301Notes2009Su_0810.pdf

Money and Banking, Rutgers University 1 Hyun Hak Kim Financial Crisis Money and Banking, Rutgers University 3 Hyun Hak Kim Financial Crisis ? Occurs when one or more financial markets or intermediaries cease functioning or function only erratically and inefficiently. ? Nonsystemic crisis ? involves only one or a few markets or sectors ? Systemic crisis ? involves all, or almost all, of the financial system to some extent, as during the Great Depression. Money and Banking, Rutgers University 4 Hyun Hak Kim Old History ? Tulip Mania ? First speculative bubble ? South Sea Company ? Tech bubble in late 1990s Money and Banking, Rutgers University 5 Hyun Hak Kim What cause a financial crisis? ? Asset-liability mismatch ? Tulip Mania ? Leverage effect ? Speculation ? Uncertainty ? South Sea ? Mississippi Bubble ? Leverage ? Regulatory failure Money and Banking, Rutgers University 6 Hyun Hak Kim Leverage Effect ?R = 10 0 tt t CP P P +? 1.20.80.31303 1.10.70.21202 10.60.11101 1000 Cumulative Return 90% Leverage Cumulative Return 50% Leverage Cumulative Return No Leverage Asset Price Period Money and Banking, Rutgers University 7 Hyun Hak Kim Asset Bubbles ? Rapid increase in the value of some asset, like bonds, commodities, equities, or real estate. ? Some combination of low interest rates, new technology, unprecedented increases in demand for the asset, and leverage typically create bubbles. Money and Banking, Rutgers University 8 Hyun Hak Kim Asset Bubble ? Cause ? Low interest rates can cause bubbles by lowering the total cost of asset ownership ? The effect of new technology can be thought of as increasing FV, leading, of course, to a higher PV. ? Demand can be increased merely by investors? expectations of higher price in the future. ? To increase their returns, investors often employ leverage, or borrowing. Money and Banking, Rutgers University 9 Hyun Hak Kim Financial Panics ? Occurs when leveraged financial intermediaries and other investors must sell assets quickly in order to meet lender?s calls. ? Calls are a normal part of everyday business, but during a panic, they come all en masse due to some shock, often bursting of an asset bubble. ? Panics often cause the rapid de-leveraging of the financial system, a period when interest rates for riskier types of loans and securities increase and/or when a credit crunch, or a large decrease in the volume of lending, takes place. Money and Banking, Rutgers University 10 Hyun Hak Kim Leverage Effect in a falling market -30+?-30+?-30703 -20+?-20+?-20802 -10+?-10+?-10901 1000 Cumulative Return 90% Leverage Cumulative Return 50% Leverage Cumulative Return No Leverage Asset Price Period Money and Banking, Rutgers University 11 Hyun Hak Kim Lender of Last Resort ? In turn, financial panics can cause firms to reduce output and employment. ? Lenders of last resort try to stop panics and de-leveraging by adding liquidity to the financial system and/or attempting to restore investor confidence. ? Make loans to solvent institutions facing temporary solvency problems due to the crisis, not inevitable bankruptcy. ? Cannot be free of moral hazard problem Money and Banking, Rutgers University 12 Hyun Hak Kim Bailouts ? Restore the losses suffered by one or more economic agents, usually with taxpayer money. ? If the lender of last resort cannot stop the formation of a negative bubble or a massive de-leveraging, bailouts can be an effective way of mitigating further declines in economic activity. Money and Banking, Rutgers University 13 Hyun Hak Kim Debate for Bailouts ? 