global financial crisis part 1 econ 730 spring 2020cengel/econ730/lecture02-global... ·...

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Global Financial Crisis

Part 1

Econ 730

Spring 2020

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Timeline of Global Financial Crisis

2002-2007 US real estate prices rise mid-2007 Mortgage loan defaults rise, some financial

institutions have trouble, recession begins March 2008 Bear Stearns fails Sept. 2008 Lehman fails, AIG fails, stock market crashes, dollar

appreciates 2008-2009 Global crisis, unconventional monetary policy,

automatic stabilizers and fiscal stimulus 2009-2011 Very slow recovery

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Timeline of European Debt Crisis

Feb 2010 Greece reveals debt problem 2010-2011 Interest rates rise 3.5%→ 9.8% (9/10) → 12.3% (1/11)

→ 26.7%(7/11) 2012 Greek debt to GDP rose toward 170% 2010-2011 IMF/EU bailouts Feb. 2012 Greek debt restructuring (default) 2012 Contagion to Spain, Portugal, Italy July 2012 Draghi “The ECB is ready to do whatever it takes to

preserve the euro. And believe me, it will be enough”

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What was the global financial crisis?

• Home prices in the US rose.

• Borrowers thought they could afford expensive homes with large

mortgages because they thought home prices would keep rising.

Optimism and misunderstanding.

• House prices peaked and defaults began.

• As prices stopped rising, more homeowners realized they could not

pay back loans. Defaults increased. This led to greater fall in prices,

and a vicious cycle of defaults.

• Financial institutions got into trouble, and were near bankruptcy.

They stopped making loans to households and businesses

• Economy was on verge of collapse

• Policy stepped in – rescued financial institutions; unconventional

monetary policy; fiscal stimulus

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Causes of crisis

1. Deterioration of household balance sheets

2. Increased riskiness of portfolios of financial institutions

3. Proliferation of new financial instruments (CDOs)

4. Credit default swaps (CDSs)

5. Rating agencies

6. Risk-taking incentives for employees of financial institutions

7. Regulatory policies

8. General miscalculation of systemic risk

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Why do we have banks (or other financial intermediaries)?

- Imperfect and asymmetric information

- Liquidity transformation

Two problems with asymmetric information:

Adverse selection: “A situation where buyers and sellers

have different information, so that a participant might participate

selectively in trades which benefit them the most, at the expense of the

other trader.”

Moral hazard: “occurs when someone increases their exposure to

risk when insured, especially when a person takes more risks because

someone else bears the cost of those risks.”

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Adverse selection in investments may mean that some worthwhile

projects do not get funded because investors cannot distinguish

between good and bad projects.

Example (from the textbook)

Suppose there are two firms.

Firm A’s project has no uncertainty. If it gets $1.00, it will return $1.20

Firm B’s project is uncertain. With probability ½, if it gets $1.00, it will

return $1.50. With probability ½, it will lose everything, including the

initial $1.00. (The firm has limited liability. If it borrows $1 and the

project fails, it pays back nothing – it does not use owner’s wealth to

repay.)

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Suppose first there is no asymmetric information. There is a lender that

knows which type of firm it is lending to. It makes loan contracts with

each firm that charge a specified interest rate.

Firm A would accept any loan for which r < 0.20. If lender was willing to

lend for r < 0.20, both parties would be happy.

Firm B will accept any loan for which r < 0.50. If the project succeeds, it

makes 0.50-r. If project fails, it pays back nothing.

But the lender’s expected return is −1 1

2 2r . In order for the expected

return to be >= 0, the lender must charge r >= 1.00, or 100% interest.

Firm B would not undertake the project.

So under perfect information, Firm A’s project is funded but not Firm B’s

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Now suppose there is asymmetric information: the firms know the

riskiness of their projects, but the lender does not.

If the lender does not know which type of firm it is dealing with, it must

charge the same rate to all firms.

Suppose it thinks that there is a 50% chance the borrowing firm is type

A and 50% it is type B. The expected return to the lender is:

+ − = −

1 1 1 1 3 1

2 2 2 2 4 4r r r .

It must charge a rate r >= 0.33 to have a positive expected return.

But a type A firm would not borrow at such a rate. A type B firm would.

But the lender knows this, and realizes that only type B firms would

borrow, and so charges r >= 1.00. No loans are made!

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Moral hazard occurs when somebody is insured. The person that is

insured takes additional risk because they do not bear the cost of the

bad outcome. The insurer does.

The previous example can be modified to illustrate moral hazard.

Suppose one firm has two possible projects, but the lender does not

know which project the firm will undertake.

The firm has the incentive to take the riskier project, because its

expected return is + =1 1

0.5 0 0.252 2

, while the riskless project has a

return of only 0.2.

If the lender cannot monitor the project, no loan will be made, following

the previous logic. It is moral hazard because the lender bears the cost

of the failure of the risky project.

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What is the role of the bank?

The bank specializes in monitoring projects. It has trained employees

that can assess the risk of a business project, or the risk that a

household will not be able to pay back the loan.

There are also economies of scale in gathering information. If a project

requires investments from 10 investors, it makes sense for only one

agent to monitor, not all 10. The bank can perform that task.

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Liquidity transformation

We will do a more detailed model later, but the idea here is that some

projects require time to complete. Lenders, however, might face the

need for cash in a short period of time – they have a desire for liquidity.

Liquidity refers to how easily an investment can be converted to cash:

“the degree to which an asset or security can be quickly bought or sold

in the market at a price reflecting its intrinsic value. In other words: the

ease of converting it to cash.”

The borrower might have a project that is not liquid, but the lender

might have some need for liquidity. But liquid assets pay a lower rate of

return.

Banks can pool investors, and conserve on liquidity.

