The Subprime Crisis The Economist, 20 Sept 2008 “Ten short days saw the nationalisation, failure or rescue of what was once the world’s biggest insurer, two of the world’s biggest investment banks, and two giants of America’s mortgage markets” “Regulation is necessary and much must now be done to improve the laws of finance: better oversight, more transparency, supervision of giants, accounting that values risk better, safer financial transactions (derivatives)”. Source: The Economist, 20 Sept 2008 http://www.economist.com/node/12263158?story_id=12263158

But first things first...

THE BUSINESS CYCLE

Good news or bad news for the GDP? recession peak expansion upturn depression downturn contraction trough downswing recovery slump boom

The economy ... ... grows ...peaks ...contracts ...bottoms out ...recovers ...expands ...booms ..works at full capacity/at below its potential

MK, pp.114-115 The Business Cycle Pg.1: general information (def. + stages) Pg.2: internal causes of the cycle Pg.3 external causes of the cycle

Notes on text (more detailed, pgs.2-3) CAUSES a) internal e.g. interest rates up→more expensive loan repayment→less money available→lower consumption→lower output →lower employment→even lower spending → … b) external (e.g. elections, natural disasters, “creative destruction”, …)

OPTIONAL EX. Keynesianism & Monetarism Make full sentences: lead / market system / full employment durable equilibrium/produce/high unemployment / market forces /reduced income and investment counteract the business cycle/ manage the demand/ governments/ excess savings / interest rates / cause / in the long run / investment / fall / increase dead / in the long run neutral / money supply / constant / non-inflationary / government / money /output & employment /no effect governments / too late / fiscal & monetary measures / recession / foresee / take effect. MK, pp.117-118

OPTIONAL EX. Keynesianism & Monetarism Make full sentences: lead / the market system / full employment (M) durable equilibrium/produce/high unemployment / market forces /reduced income and investment (K) counteract the business cycle/ managing the demand/ governments/ (K) excess savings / interest rates / cause / in the long run / investment / fall / increase (M) dead / in the long run (K) neutral / money supply / constant / non-inflationary / government /money /output & employment /no effect (M) governments / too late / fiscal & monetary measures / recession / foresee / take effect. (M) MK, pp.117-118

The Crisis

The Subprime Crisis The Economist, 20 Sept 2008 “Ten short days saw the nationalisation, failure or rescue of what was once the world’s biggest insurer, two of the world’s biggest investment banks, and two giants of America’s mortgage markets” “Regulation is necessary and much must now be done to improve the laws of finance: better oversight, more transparency, supervision of giants, accounting that values risk better, safer financial transactions (derivatives)”. Source: The Economist, 20 Sept 2008 http://www.economist.com/node/12263158?story_id=12263158

What is the chronology of the events below? Poor borrowers go bankrupt, so houses are returned to lenders. Central banks help to prevent system collapse. Poor borrowers can no longer repay their loans. Some lenders go bust as they cannot sell the property, and some lenders sell loan obligations to investors. Poor borrowers buy houses with loans. Because of low interest rates, it is easy to borrow. But after some time, interest rates go up. (RB:p.80)

The Financial Crisis Mortgage lenders Subprime borrowers Hedge funds Default (n.), to default on mortgage (v.) To release liquidity RB: p. 80

What is the chronology of the events below? Replace the red parts with the words from before: Poor borrowers go bankrupt, so houses are returned to lenders. Central banks help to prevent system collapse. Poor borrowers can no longer repay their loans. Some financial institutions go bust as they cannot sell the property, and some lenders sell loan obligations to investors. Poor borrowers buy houses with loans. Because of low interest rates, it is easy to borrow. But after some time, interest rates go up. (RB:p.80)

http://www.businesspundit.com/sub-prime/page3.php http://www.businesspundit.com/sub-prime/page3.php

OPTIONAL READING

Northern Rock: A case study of a troubled bank RB: p.59 optional reading

Do you know the meaning of the words below? Shake-out Credit squeeze Run on a bank (bank run) Solvency (being solvent) Mortgage loan Deposits Emergency funding

Which of the previous words are defined here? Government measures designed to limit the supply of credit in the economy (e.g. by restricting bank lending)………….. A loan to finance the purchase of real estate……………… The ability of a corporation to meet its long-term fixed expenses …………….. the decline in the number of commercial banks (bigger banks acquire weaker competitors who verge with bankruptcy)………..

Government measures designed to limit the supply of credit in the economy (e.g. by restricting bank lending) CREDIT SQUEEZE Loan to finance the purchase of real estate MORTGAGE The ability of a corporation to meet its long-term fixed expenses SOLVENCY The decline in the number of commercial banks (bigger banks acquire weaker competitors who verge with bankruptcy) SHAKE-OUT

Northern Rock - Basics What happened to Northern Rock? What exactly did the bank’s customers do and why? Who helped and how?

Text 2 Go bust Securities (e.g. bonds, …) Bank run The Treasury The Chancellor (of the Exchequer) Subordinated debt Piece of legislation Bailout In a transparent manner Banking regulator

A banking crisis: the worst-case scenario Put the following statements in the chronological order: The regulators do not spot the trouble in time. The bank goes bankrupt. The government (the Treasury) steps in and guarantees 100 per cent of the deposits, but repays only investors who made unsecured loans to the bank, and not those who bought the bonds issued by the bank. The bank management borrows over their heads.

So, why did all this happen to Northern Rock (and many other players)?

More about the financial crisis The subprime crisis and the credit crunch (MK, p.75) http://vimeo.com/3261363 (optional material)

The outcome In 2007, Northern Rock received liquidity from the Bank of England following problems in the credit markets caused by the US subprime mortgage financial crisis. The bank was nationalised in February 2008 as a result of two unsuccessful bids to take over the bank, neither being able to fully commit to repayment of taxpayers' money. As of 1 January 2012 Northern Rock has become part of Virgin Money.

The subprime crisis and the credit crunch MK, p.75, 76 Find definitions for the following: subprime borrowers, securitization, MBS and CDO, toxic debt, credit crunch Answer the questions: Why did banks buy MBS and CDOs? What happened in the end? What were the consequences of all this?

Joseph Stiglitz Nobel Prize in Economic Sciences 2001 Columbia University

Optional reading (RB: pp.81-84) What did Stiglitz say in his text Capitalist Fools (Vanity Fair, Jan, 2009)? Give a brief explanation of the five mistakes covered by the text in RB, pp:82-83, (1-2 sentences for each)