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Full summary - Economy of the Single Market (Chapters 6 to 9)
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Full summary of the course Economy of the Single Market in third year of bachelor business administration (second semester) - Chapters 6 to 9
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Chapter 6 : The Eurozone in Crisis - PART VI“Free movement of capital
1. Introduction
- Eurozone was celebrating rst decade when both 2008-2009 crises hit -> why ?
- Success of rst year (2001-2007/2008)
- Most of world enjoyed period of prosperity (growth and declining in ation)
- = Great Moderation -> reduction of volatility of business cycle uctuations in developed nations
starting in mid-80’s compared to decades before -> very good period
- In Europe, European Monetary Union seemed to work great
- Growth, unemployment was low, in ation low and steady
- Usually high interest rates when economic and monetary policies are not stable -> in this case
not bc Interest rate convergence -> due to prosperous situation (everything was goos) +
formation of EMU (sign of con dence)
- But in fact build-up of tension that would lead to worst economic crisis since Great Depression ->
creation of deep aws in construction os Eurozone
- They knew that good situation would not last forever -> saw something coming under
- Knowing what happened during Great Depression helped contain crisis -> but solutions led to
increase of public debt
- These increases in public debt led to second phase of crisis -> Eurozone crisis (= public debt
crisis)
2. The Global Financial Crisis (°2008)
2.1. Financial deregulation
- After Great Depression -> strict regulation was designed to limit risk-taking by banks and nancial
institutions
- Bc of stupidity of American banks -> wanted stricter regulation
- 1933 : Glass-Steagall Act -> prohibited commercial banks from participating in investment banking
business and vice versa
- Separating commercial and investment banking -> no link
- Deregulation phase started in USA in 1980’s
- Ended in 1999 with repeal of Glass-Steagall Act -> commercial banks could again participate in what
investment banks did and vice versa
- Result : rapid expansion of nancial sectors in USA
- Europe followed quickly after with its own deregulation process -> Single European Act developed more
and more in the coming decades
- Banks developed activities not directly related to their traditional role of collecting deposits and making
loans
- Banks became active investors -> they borrowed globally (on ST) but invested globally (on LT nancial
instruments
- Created two mismatches
- Maturity mismatch : between ST borrowings and LT investment -> banks had to continuously
renew borrowings -> became dependent on their ability to do so -> what if they could not do it
anymore -> fail !!
- Currency mismatch : between borrowing and ending in di erent currencies -> would run into
di culties if exchange rate movements would reduce value of their lending (assets) relative to the
value of their borrowing (liabilities)
- If you borrow money in one currency and invest in another -> if value of both currencies does not
remain the same
- e.g. Euro and USD uctuate -> one day USD < Euro, another day the opposite
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,- Result : fragility of banks increased
- BUT -> Basel II Accords provided banks to determine degree of riskiness of their assets
- Banks knew they could not go bankrupt -> bc if they did they knew they would be bailed out (bc banks
were too important)
- All individuals had deposited savings in banks -> if they wanted to take out money from bank bank still
has to be there
- Banks were needed for economic life -> if banks would fail -> they would be saved
- Thus, major risks taken by banks were carried (protected) by government
- Result : banks were encouraged to take even more risks -> “moral hazard” : lack of incentive to
guard risk when you are protected the consequences of taking that risk
- Why would I not risk taking an opportunity if I know they will save me if it fails …
- As long as economic conditions were good -> banks were pro table
- Finance became even more sophisticated -> top bank managers lost track of what they were doing ->
as long as they got big big pro ts
- Very comparable to what happened in “roaring twenties” -> proceeded Wall Street Crash
- = some people took very risky decisions and were making a lot of money -> but on the LT : very bad
- They knew what was coming but enjoyed the current situation
2.2. The roots of the nancial crisis
- Banks took major (too many) risks -> risks were protected by government (would save them)
- Why ?
- During Great Moderation : perception was that growth would persist forever -> bankers became less
sensitive to risk
- We can do everything, the sky was the limit
- Subprime mortgages
- SUB : loans given out to unhealthy economically
speaking people
2.2.1. The mechanism
- Subprime mortgages
- Invented in US
- Given to risky people (not able to repay loan afterwards)
- Everyone had to be able to live the American dream
- All individuals : even unemployed, people with no savings, money,…
- Why ?
