Download Slides part 13 :Financial Crisis

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Crisis
Prerequisite
Securitization : Special Purpose Vehicle (SPV) which buy a set of illiquid receivable
(assets), adapt it into a more suitable instrument to sell it to investors.
Monolines : credit enhancer that brings its guarantee to an organization that issues
bonds.
ABS (Asset Backed Security) : security whose cash flows are based on those of an
asset portfolio.
CDO (Collateralized Debt Obligation) : is an ABS composed of a proportion of credit
risk (subprime) assets. Its is composed by slices (equity, mezzanine and senior)
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Crisis
Internet Bubble 2000
- Bubble which affected the tech stocks (telecom, IT) : stock prices were exagerated
Consequences :
- Rise in real estate prices : money that was on the stock market has moved to the
real estate market. (more rewarding)
- The Fed maintain very low rates for a long time to revitalize the economy.
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Crisis
The Subprime Crisis
Subprimes : loans for modest holdhouses created to buy houses, hedged by
mortgage but with an floating interest rate plus a risk premium. Globally, the rate
remains the same during the first years and then is revised.
As the global rates remains low, people can redeem their debt. Banks increased the
share of subprimes because it gave an higher return than the common low rates.
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Crisis
Characteristics of the loan market in the US
- The mortgage interest is tax deductible (encourage to get into debt)
- Owners may abandon their debts by selling their house
- Can borrow up to 110%
- The Community Reinvestment Act (CRA) has limited the power of financial
institutions to deny loans.
- CRA : the State can guarantee a loan that wouldn't otherwise be granted.
- The Department of Housing and Urban Develoment has imposed targets to banks
so that less wealthy client may have access to mortgage.
- Rechargeable mortgage : to support consumption. If the house price increased, the
borrower had the ability to increase its debt ratio.
SUPPOSE THAT THE PRICE OF THE HOUSE WILL ALWAYS RAISE
AND THAT THE INTEREST RATE WILL REMAIN LOW
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Crisis
Growth of the subprime market
- Low interest rates => companies interest to the higher rates of the subprimes
- As subprimes can be resaled to be repackaged in CDO, banks passed the risks to
others => disempowerment of the lending institutions => more and more subprimes
- As the loans are resells, they are not accounted in the prudential ratios of banks
- The easier way to get a mortgage loan => prices of the houses increases (housing
bubble)
- As the return of CDOs are higher, strong demand for this kind of products => raise in
subprime offers.
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Crisis
Outbreak of the crisis
- The Fed has raised its rate by 1% to 5.25% between 2004 and 2006
- The housing prices started to fall in several regions
=>
- increase of monthly payment of borrowers => more and more were unable to meet
their repayment.
- creditors cannot recover their money by selling houses because the price of house
has fallen.
- as the FED rate increase, millions of people cannot pay, => more and more houses
were seizing => housing prices were falling down => bankruptcy of the borrower.
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Crisis
CAUSES
- Monolines : by guaranteeing the CDOs with subprimes, they were giving them their
own AAA rating. With such a rating and an higher interest rate, banks were able to
sell it everywhere.
- Rating agencies : where giving a AAA rating to these products (lack of
investigations, interest conflicts, ...). Structured products account for half of their
incomes.
- Accounting rules : * IFRS "fair value" and the rule "no market = no more current
prices = zero value provision" => virtual losses are immediate losses.
* Basle II : to maintain the solvency ratios, banks must
supplement their capital (when the market value is undetermined)
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Crisis
Equity
> 8%
<
Risks
Placements
de trésorerie
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Crisis
- Financial products that are too complex : understanded by too few people
- Economic mathematic modeling : is the mathematical tool good? Wise Random vs
Wild Random. During the crisis we saw things that are as probable as to win 20
consecutive times to the lotto.
35000
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Crisis
Contagion to the whole system
- Transmission to securitization : doubt on all securitization vehicles. Investors fears
that they bear hidden risks.
- Transmission to investment funds : which have bought securitized assets because
of high return. => Fall of their assets value => all investment funds became suspect.
- Indirect exposure of banks : investment funds are owned or financed by banks
(hedge funds are financed through loans) => banks are taking back the risks they
were initially assigned to markets => the entire banking system bear credit risks.
- Contagion to the whole system : * As banks are in SICAV portfolios, SICAVs are
also suspects and also everyone who hold SICAVs (people, companies, etc.) =>
every stock is suspect.
* As banks are the main borrowers and as they
have to balance their accounts to maintain their solvency, they were reluctant to
provide credit => this have a huge impact on the real economy as the banks are
financing it.
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Crisis
CONSEQUENCES : Great Recession
- Great Recession : unemployment due to the recession, inflation due to the
injection of liquidity into the banking system.
- Rise in oil prices and agricultural products , partially attributable to speculation as
speculators went to those markets as the others was trending down. But also
because of the abundance of liquidity.
- In 2009, only agricultural products escaped from recession, coupled with inflation,
made the food prices raise. With unemployment, this is considered as a cause of
the arabic revolutions.
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Crisis
- Transmission of the recession to the other countries : Lower importations and
reductions in investment (credit crunch) impacts other countries.
- International trade and industrial production : declined dramatically
- Unemployment : 200 millions of unemployed people around the world.
- Financial Markets : increase in banking concentration.
- States has to refund the banking system => the state debt has raise => some state
are in financial trouble.
- Risks of political instability : Iceland, China, changes in governments (Greece, Italy,
Ireland, ...), Arabic revolutions (Tunisian, Egyptian, Lybian, Syrian revolutions)
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