Finnancial Crisis

2008 Global Finnancial Crisis
4 underlying Microeconomic Elements
1.	Traditional Residential Mortgages (originate to own) -  bank finds and evaluates potential borrowers, lends money to acceptable borrowers and keeps mortgage as an asset. Banks collateral for the loan is the market value of the home
2.	Specialization in Mortgage lending(originate to distribute) – Bank creates mortgage and sells it to another financial institution – bank uses money from the sale of mortgage to fund more mortgages which it also sells – no collateral but also no risk – Result is specialist financial institutions buy many mortgages
3.	The rise of Securitization – what to do with all the mortgage assets
a.	Keep and manage a large portfolio of risky assets
b.	Create lower risk securities by repackaging small bits of many higher risk securities – (latter is securitization – reduces risk by portfolio diversification – although it reduces individual risk from a specific security losing value, it doesn’t reduce the risk from an external shock – the aggregate risk does not fall)

Securitization – Turning future cash flow into tradable, bond like security – this became a lucrative business in the 90s and they invented new securities based on such future cash flows as
-	Future mortgage payments
-	Future credit card payments
-	Movie revenues
-	Even royalties on songs by David Bowie – called Bowie-Bonds

Benefits of securitization for issuers
-	Immediate access to money
-	Reduce risk that expected revenue will not materialize


Mortgage backed assets are an example of what are known as collateralized debt obligations or CDOs – reduced individual risk within the assets but did not reduce aggregate risk if all the component parts were the same type of security – in this case – the housing market
Results: Many mortgage backed assets got AAA ratings by the rating agencies – same as government bonds

4.	Regulatory Arbitrage, leverage, and capital adequacy ratios
a.	Regulatory Arbitrage
i.	Capital adequacy ratio: banks capital as % of its total assets(including loans and CDOs) – regulators set minimum ratio to minimize risk of insolvency of the financial institution but set much lower for investment banks than for commercial banks so for same cash base, make more loans(so more interest) which is OK when asset values rising but not when falling which causes regulatory arbitrage – firms to where regulations best for them
ii.	Lowr capital adequacy ratios attract greater securitization 0 money will flow to where it gets the bigger return and less constrained in what it does so financial institutions with the more stringent constraints may set up shadow companies – securitization could be done off balance sheets of parent companies – shadow companies referred to as structured investment vehicles(SIV)
iii.	So securitization and different rules led to more leverage and more mortgage backed assets
b.	Leverage
i.	Using borrowed money to finance more assets so firms with significantly more debt than equity is highly leveraged
ii.	The greater the leverage the greater the possible gain but the greater the potential loss if asset values fall
iii.	Throughout 2000s average leverage ratio was rising


Important Macroeconomic Pressures
1.	Expansionary monetary policy
2.	Global Savings Glut
a.	Big accumulations of foreign exchange reserves by large Asian economies with big current account surpluses and oil exporting countries with large sale and fast rising oil prices
b.	Much of the foreign exchange reserves were invested in US securities like short term US treasury bills or other longer term assets
c.	Reduced long term interest rates and pulled short term rates down too so the yield on government bonds was not as attractive as before
3.	Global search for yield
The combination of expansionary monetary policy and the global savings glut
	Reduced interest rates which reduced the yield on governments bonds which caused financial institutions and others to search for yield elsewhere
	Growing demand for mortgage backed securities
	Growth in lower quality mortgages ensued because the demand was there i.e. sub prime mortgages

Fatal Interactions – The housing collapse and subsequent financial crisis
1.	Late 2006 housing bubble burst
2.	Negative equity cause rising foreclosures and further downward pressure on house prices
3.	Financial losses on mortgage backed securities spread through financial sector and securitisations collapsed
4.	Markets for CDOs practically vanished, causing big losses on firms balance sheets. Hard to shed debt to deleverage stock market crashed
5.	Effects spread to real sector via
a.	Wealth effect
b.	Expectations
c.	Credit Drying Up
The role of Globalisation
a.	International movement of financial capital was quite easy with lenders and borrowers interacting on global scale
b.	Aggregate risk in securitized mortgage assets hit many countries but Particularly US and UK
c.	Resulting loss of wealth and drying up of credit was global
d.	Heavy demand for credit pushed the price of credit up which raised costs substantially for borrowers trying to refinance their debt

Policy Responses
The financial sector in inextricably linked to the real sector
The real sector is the ‘engine’ of the economy – but the financial sector is the ‘oil and grease’ allowing components to work by providing jobs output and growth
Big drop in flow of credit would inevitably lead to major global recession big declines in real output and employment
Governments stepped in to prevent the largest recession for many years from becoming even bigger