Summary
Full summary - Economy of the Single Market (Chapters 6 to 9)
- Course
- Institution
Full summary of the course Economy of the Single Market in third year of bachelor business administration (second semester) - Chapters 6 to 9
[Show more]
Seller
Follow
Marie470
Content preview
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
1
ffi fi fl fl fifi fi fl ff fl fl fi fi
,- 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
2
fi fi fi
, - 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
3
fi ff ff
, - 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
4
ff fi fi fl ff
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller Marie470. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $7.46. You're not tied to anything after your purchase.
Can Stuvia be trusted?
4.6 stars on Google & Trustpilot (+1000 reviews)
73216 documents were sold in the last 30 days
Founded in 2010, the go-to place to buy study notes for 14 years now