AC100

Elements of Accounting and Finance

Part 1: The 2007 global financial turmoil a general

overview
A.
B.
C.
D.
E.

Module 3: FINANCE
Dr Elisabetta Bertero

Long term context of the crisis

Credit boom led to search for yield
Then US house prices started to fall..
Time line - Some major events in 2007 and 2008
Europe sovereign debt crisis (2009- )

Part 2: Link between Part 1 and what learnt in previous

Finance lectures
2.A Role of the financial system (Lecture 4)
2.B Flow of funds (Lecture 1)
2.C Yield spread tables (Lecture 4)

Readings:

AC100 Module 3: Finance - Dr Elisabetta Bertero -

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Part 1: The 2007-08 global financial turmoil

1.A Long term context of the crisis

Bank of England, Financial Stability Report, October 2008, pp. 7-9 (the rest, optional)

Lord Turners speech September 2009 - for Class 2

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Great moderation period

1990 - 2008
- A period of stable macroeconomic conditions by
historical standards

Mid-1980s to mid-2000s
- Liberalisation and globalisation of capital flows in
the last decades
- Development of new financial instruments and
banking model
- Lighter financial regulatory regime and shadow
banking

AC100 Module 3: Finance - Dr Elisabetta Bertero -

- This prolonged stability fuelled expectations of a

continuation of this stability boosting supply and demand
for credit in developed countries
- Also contributed to the continuation of a relaxed
regulatory environment trusting self-regulation of the
financial services

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GREAT MODERATION: 1990 2008 LOW VOLATILITY OF GDP GROWTH

Chart 1.1 Volatility of real GDP growth (a)

Long term context of the crisis

global imbalances
Low savings rates in the US and high in Asian
countries
Large US current account deficit, large external
debt and weak dollar

Sources: Bank of England, Financial Stability report, October 2008 [Original sources: ONS, Thomson
Datastream and Bank calculations]
(a) Five-year rolling average of annualised volatility of quarter-on-quarter growth rate. 2008 data are to
Q2.
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Large China and other countries current account

surpluses, substantial accumulation of reserves and
strong yuan

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Resulting in:
- Historically-low US interest rates and low inflation
- Rising US house prices and stock prices (bubble)

- Large increase in households debt

- Large increase in leveraging and borrowing in
industrialised countries
- Increase of global liquidity
- Greater global financial interdependence
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Chart 1.2 Bank lending to households and non-financial

companies in the United Kingdom(a)

End of year discount rate, 3-month Treasury Bills

Source: Bank of England
AC100 Module 3: Finance - Dr Elisabetta Bertero -

Sources: Bank of England, Thomson Datastream and Bank calculations. Data include the value of loans that have been securitised.

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Chart 1.7 Major UK banks customer funding gap, (a)

household saving ratio and foreign interbank deposits (b)

Consequences
- Leverage to obtain higher returns and greater
dependence on overseas funding
- Reckless lending (US sub-prime mortgages)
- Excessive risk taking
- Securitisation and mispricing of risk
- Inaccurate ratings by credit rating agencies
Sources: Bank of England, Dealogic, ONS, published accounts and Bank calculations.
(a) Customer funding gap is customer lending less customer funding, where customer refers to all non-bank borrowers and depositors.
(b) Data exclude Nationwide.
(c) UK household savings as a percentage of post-tax income.

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Low credit quality mortgages

Rapid expansion of banks balance sheets

No documentation
Teaser rates

Originate and distribute banking model:

No income, no job or asset mortgages

Securitisation and structured products

Note: in the US, mortgage interest rates are tax

deductible, but rent is not
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Bank collects deposits and lends

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Rather than deposits, source of funding is borrowing from

other banks (high leverage)

Loans held by banks until maturity

Loans with either:
Fixed interest rates: high interest rate risk for
lender - interest rates may increase
Flexible interest rate: lower interest rate risk for
lender, but higher credit risk

Rather than keeping and monitoring mortgages and other

debt contracts, these are sold to other institutions who would
pool them and create new securities - collateralised debt
obligations (CDOs)
In turn these securities are slicedinto tranches and sold as
new securities
Credit default swaps: insurance contracts against the default
of a bond or tranche Over The Counter (OTC) contracts

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(in all US states)

Safest tranche: first to be paid out, less risky,

lowest return, highest rating (AAA)
Mezzanine tranche: next to be paid out,
medium risk, higher return, medium rating
Equity tranche (toxic assets): last to be paid
out, highly risky, low rating or unrated

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- Defaults in US sub-prime mortgages

- Breaking down of securitisation markets
- Uncertainty in valuations due to opaqueness of
instruments and complexity of interdependence of
financial institutions
- Trust breaks down, fear of counterparty (default)
risk

- July August 2007: IKB and BNP Paribas

reveal difficulties related to US subprime market
- September 2007 bank run on UK bank Northern
Rock, nationalised in Feb 2008
- Governments intervene to provide funds and
liquidity

- Banks stop lending to each other, liquidity dries up

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Spread on three-month UK interbank lending (a)

Chart 1.5 Financial market liquidity (a)

Sources: Bank of England, Financial Stability Report, October 2008 (sources: Bank of England, Bloomberg, Chicago Board Options Exchange, Debt
Management Office, London Stock Exchange, Merrill Lynch, Thomson Datastream and Bank calculations)
(a) The liquidity index shows the number of standard deviations from the mean. It is a simple unweighted average of nine liquidity measures,
normalised on the period 19992004. The series shown is an exponentially weighted moving average. The indicator is more reliable after 1997
as it is based on a greater number of underlying measures. The recent fall in the indicator is largely due to a sharp decline in the interbank
market liquidity measure.