1979 Chrysler bailout ? It quickly paid off its debt which the government guaranteed ? US Treasury, and taxpayers were actually the richer for it. ? Creditors received 30 cents for every dollar ? Workers lost their job ? How about current bailout? Money and Banking, Rutgers University 14 Hyun Hak Kim Financial Crisis 2007~2009 ? Asset Bubble ? Subprime Mortgage ? February 27, 2007 ? Freddie Mac announces that it will no longer buy the most risky subprime mortgages and mortgage-related securities. ? April 2, 2007 ? New Century Financial Corporation, a leading subprime mortgage lender, files for Chapter 11 bankruptcy protection. Money and Banking, Rutgers University 15 Hyun Hak Kim Financial Crisis 2007~2009 ? 30Y Conventional Mortgage Rate Money and Banking, Rutgers University 16 Hyun Hak Kim Financial Crisis 2007~2009 Money and Banking, Rutgers University 17 Hyun Hak Kim Financial Crisis 2007~2009 0.00 50.00 100.00 150.00 200.00 250.00 Ja n - 8 7 Ja n - 8 8 Ja n - 8 9 Ja n - 9 0 Ja n - 9 1 Ja n - 9 2 Ja n - 9 3 Ja n - 9 4 Ja n - 9 5 Ja n - 9 6 Ja n - 9 7 Ja n - 9 8 Ja n - 9 9 Ja n - 0 0 Ja n - 0 1 Ja n - 0 2 Ja n - 0 3 Ja n - 0 4 Ja n - 0 5 Ja n - 0 6 Ja n - 0 7 Ja n - 0 8 ? House Price Index Money and Banking, Rutgers University 18 Hyun Hak Kim Financial Crisis 2007~2009 ? Mortgage ? Prime Mortgage ? Alt A Mortgage ? Subprime Mortgage ? Subprime mortgage ? A type of loan granted to individuals with poor credit histories (often below 600) Money and Banking, Rutgers University 19 Hyun Hak Kim Financial Crisis 2007~2009 Money and Banking, Rutgers University 20 Hyun Hak Kim Financial Crisis 2007~2009 ? Mortgage Back Securities (MBS) ? The loan is made by a financial institution or other lender to a borrower to finance or refinance the purchase of a home or other property. ? Because mortgage loans may take years to pay off, lenders must find ways to replenish their funds in order to make more mortgage loans. ? To do this, lenders sell groups of mortgages with similar characteristics into the secondary mortgage market to issuers or guarantors of MBS ? CMBS : secured by commercial and multifamily properties. Money and Banking, Rutgers University 21 Hyun Hak Kim Financial Crisis 2007~2009 ? Collateralized mortgage obligations (CMOs) ? A type of derivative formed by financial engineering mortgage backed securities into tranches with different risk-return characteristics ? Legally, a CMO is a special purpose entity that is wholly separate from the institution(s) that create it. ? The mortgages themselves are called the collateral, the bonds are called tranches (also called classes) ? Investors in CMOs include banks, hedge funds, insurance companies, pension funds, mutual funds, government agencies, and most recently central banks. Money and Banking, Rutgers University 22 Hyun Hak Kim Financial Crisis 2007~2009 ? Getting Worse ? Securitization allowed mortgage lenders to specialize in making loans, turning them more into originators than lenders. ? Originators had little incentive ? At the height of bubble, loans to NINJA borrowers. ? Responsibility ? Freddie Mac, Fannie Mae ? Federal Government ? Credit-rating agencies Money and Banking, Rutgers University 23 Hyun Hak Kim Financial Crisis 2007~2009 ? Some warnings ? As long as housing prices kept rising, shoddy underwriting, weak regulatory oversight and overrated securities were not problems because borrowers who got into trouble could easily refinance or sell the house for a profit. Money and Banking, Rutgers University 24 Hyun Hak Kim Financial Crisis 2007~2009 0.00 50.00 100.00 150.00 200.00 250.00 Ja n - 8 7 Ja n - 8 8 Ja n - 8 9 Ja n - 9 0 Ja n - 9 1 Ja n - 9 2 Ja n - 9 3 Ja n - 9 4 Ja n - 9 5 Ja n - 9 6 Ja n - 9 7 Ja n - 9 8 Ja n - 9 9 Ja n - 0 0 Ja n - 0 1 Ja n - 0 2 Ja n - 0 3 Ja n - 0 4 Ja n - 0 5 Ja n - 0 6 Ja n - 0 7 Ja n - 0 8 ? House Price Index Money and Banking, Rutgers University 25 Hyun Hak Kim Financial Crisis 2007~2009 ? In June 2006, housing prices peaked ? By summer 2007, prices