- Even if person could not repay loan in the end -> would take their house and sell it
- As the prices of housing increases continuously -> would be worth more than when bought ->
“no problem” : give loan of $20 000 to unemployed -> 10 years later worth $200 000
- How did these mortgages works ?
- Low interest rate + low debt services -> would increase after 2 or 3 years
- Even if people were unemployed at that time -> said that all would increase later
- When IR increased -> new similar loan would be granted to enable debtor to pay back previous loan
- Called ‘step-up’ mechanism : if price of house and increased, borrower could even borrow more +
keep some cash after repaying previous loan
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, - Us consumers loved this system
- BUT, these loans were sold by mortgage companies to banks -> passing risk of non-repayment to the
banks while being able to lend again and again
- Mortgage companies gave out loan -> then sold to banks -> but then banks had to deal with non-
repayment of loans by unemployed people
- In 2005-2006 : 25% of total mortgages were unhealthy (subprime mortgages)
- Banks now carried the risk of non-repayment of subprime mortgages -> gave it to other banks as
‘securitization’
- = banks added together large number of individual mortgage loans into larger bundle -> bundle is
less risky than any of loans taken separately as long as they do not go bad at the same time
- If one person does not repay loan but 9 others do -> not that bad
- Then bank divided bundle into tranches and ranked them (bad, intermediate, and very good)
- If mortgage was not repaid -> loss would go to lowest tranche (most risky tranche)
- If losses exceeded the value of the lowest tranche -> go to the next lowest one (most risky
tranche)
- Top tranches were considered perfected safe as many loans would have to sour before these
tranches could be a ected -> need a lot of people who did not repay before you would end up
losing money in the top tranche)
- Top tranches received AAA ranking and were sold at high prices
- Lowest tranche sold for much less -> still nice price bc of optimism of the Great Moderation
- Buyers of these bundles were the most prestigious banks
- 5 people who bought a house (prime and subprime
mortgages)
- Made a pool and divided pool into di erent
tranches according to risk (unsecured, mezzanine,
secured)
- Unsecured (high risk and low quality) loan
brought the highest return
- How quickly did the phenomenon of subprime mortgages grow ?
- Banks that bought bundles (securitisation) were not so worried
- Even though they knew that some of the loans would not be paid back -> very unlikely that many
loans would sour together (hundred’s of people could not pay back at the same time)
- Problem : subprime loan system relied on belief that housing prices would continue to rise for the
inde nite future
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, - This system worked fore a long time (housing prices doubled from 2000-2006)
- Securitisation : dangerous situation -> why ?
- Lack of transparency : investors had no clue what they were buying
- Expensive : even lowest tranches were expensive bc idea of housing prices
increasing continuously
- Inaccurate risk assessment : not looked at actual risk of subprime mortgages
- Investor bears risk : if something would go wrong (even small investors)
System
- Mortgage companies sold subprime mortgages (received from individuals) to banks
- Banks put them into bundle and divided them into tranches (low : more risky, high : less risky)
- Sold them to other banks but also small investors (high/low return) but everyone was happy bc
housing prices increased
2.2.2. So what happened that went wrong ?
- Housing prices paused in 2006 (they thought it would go on forever)
- Doubt set in -> lending slowed down (not everyone got a loan anymore) -> housing prices fell (less
people were looking for loans)
- But borrowers could not avoid increase in IR and many stopped paying o their debts (as housing
prices was decreasing -> why would I continue to repay my loan at $200 000 if my house is only worth
$180 000 now)
- If banks wanted their money back -> they had to sell the house by throwing people out of the houses
- Many houses were on sale -> housing prices dropped -> bankrupting both borrower and lender
- Bc when housing prices fell -> many borrowers did not want to (were not able to) repay loans that
had a higher value than the value of the house they had bought -> repay more than what they
received
- Important to know that it is not only the unhealthy people (subprime mortgages) that created the
crisis but also the healthy people (prime mortgages)
- Loans that were sold after 2008 : nanced by healthy loans
- When housing prices started to fall and all loans going bad at the
same time -> even top AAA tranches were in fact worth nothing
- Needed 4 years for prices to nd a oor
- By then, the world was in crisis
- Domino-e ect
= realisation of what was happening : collapse
2.2.3. Why did the rest of the world get into trouble
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