global financial crisis

The Global Financial Crisis GFC according to Wikepedia • The financial crisis of 2007–2009, also known as the Global Financial Crisis and 2008 financial crisis, • is considered by many

The Subprime Crisis /

Global Financial Crisis /

Great Recession

April 2015

Dr Loeffler and Dr Wonil Lee

CAU MBA

The Global Financial Crisis Tale 1

The Global Financial Crisis (GFC) according to Wikepedia

• The financial crisis of 2007–2009, also known as the Global Financial

Crisis and 2008 financial crisis,

• is considered by many economists the worst financial crisis since the Great

• It resulted in the threat of total collapse of large financial institutions, the

• and downturns in stock markets around the world

• In many areas, the housing market also suffered, resulting in evictions,

• The crisis played a significant role in the failure of key businesses, declines

in consumer wealth estimated in trillions of U.S dollars, and a downturn in

economic activity leading to the 2008–2012 global recession and

contributing to the European sovereign-debt crisis

• The active phase of the crisis, which manifested as a liquidity crisis, can be

dated from August 9, 2007, when BNP Paribas terminated withdrawals from

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The Great Recession: US Unemployment

The Great Recession: GDP growth Q4/2008

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Here comes the „The Subprime“

• The bursting of the U.S housing bubble, which peaked in 2006, caused the values of securities tied to U.S real estate pricing to plummet, damaging

financial institutions globally

• The financial crisis was triggered by a complex interplay of policies

• that encouraged home ownership, providing easier access to loans for

• overvaluation of bundled sub-prime mortgages based on the theory

that housing prices would continue to escalate,

• questionable trading practices on behalf of both buyers and sellers,

• compensation structures that prioritize short-term deal flow over term value creation, moral hazard

long-• and a lack of adequate capital holdings from banks and insurance

companies to back the financial commitments they were making

And, the solution was

• Questions regarding bank solvency, declines in credit availability and

damaged investor confidence had an impact on global stock markets,

where securities suffered large losses during 2008 and early 2009

• Economies worldwide slowed during this period, as credit tightened and

international trade declined

• Governments and central banks responded with

• unprecedented fiscal stimulus,

• and institutional bailouts

• In the U.S., Congress passed the American Recovery and

• In the EU, the UK responded with austerity measures of spending cuts and tax increases without export growth.[13]

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From a historical perspective the GFC (2007-09)

 was nothing special

 it basically was a severe, and widespread, banking crisis (even so the

so called shadow banking played a major role)

 Because of large scale central bank and government intervention a

systemic financial crisis resulting in a total meltdown of the financial

system and subsequently the real economy could be prevented

 The world economy was closer to the abyss than ever before the 1930s

 Strange things happened …

Strange things happened

Bank Run in the UK

Past and Present (2007)

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Banks runs/panics and systemic banking crisis

• A bank run (also known as a run on the bank) occurs when a large number of

customers withdraw their deposits from a financial institution and either demand cash or transfer those funds into government bonds or a safer institution because they believe that financial institution is, or might become, insolvent

• As a bank run progresses, it generates its own momentum, in a kind of self-fulfilling prophecy (or positive feedback loop) – as more people withdraw their deposits, the likelihood of default increases, thus triggering further withdrawals This can

destabilize the bank to the point where it runs out of cash and thus faces sudden bankruptcy

• A banking panic or bank panic is a financial crisis that occurs when many banks

suffer runs at the same time, as people suddenly try to convert their threatened deposits into cash or try to get out of their domestic banking system altogether

• A systemic banking crisis is one where all or almost all of the banking capital in a

country is wiped out

A very recent unsystemic „bank run“ in Korea

Korea Economic Daily

Tongyang Securities Sees Its Customers Defect En Masse

September 25, 2013 11:16 l 09 25, 2013 11:55

As Tongyang Securities was unable to offer any convincing plan

for the group's liquidity crisis, it is facing a major run on its

deposits by skittish investors Although the company and the

Financial Supervisory Service persuaded on September 24 the

investors that their money will be safe, it was not enough to talk

them into going home

According to the financial regulator, the amount of money

withdrawn on the whole days of the 23rd and up to 3 pm on the

24th would be in the range of 2 trillion won It is estimated that

the withdrawal balance will soon surpass the 3-trillion-won level

unless something is done about it Financial Services

Commission chairman Shin Je-yoon said on the same day,

"There is no reason for customers to be panicky because

Tongyang Securities is a blue-chip company." But it could not

stem the tide

Tongyang Securities, jointly with the Financial Supervisory

Service, published a statement that there is little problem for the

company to survive except damages to its reputation that will

affect its ability to attract future customers even if 8 to 9 trillion

won of deposits are withdrawn in the form of 2 trillion won of

Corporate Governance of a listed firm influence long term value of the firm

 Orion : started as a small confectionary company’s market cap rose by 50x in 15 years,

