Week 2

• the first stage of a financial crisis is initiation
• initiation of a financial crisis starts with Credit boom and bust which triggers deleveraging. this creates an asset price bust, and increases in uncertainty
• uncertainty during the initation of a financial crisis makes issues associated with asymmetric information worse
• the second stage of a financial crisis is a banking crisis
• a banking crisis involves the owners of assets, and the people who loan money against shares
• a banking crisis occurs because balance sheets deteriorate, and institutions become insolvent. this means they have to sell assets, which reduces their value, and further deteriorates balance sheets
• stage 3 of a financial crisis is debt deflation
• debt deflation occurs because nominal debt payments are fixed, but a decline in price level means that the real value of the payments increases
• banking crises are quite common, with many countries spending 8% or more years in a banking crisis since 1800
• during the Great Depression, the stock market shrunk by 90% in just over 2 years, so people lost 90% their wealth
• from 1929 to 1931, arbitrage and panic caused downwards trends in stock prices in many different advanced economies
• the Great Depression downturn was made worse due to a decline in asset prices, bank failiures and runs, and a contractionary US Fed Monetary policy
• bank runs in the Great depression were frequent, as there were no rules on minimum reserve requirements, and so people stopped relying on banks
• at the start of the Great Depression, the Fed increased interest rates in a big economic contraction, which made things much worse
• In the Great Depression, debt deflation resulted in mass unemployment
• US monetary policy has a dual mandate, to focus on both price stability and financial stability
• the US dual mandate can result in conflicting actions, as actions to stabilise prices may also result in unemployment (Reduces financial stability)
• US fiscal policy focused on growth, counter-cyclical goals, and reduction of fiscal debt
• Financial Infrastructure and regulation was not implemented significantly until after the 2009 crisis, not after the Great Depression
• the G20 set up the Financial Stability Board in 2009, to set up collective supervisory cooperation, which tried to harmonise financial regulations on national and international institutions
• the Global financial crisis from 2007 to 2009 was a period of extreme stress in global financial markets and banking systems
• the downturn in the US housing market was a catalyst for the GFC, because a lot of banks were directly linked to the housing market so were vulnerable to its shocks
• recovery from the GFC was much slower than past recessions
• the GFC is the 2007- 2009 Global Financial Crisis
• the main causes of the GFC are excessive risk taking in a favourable macroeconomic environment, increased borrowing by banks and investors, and regulation and policy errors (or lack of)
• before the GFC, the macroeconomic environment was solid, as there had been no distress for 5+ years, and the economy had recovered from the .com bubble in 2000
• before the GFC, economic growth was strong and stable, inflation and unemployment were low, and house prices grew strongly
• before the GFC, people expected house prices to continue to rise, so took out lots of loans to buy houses because of their confidence. this happened in the US and European countries
• before the GFC, a lot of the excessive risk taking was done through subprime borrowers, because there were no rules about who can recieve loans, so people with high default risks or a record of missed loan repayments took out loans
• before the GFC, banks were willing to make high-risk loans to avoid losing market share, and it felt like the right time due to strong economic conditions.
• Mortgage backed Securities were popular to be sold by banks, and were securities formed by pooling together mortgages of varying qualty
• MBS were rated by external agencies, but the products got more complex and difficult to rate, which caused the rating of the risk to be less reliable
• external agencies continued to rate MBS as if they were safe, even after the products got more complex and opaque.
• external agencies rating MBS as if they were safe is an example of Asymmetric Information, a the creator pays the agency money to rate their MBS higher, and act as if they were safe
• investors including large US and European banks invested in the MBS market and took on more risk than they anticipated, because they thought they were buying low risk assets- but the MBS were actually much more risky than they were advertised
• investors had high leverage before the GFC, and this high borrowing by banks and investors contributed to the GFC
• regulation of MBS was too lax, and allowed for opaque MBS products of varying quality to be sold. this introduced asymmetric information, as noone knew what they contained
• the GFC started with the US labour market showing weaknesses and deteriorating, with unemployment increasing. this meant that borrowers started missing repayments
• at the peak of the GFC, the US residential delinquency rate was over 11%
• house prices peaked in 2006, and then started to fall. this is because companies were building lots of houses, but the deteriorating labour market meant that people were less willing to take out mortgages. this resulted in an excess supply of housing, so their prices fell