BRANDEIS INTERNATIONAL BUSINESS SCHOOL 15 April 2015 Financial Crises Fin252F1 What were the main causes of the 2007-2009 crisis? What is the order of importance? Who were the key players in the crisis and how did they contribute to it? What can be learned from the crisis? BRANDEIS INTERNATIONAL BUSINESS SCHOOL Questions for discussion Incentives Consumers assumed someone else was watching Complexity was mistaken for sophistication Compensation schemes drove short-term focus Rating agencies paid by issuers Risk measurement Little history for new instruments High weight on recent low volatility experience Weak governance of risk management Regulation Relied on self-regulation Allowed activities to move outside regulatory perimeter BRANDEIS INTERNATIONAL BUSINESS SCHOOL Causes of the Crisis: Microeconomic Large, persistent current account imbalances Protracted period of low real interest rates Credit boom Increased risk-taking BRANDEIS INTERNATIONAL BUSINESS SCHOOL Causes of the Crisis: Macroeconomic BRANDEIS INTERNATIONAL BUSINESS SCHOOL BRANDEIS INTERNATIONAL BUSINESS SCHOOL Graph 1 Non-financial sector debt As a percentage of GDP1 Real levels, deflated by consumer prices2 1 Simple averages for 18 OECD economies. 2 Rebased to 1980 = 100; simple average of 16 OECD economies, including the United States. BRANDEIS INTERNATIONAL BUSINESS SCHOOL 0 50 100 150 200 250 300 350 Private Sector Debt to GDP, 2006 and 2013 2006 2013 BRANDEIS INTERNATIONAL BUSINESS SCHOOL 0 50 100 150 200 250 Gross General Government Debt to GDP, 2006 and 2013 2006 2013 1. The list of causes is very long 2. Focus on incentives 3. Don’t get distracted by fraud 4. Watch debt and look for leverage 5. Focus on property prices BRANDEIS INTERNATIONAL BUSINESS SCHOOL Main Lessons 10-Year Treasury Futures: Face: $100,000 Coupon: 6% Duration for yield of 2% = 8 Margin= $1350 Two investments: 1) Long a bond: Exposure is $100,000 2) Long 70 futures contracts: Exposure if $7,000,000 Move of 10bps: each $100,000 changes by $800 1) $800 if you own the bond 2) $56,000 if you are long 70 contracts! Over a week, the 10yr yield moves 10bps about 40% of the time! BRANDEIS INTERNATIONAL BUSINESS SCHOOL Hidden Leverage: An Example Bank runs Liquidity spirals Fire sales Interbank market strains BRANDEIS INTERNATIONAL BUSINESS SCHOOL Dynamics of a crisis BRANDEIS INTERNATIONAL BUSINESS SCHOOL BRANDEIS INTERNATIONAL BUSINESS SCHOOL Berkeley Square London BRANDEIS INTERNATIONAL BUSINESS SCHOOL BRANDEIS INTERNATIONAL BUSINESS SCHOOL Why are financial crises so prevalent in history? What were the causes of the Great Depression of the 1930s? Why is the Gold Standard viewed as a villain? BRANDEIS INTERNATIONAL BUSINESS SCHOOL Questions for discussion Debt increases precede ...