were falling quickly. ? Highly leveraged subprime mortgage lenders (Countrywide and Indymac) suffered large loss. ? By early 2008, Bear Stearns teetered on the edge of bankruptcy. Money and Banking, Rutgers University 26 Hyun Hak Kim Financial Crisis 2007~2009 ? Accelerator ? Limit on the leverage ? Credit Default Swap ? A swap contract in which the buyer makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument goes into default. Money and Banking, Rutgers University 27 Hyun Hak Kim Financial Crisis 2007~2009 ? Failures ? Bear Stearns sold to JPMorgan Chase ? Nationalization of Fannie Mae & Freddie Mac ? Lehman Brothers bankruptcy ? Merrill Lynch sold to Bank of America ? American International Group collapse ? CIT group, a lender to hundreds of thousands of small and midsize business, is in danger of bankruptcy. Money and Banking, Rutgers University 28 Hyun Hak Kim Financial Crisis 2007~2009 ? Lender of Last Resort ? Cutting its federal funds rate from 5 to almost zero percent. ? Currently, target range of FFR is 0~0.25% ? Establish swap lines with foreign banks. ? Creates a Term Auction Facility (TAF) in which fixed amounts of term funds will be auctioned to depository institutions against a wide variety of collateral. ? Creates of the Term Securities Lending Facility (TSLF), ? Purchases up to an additional $750 billion of agency mortgage- backed securities, bringing its total purchases of these securities to up to $1.25 trillion in 2009, ? Purchases agency debt this year by up to $100 billion to a total of up to $200 billion. ? Purchases up to $300 billion of longer-term Treasury securities over the next six months to help improve conditions in private credit markets. Money and Banking, Rutgers University 29 Hyun Hak Kim Financial Crisis 2007~2009 ? Bailouts ? Treasury Department announced $700 billion proposal that would allow the government to buy toxic assets from the nation?s biggest banks ? Congress eventually amended the plan to add new structures for oversight, limits on executive pay and the option of the government taking a stake in the companies it bails out. ? Suspect on the effectiveness of bailout Money and Banking, Rutgers University 30 Hyun Hak Kim Financial Crisis 2007~2009 ? Bailouts ? In Oct. 2008, the Emergency Economic Stabilization Act of 2008 which establishes the $700 billion Troubled Asset Relief Program (TARP) passed ? The U.S. Treasury will make available $250 billion of capital to U.S. financial institutions.. ? TARP funds is not to be used to purchase illiquid mortgage-related assets from financial institutions. ? The U.S. Treasury Department authorizes loans of up to $13.4 billion for General Motors and $4.0 billion for Chrysler from the TARP. Money and Banking, Rutgers University 31 Hyun Hak Kim Financial Crisis 2007~2009 ? Regulatory Reform Proposal ? The U.S. Treasury Department releases a proposal for reforming the financial regulatory system. The proposal calls for the creation of a Financial Services Oversight Council and for new authority for the Federal Reserve to supervise all firms that pose a threat to financial stability, including firms that do not own a bank. ? SEC proposal ? To strengthen the regulatory framework for money market funds, SEC intended to reduce the risk in MMF by introducing liquidity requirements, shortening the average maturity limits, and increasing the requirements for credit quality. Money and Banking, Rutgers University 32 Hyun Hak Kim Is this economy recovering? ? Evidence for recovering ? Rally in the stock market ? Housing price ? Consumption Money and Banking, Rutgers University 33 Hyun Hak Kim Is this economy recovering? ? Evidence against ? Everything ? Unemployment ? Bad loans remain on the banks? books Hyunhak Microsoft PowerPoint - 301PPT21Su09_FC