Practical Class
The Financial Crisis of
2007-2009
Overview
Some Financial Market Terminology
The Facts of the Crisis
Amplifying Mechanisms
Innovative Monetary Policy (Central Bank as
`lender of last resort’)
Lessons for the Future
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Terminology of the Financial
Markets I: Securitization
Credit rating agencies
AAA, ...,AA, ..,BB,...C,.. rated bonds
CDOs and Credit Default Swaps
Subprime Mortgages
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CDOs are Mortgage-backed
Securities
To create a Structured product such as the
Collateralized Debt Obligations (CDOs)
Take bad and good assets, pool together, rate
them via agency, sell in different `tranches’
Super-Senior Tranche: AAA
....
Junior Tranche: C
Credit Default Swaps are insurance contracts
against default on assets behind the security 4
Terminology of the Financial
Markets II: Interest Rates
US Federal Funds Rate (interest on excess
reserves) is adjusted via `Repos’ (with sure
collaterals) and Open Market Operations
Discount Rate (loans from central bank to
commercial banks) Lender-of-last-resort
LIBOR: London Interbank Offered Rate
(unsecured interbank credit)
Treasury Bill Rate (government bonds)
Interest rate spreads (TED: LIBOR-TBR)
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The Facts of the Crisis
Situation Before Summer 2007
Why the Situation was like that
Sequence of Events
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The Situation Before the Crisis
A lot of risky lending (subprime mortgages)
Uninsured systematic risk
Default Risk and Liquidity Risk
Little monitoring, little information on borrower
Important maturity mismatches
Many assets in the investment bank balance
sheets rates AAA at the margin
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Systematic vs Diversifiable Risk: A
Numerical Example
Two £100 assets; default probability=10%; 20%
Two tranches: £100 pays whenever one does
not default (Senior tranche); the other £100
pays only when none defaults (Junior)
Fully Diversifiable Risk:
Senior default probability=0.1*0.1=1%, or 0.2*0.2=4%
Junior default probability=1-.9*.9=19%, or 1-.8*.8=36%
Fully Systematic Risk (either all pay or all default):
Senior=Junior default probability=0.1=10% or
Senior=Junior default probability=0.2=20% 8
Why the situation was like that?
House prices were growing (re-financing)
Securitization with small `mistakes’
Rating agencies paid by investors
Law probability events
Ignoring correlations (nondiversifiable risk)
CEOs took too much risks (moral-hazard)
Too-big-to-fail doctrine
Law controls and monitoring
Pressure to generate high returns
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The Facts of the Financial Crisis
Starts July 2007 or even March 2007 →
August 2007: BNP Paribas questioned collateral value of
US AAA securities. → TED rocked →
US Fed reduces Discount and FFR rate with no effect
September 2007: Northern Rock’s run and financial help
October-November 2007: $200 bill. of mortgage market
losses must be revised upwards → TED up →
February 2008: Northern Rock nationalized by UK govn’t
March 2008: JPMorgan Chase acquires Bears Stearns
with a $30 billion loan from NYFed + Fed takes over
Fannie Mae ad Freddie Mac (govn’t sponsored lenders)
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2008 Global Financial Crisis
Sept. 2008: Lehman Brothers left go bankrupt but AIG
saved with a bailout of $85 billion for 80% shares + $700
bil. frozen by US government as mortgage insurance plan
Sept.-Oct. 2008: Large financial losses all over the world
Sept. 08: Troubled Assets Relieve Program (toxic assets)
Dec. 2008: Madoff Ponzi scheme scandal + several
money market funds `broke the buck’
Jan. 2009: Obama’s $1 trillion plan + Silent (electronic)
bank runs $550 bil. withdraw
Feb. 2009: Easter Europe crisis
All over Europe, Cina, Japan, ...
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Amplifying Mechanism I:
Terminology
Leverage and Maturity Mismatch (liquidity
concepts)
Liquidity Shocks and Liquidity Spirals
`Fire-sale’ Externality
Network Effects
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Leverage and Margin
k=net equity capital
Leverage: Debt/k=D/(qN-D)
Margin: q=price of asset, αq=collateral,
The value (1- α)q is the `margin’
1. The margin must be financed by net equity
2. The value k depends on the value of assets
3. Obviously, capital losses must be covered
with k
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Liquidity Spirals
I. If there is a loss (subprime default), the
investment fund needs liquidity and ↓k
II. But, since k (or q) is low, it cannot borrow
III. The investor must sell some assets
IV. This reduces q further: q’
V. A low q’ implies losses, hence lower k, and a
tighter liquidity constraint D≤αqN
VI. That is, Higher Leverages D/k
VII. The leverage must be re-balanced by sales
VIII. Again, ↓q’ and losses require liquidity → I.
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IX. Moreover, ↑α because of the risk → VI.
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The Role of the Central Bank
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The Role of the Central Bank
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The Role of the Central Bank
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Short Selling (Hedge Funds)
•Short sellers sell share (that do not have, so
they borrow them) while the stock price is high.
• They then wait until the stock price is low and
buy back the shares to return to the lender.
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Example
Shares in XYZ Company currently sell for
$10 per share.
short seller borrows 100 shares of XYZ
Company, and then immediately sell those
shares for a total of $1000.
price of XYZ shares later falls to $8 per
share, the short seller would then buy 100
shares back for $800, return the shares to
their original owner and make a $200 profit
(profit is limited but the loss is unlimited).
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The Role of the Central Bank
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The Role of the Central Bank
The Fed balance sheet: Liabilities
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