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March: Bear Stern defaults and is rescued

September:
- Fannie Mae and Freddie Mac effectively nationalised
- Lehman Bro defaults and is not rescued
- Merrill Lynch defaults and is bought by Bank of America

Sharp drop in banks stock prices

Stress transmitted to money markets and credit derivatives

contracts

International system-wide fragilities

Widespread government interventions to provide liquidity,

recapitalise banks and lower interest rates to mitigate deep
recession

Source: Bank of England, Fin Stability Report, October 2007 (Bloomberg and Bank
calculations)
(a) Three-month sterling-Libor spread over sterling over overnight index average swap rate.
Dotted lines show three-month forward spreads. Spreads are a measure of risk premium
perceived by markets.
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1. 2007 financial crisis: it originated in the private sector, but the cost of the
solution (bail-out of banks) was borne by many countries governments and
ultimately taxpayers (e.g. Iceland and UK) , with severe consequences
particularly for some EMU countries (Ireland and Spain)
2. Greece (2-3% of EMUs GDP): free rider of EMU + false statistics - enjoyed
benefits of low interest rates but did not introduce necessary structural changes
high government deficit + low savings solutions and contagion
Hence: PIGS acronym misleading
3. Structural unresolved fiscal issue/political union within EMU

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4. Poorly regulated, irrational, herd-prone financial markets (and betting

instruments -CDS) exacerbate problems

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Europe sovereign debt crisis

Good overview in: Staring into the abyss,
Special Report, The Economist, 12 November 2011

Source: M. Wolf, Why the Eurozone will suvive, FT 8 March 2011 See AC100 Moodle page

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Part 2: Links to previous lectures

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2007-09 mis-functioning of financial system

2.A Six key functions of the financial system

(see lecture 4)

1.

Easy geographical transfer of resources enhanced interdependence

and contagion

2.

Excessive risk-taking and mispriced risk

3.

With fear of counterparty risk, gridlock of clearing and settling of

payments

3. Clearing and settling payments

4.

Pooling of instruments, e.g. loans, resulted in opaque instruments

and mispriced asset-backed securities

4. Pooling resources and subdividing shares

5.

Information may be difficult to extract if trading and pricing not

possible

6.

Incentive problems arose with respect to large financial

institutions; uncertainty on how much weight to give to moral
hazard, e.g. Lehman Bros default

1. Transferring resources across time and space

2. Managing risk

5. Providing information
6. Dealing with incentive problems

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2.B Flow of funds

Traditional housing financing

Mortgages held by banks until maturity

Surplus Units
Saver

Banks

Deficit Units
Borrowers

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Fixed interest rates loans

Flexible interest rate loans

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A bank may collect deposits or borrow from other banks, issue

mortgages and then pool together mortgage contracts to construct a
new security which is sold to institutional investors/ investment
banks.
In general, banks combine assets (e.g. mortgages) and sell
immediately the claims on these assets

AC100 Module 3: Finance - Dr Elisabetta Bertero -

Other financial
institution
Creation of new
markets

Other financial
institution
Creation of new
markets

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Other financial
institution
Creation of new
markets

Surplus Units,

Deficit Units

Households
Depositors

Households
Mortgage holders

These are called collateralised debt obligations (CDOs), assetbacked securities, mortgage-backed securities, mortgage bonds
These assets are often sold and traded within the shadow banking
system
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Intermediaries
e.g. banks
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 Broken link between lender and borrower

difficult to monitor borrower
difficult to restructure contract
Highly risky assets transformed into high grade
assets
Loss of transparency
Legenda - MMMF: money market funds; SIVs: Special Investment Vehicles; GSEs: Government Sponsored Enterprises

Instruments so complex that are difficult to price

Source: Krohn and Gruver, 2008

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2.C Yield Spreads (see Lecture 2)

Yield Spreads

(with respect to Treasury Bills)

1 March 2006 (before the crisis)

(with respect to Treasury Bills)

26 November 2008 (during the financial crisis)

US
Treasury
Bills
2 years

Yield
Spread
Definition:

Corporate High
Quality (AAA)

4.71%

Corporate
Medium Quality
(A)

4.85%

5.22%

16 basis points

51 basis points

2 years

Yield
Spread
Definition:

1 basis point = 1 percent of 1 percent = 0.0001

Source: www.bondsoline.comw.bondsonline.com

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US
Treasury
Bills

Corporate High
Quality (AAA)

1.06

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Corporate
Medium Quality
(A)

5.37

6.82

431 basis points

576 basis points

1 basis point = 1 percent of 1 percent = 0.0001

Source: www.bondsoline.comw.bondsonline.com
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