Theoretische achtergronden van de financiële crisis

1. Theoretische achtergronden van de financiële crisis HOVO College 3

2. Hoofdverklaringen Financiële Crisis • Financiële alchemie en de sub-prime hypotheekmarkt. • Perverse prikkels in de financiële sector (en meer algemeen de opkomst van de markteconomie). • Macro-economische onbalans en kapitaalstromen.

3. Diversification Suppose that there are two countries A and B. Both have one industry. Citizens in each county can invest in their own industry or, when capital mobility is possible, in the other country. There are two possible states of the world ‘normal’ and ‘bad’. The chance on normal is p=¾, and for bad is 1-p= ¼ . When it is normal, returns are 100, and when bad 0. Hence, expected returns when citizens invest in home only are ¾ *100 + ¼ *0 = 75. When citizens invest 50% of their portfolio in home (A) and 50% in foreign (B), expected returns are: ¼ * ¼ *0+ ¼ * ¾ *2 *50 + ¾ * ¾ * 100 = 75 However, when citizens are risk averse, they choose international diversification. This is also the reason why banks exist: there is arbitrage between risk neutral institutions and risk averse individuals.

4. Risk aversion People put positive value on obtaining a certainty equivalent. This is a role for banking. 50 75 100 X

5. Optimal portfolio Capital allocation line 450 B Return The big question: how specific is the risk to the asset? How systematic is the risk across assets? Risk free rf A Risk

6. Structured Debt Transfornation Two bond with default probability Pd. Bond X $1 (B) Bond Y $1(B) CDO $2 Two tranches: Senior bears first dollar loss Junior bears second dollar loss Senior Tranche AAA Junior Tranche BBB

7. Diversification BOND Z $1 Bond X $1 (B) Bond Y $1(B) CDO $3 By pooling more reserves, a larger share of the CDO can be sold as AAA Senior Tranche $2 AAA Junior T $1 BBB

8. CDO2 BOND Z $1 Bond X $1 (B) Bond Y $1(B) CDO $3 CDO $3 JT $1 BBB JT $1 BBB ST $2 AAA CDO2 ST AAA (!) Junk Bond

9. The Financial System Investment Bank Commercial Bank Mortgages Own capital CDO CDS Loans to firms Deposits Money markets Securitization • Value At Risk (VAR): • Own portfolio • Combined with structured products • Portfolio theories and stress tests • Non-linear default risk • Non-linear conter parties risk Concentrated insurance risk Rating agencies moral hazard risk

10. Transformation in the financial system CDO Fix for Flex Individual to Pooled Institutional investors Investment Banks Commercial Banks Savers Subsidizing mortgage actors (Fanny May) Rating agencies Information moral hazard Moody’s, S&P, Fitch

11. Incentive problemen in het bankwezen • De bonuscultuur: • Op zich zijn bonusregelingen efficiënt in verband met ‘moral hazard’. • Maar, bij banken is de ‘leverage’ met andermans geld zo groot dat het niet reëel is. • Banken hebben ‘private kennis’ van hun eigen onderliggende assets, wat kan leiden tot adverse selection: • De markt voor tweedehands auto’s. • Het libor schandaal.

12. The Balance of Payments Money flows in Money flows out uit Exports Imports Sell domestic assets Buy foreign assets Decrease in reserves Increase in reserves

13. Source: The Economist

14. Global Imbalances: The US US Balance of Payments Consumption Investment (!) Gov. Spending Export Import Selling assets Buying assets Decrease reserves Increase reserves Global savings glut: - China - Oil exporters Domstic imbalances - Loose monetary policy - Rising asset prices - Financial innovation - Increased government spending

15. Global Imbalances: China - Growth - FDI China Balance of Payments Export Import Investment Selling assets Buying assets Decrease reserves Increase reserves Sources: - Outsourcing - Low prices - Undervalued exchange rate (?) - Supporting the fixed exchange rate - Sterilizing money supply effects

16. Export led growth Asia China’s fixed exchange rate Surplus oil exporters Macroeconomic Financial Imbalances US savingsrate US government deficit Unbalanced Europe