs and CDOs
2 - Trade flows contracted due to fallen demand and lack of trade credit
3 - Increased US interest rates led to increased European interest rates - firms found it difficult to borrow

Question 25

What was the initial US monetary policy response?

Answer 25

• Cut interest rates
• Increased federal deposit insurance in order to prevent bank runs
• Provision of wide spread liquidity to the financial system

Question 26

What was the initial European monetary policy response?

Answer 26

• Cut interest rates
• Unlimited liquidity for European banks at a fixed interest rate of maturities up to a year
• Purchase of covered bonds by the ECB

Question 27

How did governments use fiscal policy in response initially?

Answer 27

• Replaced private demand with public demand
• Tried to replace the fall in private consumption and investment with higher gov spending

Question 28

What were the limits to these policies?

Answer 28

• Central banks of major advanced economies has decreased interest rates to zero
• The Fed turned to credit/quantitative easing

Question 29

Why was the recovery so slow on the supply side?

Answer 29

• The banking crisis had decreased the natural level of output
• The expectation was not to go back to the level pre crisis

Question 30

Why was the recovery so slow on the demand side?

Answer 30

Policy interventions were limited