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Summary IBF Material Week 8 - The Banking and Finance of COVID-19
Tooze (2021), and Dafermos, Gabor & Michell (2021)
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Voorbeeld 2 van de 14 pagina's
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Voorbeeld van de inhoud
W8 - Lecture prepOctober 17, 2022 4:25 PM
Title: Shutdown - How COVID shook the world economy
Tooze, 2021 - Ch. 6: "Whatever it takes", again
• In March 12 2020 stock prices started to fall (largest drop since Great Depression)
W was strange about anticipating a shutdown caused by the pandemic
fall in security • Normally speaking, the increased relative risk of stocks would make bonds
prices in March 2020?
relatively more attractive, causing their prices to be (somewhat) negatively
correlated.
Y did bond prices ○ When bond prices rise, their yields fall
decrease?
○ Lower yields mean lower borrowing costs faced by firms, which should
stimulate new investment
○ However, government bond prices ALSO fell as investors fled from both
stocks and bonds to cash.
▪ On March 13, there was less than 1/10th of market liquidity in
bonds market
W were the 2 key
problems leading to • In 2008, the (key) problems were mortgage based securities (MBS) and
the crisis in 2008? financialization. The drop in house prices caused collateral to lose value and the
market-based liability market broke down, causing a banking crisis due to illiquid
liability (repos) markets.
• What brought banks down was not the drop in house prices, but that they lost
access to the repo markets in which they had previously funded their giant
balance sheets of MBS.
• Central banks and treasuries intervened by quantitative easing (asset purchases)
to supply liquidity and avoid further chaos; and bailouts…
Y were banks making • In 2020, house prices were solid but banks were making a loss on existing loans due to
loses in 2020?
falling interest rates (remember the maturity transformation and the exposure to
interest risk…)
• Their shares lost value
• If banks in 2020 were as weak as in 2008, many of the biggest banks would have
failed (N.B.: they weren't thanks to post-2008 regulations)
WI market-based
finance? • market-based finance: financial relationships that are not based on the balance sheets
of banks, but are mediated through markets in which loans and bonds, and the
derivatives built on them, are bought, sold, rebought, and resold.
Y did repos used US • After 2008, most repos posted US gov't bonds as collateral (thanks to their liquidity).
Treasuries as
collateral since • These were readily available due to the 2008 crisis (supply)
2008? • Demand was high as financial institutions could use them as collateral for repos
to continue with the market-based system
○ Mutual funds absorbed them as interest-bearing liquidity reserves
○ Hedge funds built elaborate strategies to profit from tiny deviations in
their price.
○ Banks held them to meet the liquidity buffer requirements of the new
Basel Ill regulations.
○ Central banks in emerging countries held them (in their reserves) to hedge
currency risk
Y was the drop in • With such an important role of US gov't bonds in international financial systems,
Treasury interest the drop in their price in March 2020 (due to loss of liquidity) was terrifying
rates terrifying?
○ The economy entered a loss spiral, as everyone was trying to exit their
positions in US Treasuries and change them for dollars (causing large
appreciation of the dollar and increasing interest rates of US bonds)
Banking Page 72
, • Sale of treasuries in March 2020:
• Foreign central bank: reserve managers were trying to keep up with the demand
Y were foreign
central banks selling for dollars in their economies by borrowers who were having a hard time rolling
treasuries? over funding.
○ This mitigated the depreciation pressure of those treasuries sales.
• US financial system:
○ Mutual funds: facing massive withdrawals they had to sell assets.
Y were mutual funds
selling treasuries? ▪ Normally, they would have sold riskiest assets (i.e.: shares &
corporate bonds) but their recent drop in price would have meant
large losses. Instead, they sold treasuries.
□ Uncertainty of corporate debt and equity markets spread to
treasury market: rather than balancing out, the prices of
shares and bonds were collapsing together…
○ Hedge funds:
Y were hedge funds ▪ Hedge funds normally trade on the tiny differences between the
selling treasuries? price of Treasuries and futures secured on them. The increasing bid-
ask spread and drop in prices was bad news!
▪ Although they are small actors (compared to banks or asset
managers), they have an outsized role in the Treasuries market
because of their large leverage strategies based on repo market
▪ A loss in value of their collateral (largely reused) meant massive
margin calls, which had to be met by off-loading over $100 bill. Of
treasuries. This contributed to a loss/margin spiral…
○ Banks: normally they would have bought the dip and take all those
Y were banks not Treasuries off the market, but they were already loaded with Treasuries as
buying treasuries?
a consequence of huge budget deficits run up by the Trump
administration.
• Consequences:
W was the consequence
of such a large sale ○ A “safe” asset (i.e.: Treasuries) that could no longer be easily sold, or could
of treasuries? be sold only at a fluctuating discount, was no longer a safe asset.
▪ if the Treasury market stopped functioning, it was "a national
Y would it mean a security issue" as it would limit the capacity of US gov't to respond
national security to the coronavirus.
issue? ▪ If you could not be sure of being able to convert your piggy bank of
safe Treasuries into cash, it was not safe to hold the rest of your
portfolio either
• Fed's and other CBs responses:
H did central banks • First they tried their conventional measure of cutting rates to support markets
responded to
COVID-19? (a • Second action: NY Fed (closest to Wall Street) made it as cheap as possible for
timeline…) dealers to fund their portfolios, aiming to restore the depth of the Treasuries
market and to calm the nerves in the market by showing daily responses.
○ March 9th: US $150 bill. Were made available in overnight repo funding
○ March 11th: an increase to $175 billion, as well as a further $95 billion in
two-week and one-month repo.
○ March 12: Fed began to offer one-month and three-month repo in $500
billion batches.
• Third action: Fed assumes the role of the world's central bank
○ Fed cuts (with immediate effect on March 15th) rates to zero and to
stabilize the market it would buy at least $500 billion in Treasuries and
$200 billion in mortgage-backed securities, and it would start big
▪ In the first 48 hours, the Fed bought more than what Bernanke's Fed
would in a typical month
○ Fed eased the terms of the liquidity swap lines
▪ Liquidity swap lines: deals under which the Fed swaps dollars for
WI a liquidity swap sterling, euros, Swiss francs, and yen in potentially unlimited
line? amounts
Banking Page 73
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