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Balance sheet of commercial bank

It is helpful and important to understand the balance sheet of banks and

financial institutions in “shadow banking”

“Shadow banking” refers to financial institutions that offer ‘safe’ assets

to groups with pools of cash, and makes loans to businesses, real estate,

etc.

• Shadow banking is less regulated

• Liabilities not guaranteed by government

• Includes hedge funds, money market funds, structured investment

vehicles (SIVs), credit hedge funds, private equity funds, broker-

dealers, finance companies

We will call all of these “banks” for now.

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Bank Assets Liabilities

Loans to businesses, homeowners “Liquid” securities Reserves (cash and deposits at

Central Bank)

Deposits Other borrowings Net worth or equity

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Insolvency or bankruptcy:

• When equity < 0

• Value of all assets – (deposits+other borrowings) < 0

Illiquidity

• When loans cannot be sold at market value

• “Fire sale” – when a distressed bank must sell its illiquid assets at

less than true value

• The bank is said to be illiquid when

Fire sale value of loans + other asseets – (deposits + borrowings) < 0

Why would a fire sale occur?

Why could a bank not sell an asset for its true value?

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1. Bank needs money

immediately, but the market does not have time to assess value of assets.

2. Bank has private information about value of assets. Market fears “adverse selection.”

3. The rest of the market is also illiquid, so cannot “afford” to pay the true value of the asset.

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Liquid Assets

Liquid assets are assets that can be quickly converted to cash with little

or no loss of value.

Liquid assets tend to pay a lower rate of return on average than other

loan opportunities for banks.

Why do banks hold liquid assets?

Why do liquid assets pay a lower average rate of return?

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How much liquid assets should a bank hold?

1. The more uncertain withdrawals are, the more they should hold.

2. The costlier it is to sell loans and other assets , the more liquid

assets the bank should hold.

3. The higher the cost of insolvency, the more liquid assets.

4. The larger the spread between returns on loans versus liquid

assets, the less liquid assets the bank should hold.

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Example of Insolvency (credit risk)

Initial balance sheet:

Assets Liabilities Loans $100 Securities $10 Cash Reserves $10

Deposits $100 Borrowings $0 Equity $20

Now suppose that there is default on 25% of the bank’s loans:


Deposits $100 Borrowings $0 Equity -$5

The bank is insolvent or “bankrupt”. It cannot fully repay its creditors.

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This was an example where the bank’s leverage ratio was high. Leverage

is the ratio of liabilities to equity. In the above example, it was initially

100/20 = 5. Less leverage makes the bank more resilient. Suppose

initially:



Then after defaults on loans occur:



The bank is still solvent.

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Liquidity risk

Start with the original initial balance sheet.



Depositors unexpectedly withdraw $20. Cash and securities are liquid. They can be costlessly converted to cash to pay off depositors:



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Now, suppose depositors withdraw another $30. Loans must be sold.

But they cannot be sold at face value, as discussed previously.

Suppose in order to raise $30, the bank must sell $60 of loans.


Deposits $50 Borrowings $0 Equity -$10

The bank was fundamentally solvent, but because of a liquidity

shortage, it went bankrupt.

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Suppose instead the bank initially held more liquid assets, and then

depositors withdrew $50.

Initial balance sheet:



After withdrawals:



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Traditional view of balance sheets

Household or business:

Assets Liabilities House or business Deposits at bank

Loans from bank Equity

Bank:

Assets Liabilities Loans Securities Cash Reserves

Deposits Equity

To understand the modern system of financial intermediation, we need

to introduce some new concepts.

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Asset-Backed Securities (ABS)

A pool of loans – for example, a pool of 1000 home loans.

An originator – such as a bank – makes the loan but sells the loan to an

investment bank that packages the loans together.

The investment bank then sells shares in the ABS to investors – banks,

money market funds, hedge funds, etc.

The idea is that risk is pooled. One loan might be risky, but 1/1000th of

1000 loans is much less risky.

For mortgage loans (MBS), it is particularly helpful in that there may be

a lot of correlation in risks locally, but less so if mortgages from across

the nation are pooled together.

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Tranching of ABS

An investment in an ABS can be made even less risky by dividing the ABS

into tranches. Suppose there are five tranches:

Riskier loans are placed in the lowest tranche. More highly rated loans

are in the upper tranche.

The upper tranche then is pooling together individual loans which

themselves are not very risky.

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Repurchase agreement (repo)

A repo is a very liquid type of asset for an investor (liability for a

borrower.) It is a securitized loan.

Effectively the borrower offers an asset – perhaps an ABS – as collateral

for an overnight loan from a lender. If the borrower fails to pay back the

loan, the lender has possession of the collateral.

The way that interest is implicitly paid is that the borrower “sells” the

asset to the lender, and then agrees to buy it back from the lender at a

slightly higher price the next day.

But because of adverse selection, the borrower may not be able to sell

the asset at its true value. The difference between its true value and

what it can sell it for on the repo market is called the “haircut”.

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Modern Financial System:

Households:

Assets Liabilities House or business Deposits at bank Money market deposits Insurance guarantees Retirement funds Stock-market mutual funds

Loans from bank Credit card balances Equity

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Balance sheets of money-market funds, insurance companies, stock-

market mutual funds, retirement funds

Assets Liabilities Less liquid securities More liquid securities such as

stocks and ABS Repo Cash

Liabilities to households Equity

Balance sheets of investment banks and hedge funds:

Assets Liabilities Less liquid securities Some liquid securities ABS

Repo Borrowing on money markets Equity

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Balance sheets of traditional banks:

Assets Liabilities Loans ABS Liquid securities Repo Cash and reserves held at Central

Bank

Deposits Repo Money market borrowing Equity

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