12.2 Asset Bubbles #Notebook

12.2 Asset Bubbles #Notebook

Low interest rates can cause bubbles by lowering the total cost of asset ownership. Interest rates and bond prices are inversely related. The PV formula, PV = FV/(1 + i)n

In colonial New York about the 1740s, interest rates on mortgages were generally 8%. In the late 1750s and early 1760s, they fell to about 4%, and expected revenues from land ownership increased by around 50%. 

What happened to real estate prices? 

The land was expected to create higher revenues.

The real estate prices rose significantly because it was cheaper to borrow money, and the total cost of real estate ownership was lower. 

Thinking of the land as a perpetuity and FV as the expected revenues arising from it:

PV = FV / i 

PV = £100 / .08 = £1,250 

PV = £100 / .04 = £2,500

The effect of new technology can increase FV, leading to a higher PV. 

Large increases in the demand for an asset occur when investors’ expectations of higher prices in the future.

In the Gordon growth model

Lower interest rates decrease k(required return) and new inventions increase g (constant growth rate).

 P = E × ( 1 + g ) / ( k – g )

If investors believe that P2 will be higher than P1, then a self-fulfilling cycle begins, repeats through P3 to Px.... 

In fact, the existence of an asset bubble when news about the price of an asset affects the economy, rather than the economy affecting the price of the asset.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

 

12.6 The Crisis of 2007–2008 #Notebook

12.6 The Crisis of 2007–2008 #Notebook

The financial crisis began in 2007 as a nonsystemic crisis linked to subprime mortgages, or risky loans. In 2008, the failure turned it into the most severe systemic crisis in the United States since the Great Depression.

Between January 2000 and 2006, Home prices rose rapidly as mortgage rates were low. Mortgages also became much easier to obtain. 

Traditionally, lenders verified that borrowers were employed or had a stable income from any sources. But it all changed with the widespread advent of securitization which bundling and selling mortgages to institutional investors. 

Then more complex derivatives were created...

Mortgage-backed securities(MBSs), Collateralized mortgage obligations (CMOs)....

MBSs afforded investors the portfolio diversification. 

CMOs allowed investors to pick the risk-return they desired. 

Securitization allowed mortgage lenders to specialize in making loans. 

Origination was much easier than lending because it required little or no capital, Originators had little incentive to screen good borrowers from bad and incentive to sign up anyone with a pulse.

At the height of the bubble, loans to no income, no job or assets borrowers were common...

Regulators allowed Fannie Mae and Freddie Mac, two giant stockholder-owned mortgage securitization companies whose debt was guaranteed by the federal government, to take on excessive risks and leverage themselves to the hilt.

As long as housing prices kept rising, overrated securities were not problems since they all count on selling the house.

By summer 2007, prices were falling quickly, triggered the wide-ranging defaults.

How about bond yields, September–October 2008?

Investors sold corporate bonds, especially the riskier Baa ones, forcing their prices down and yields up. 

In a classic, switch to bought Treasuries, especially short-term ones, the yields dropped from 1.69% to 0.3%.

Policymakers are now carefully trying to prevent a repeat performance or the next bubble.

One approach is by education, to teach investors about bubbles.

Another is by regulation, to keep the leverage to a minimum.

The third approach is to use monetary policy, higher interest rates, or tighter money supply.

However, each of these approaches has its pros and cons.

Education might make investors afraid to take on any risk. Tighter regulation and monetary policy might squelch wealth-creating industries.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.  

12.3 Financial Panics #Notebook

12.3 Financial Panics #Notebook

Financial panic occurs when leveraged financial intermediaries and investors must sell assets quickly to meet lenders’ calls, or ask for repayment. It happens when interest rates increase or when the value of collateral pledged sinks.

Calls may all come due to some bursting of an asset bubble, often triggered by an obvious shock, like a natural catastrophe or a huge failure.

During a panic, almost everybody must sell, so prices plummet, triggering more selling.

Panics often cause rapid deleveraging during a credit crunch....

Usually, highly leveraged investors cannot sell assets quickly enough, to “meet the call” and repay their loans. Banks and lenders begin to suffer defaults. As asymmetric information and uncertainty reign supreme, lenders restrict credit.

A negative bubble

When high interest rates, tight credit and expectations of lower asset prices in the future, asset values trend to go downward, even below the values indicated by underlying economic fundamentals. 

In New York in 1764, interest rates spiked from 6% to 12% and expected revenues from land plummeted by about 25%. What happened?

Obviously, it must drop because it was more expensive to borrow money. Thus, the total cost of real estate ownership will increase. In addition, the expectation of yield revenues from the land was lower.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

 

12.4 Lender of Last Resort #Notebook

12.4 Lender of Last Resort #Notebook

Financial panics and deleveraging can cause firms to reduce output and employment. 

Lenders often try to stop panics and deleveraging by adding liquidity or attempting to restore investor confidence. 

They add liquidity by increasing the money supply, reducing interest rates, and making loans to worthy borrowers.

They try to restore investor confidence by making upbeat statements or by implementing helpful policies.

During the darkest days of 1933, the U.S. federal government restored confidence in the banking system by creating the Federal Deposit Insurance Corporation.

A big event on October 19, 1987, in a single day, the S&P fell by 20%...

The macroeconomic outlook during the months leading up to the crash had become somewhat less certain. . . . 

A growing U.S. trade deficit and decline in the value of the dollar were leading to concerns about inflation and the need for higher interest rates in the U.S. as well. 

As prices dropped, fueling further selling....

To restore confidence, the most common form of lender of last resort today is the government central bank, the Federal Reserve....

The Federal Reserve Chairman Alan Greenspan restored confidence in the stock market by promising to make loans to banks exposed to brokers hurt by the steep decline in stock prices. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

12.5 Bailouts #Notebook

 12.5 Bailouts #Notebook

Bailouts restore the losses suffered by economic agents, usually with taxpayer money, outright grants, or purchase their equities, subsidized or government-guaranteed loans. 

However, it's politically controversial because it's usually unfair and increases moral hazard.

But, bailouts can be an effective way of mitigating further declines, if the massive deleveraging cannot stop.

During the Great Depression, the federal government used $500 million to capitalize on the Reconstruction Finance Corporation (RFC). 

In its initial phase, the RFC made some $2 billion in low-interest loans to troubled banks, railroads businesses, helped the economy to recover by keeping important companies afloat. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.