Introduction to Banking & Finance The financial crisis

Learning objectives To understand the causes of the 2008 financial crisis To examine the responses of some of the international communities affected To investigate if it could happen again To put in context other financial cissies using the Madoff scandal as a proxy

The 2008 crisis The 2008 financial crisis is the worst economic disaster since the Great Depression of 1929. It occurred despite the US Federal Reserve and Treasury Department, the UK FSA and Bank of England, HKMA, ECB and various other regulators best efforts to prevent it. It has lead to wholesale reforms, tightening of regulation (e.g. Basel III) and the introduction of EWS and Stress testing.

Macro economic conditions The situation Macro economic conditions Especially in the USA (largest economy in the world) Philosophical bent towards home ownership Historically stable period Low interest rates Low rate volatility Low inflation Slow but steady growth in the money supply Slow but steady growth in supply and demand in consumer markets Relatively low unemployment Stable exchange rate BUT house prices were rising

The problems The first sign that the economy was in trouble occurred in 2006. That's when housing prices started to fall. Banks didn't realise there were too many homeowners with bad credit. They had allowed people to take out loans for 100% or more of the value of their new homes. This happened because of the Gramm-Leach-Bliley Act and many banks made investments in subprime areas (<BBB-). The Act allowed banks to engage in trading CDOs based on these mortgages to investors. These mortgage-backed securities needed home loans as collateral. The derivatives were, on paper, very profitable~ as long as people paid their mortgages! This created a massive demand for more and more mortgages.

The problems At first, the FED believed this “subprime mortgage crisis” would be confined to the housing sector. BUT the FED didn't understand the actual causes of the crisis. Problem 1. The banks had chopped up the original mortgages and resold them in ”tranches”. That meant no one understood who owned which part of the underlying asset pool and made the derivatives impossible to price. Problem 2. Hedge funds and other NBFIs around the world owned the mortgage-backed securities. Problem 3. The securities were also owned by mutual funds, corporate assets, and pension funds.

The problems Why did pension funds buy such risky assets? They thought an insurance product called credit default swaps protected them. A traditional insurance company known as AIG invented and sold these swaps. When the derivatives lost value, AIG didn't have enough cash flow to honour all the swaps. AIG was BIG!! It was a G-SIFI The banks panicked when they realised they would have to absorb the losses. They realised they did not have enough capital to cover he vast exposures they now had following AIG failing topay out on CDSs They stopped lending to each other. They didn't want other banks giving them worthless mortgages as collateral. his mistrust within the banking community was the primary cause of the credit crunch and subsequent financial crisis.

The response On 19/9/2008, despite the FED pumping $200 BILLION into the banks, the crisis created a run on low interest, ultra-safe money market “sight” funds, During the run, companies moved a record $140 billion out of their money market accounts into even safer Treasury bonds. If these accounts went bankrupt, business activities and the economy would grind to a halt. The FED constructed a $700 billion bailout package. Their fast response convinced businesses to keep their money in the money market accounts. (remember yesterdays slide on bank resolution: speed!) The free banking lobby tried to stop it! They didn't want to bail out banks. They didn't approve the bill until global stock markets almost collapsed.

Could it happen again? YES! Maybe not with CDOs but there are lots of other instruments out there that could lead to similar problems “Derivatives are weapons of financial mass destruction” Warren Buffett Governments must step in to regulate e.g. The Dodd-Frank Wall Street Reform Act 2010 to prevent banks from taking on too much risk. It also allows the Fed to reduce bank size for those that become too big to fail Financial Services Act 2013 (UK)  Many measures left to regulators to sort out the details Meanwhile, banks keep getting bigger and are pushing against regulation.

Source: European Central Bank 2018

Round it goes, where it stops……