 Tong Yang Group: composed of Securities, Insurance, Cement, IT firms but failed via bank run in 2014 due to bad corporate governance

* Orion: +4,959 % up

* Toyang: -42 % down

(2001/09/01 = 100)

자료 : DataGuide

Crisis and Corporate Governance

• On Sept 1 2001 former Tong Yang Group spined off as Orion and Tong Yang Group

• At that time, Orion market cap was only 100bn won

• Tong Yang market cap was 2.8tn won

• In July 2014, Orion market cap reached 5.8tn won while Tong Yang was only 500bn won

Orion Market Cap

Strange things happened

or rather were uncovered because of the crisis

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Strange things happened

 Global economic crisis spurred 5,000 additional suicides

[in 2009], study says (Los Angeles Times September 18, 2013)

 Shortly before 5pm on Monday night, Adolf Merckle [74] quietly put on his coat, told

his wife "I have to go to the office for a while", and drove to a railway embankment near his home, where he lay on the frozen tracks and waited patiently for death

 Merckle was once ranked as one of the 100 richest men in the world, with an £8.5 billion personal fortune

 What baffles Merckle's friends most of all about his death is that he was by no

means ruined True, his holding company had lost £400 million by betting on the

falling price of VW shares in October Yet Merckle's personal fortune still stood at around £6 billion and, on the day he killed himself, he had successfully negotiated a

£360 million bridging loan to keep his holding company … afloat

 … but his creditors had also made it clear that the bridging loan was conditional on his son Ludwig, named after Merckle's father, stepping down as director of VEM Was this the final indignity which tipped Merckle over the edge?

 "His companies were his life and when he was going to lose control of them he

obviously felt he would lose control of his life, that is the only way I can see it," said Ernst Junger, a friend in Blaubeuren

(The Telegraph 09 Jan 2009)

Strange things happened „it‘s all about liquidity“

• In a rare interview last month, Mr Merckle told the German newspaper Frankfurter Allgemeine Zeitung he had survived "many so-called stock-market crashes" but that

he "couldn't calculate a banking and financial crisis of this dimension."

• Mr Merckle voiced distress about the rapidly changing opinions of his business

dealings as reports surfaced in recent weeks about his debt problems "We are

being thrown into the same pot as hedge funds," he told Frankfurter Allgemeine

Zeitung last month

• But he insisted that his holding company was suffering from a "pure liquidity

problem" and that his focus had always remained building up solid businesses

• As Mr Merckle grew increasingly desperate to keep his empire afloat, he lobbied the regional government in his home state of Baden-Württemberg late last year for

temporary financial backing but was turned down

(Europe Business News 07 Jan 2009)

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„it‘s all about liquidity“

The “NORMAL”

• Liquidity is abundant, credit is available

• Economic fundamentals are strong and are getting better

• The prevailing mood is optimism and trust in the economic future and in business

and financial counterparts

The CRISIS

• “rapidly changing opinions” turn optimism into pessimism and distrust

• Safety first prevails and liquidity is drying up: Flight to Quality quickly happens

• Yesterday’s strong banks and businesses are struggling for money and are even threatened by bankruptcy

Ben Bernanke, Fed Chairman:

“I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression.”

Almost all investment banks were at risk ”Even Goldman Sachs, we thought there was

a real chance that they would go under.”

Financial crisis are inherent features of

credit based market economies as economic cycles are

All that is possible because

• Market economies are based on expectations for the future, which can change any time and are not anchored in “fundamentals”, as even “fundamentals” are not fixed

• In an expectation based system with feedback loops, there is no “fair value” for

assets or the “potential growth rate” of an economy, no mean reversion and no

equilibrium

• This inherent instability is greatly magnified by credit / leverage

• Proper financial regulation and policy making can limit the frequency and extent of financial crises, but will never be able to root them out completely

Blaming financial and economic crises on the “irrational”(behavioral economics) or unethical (“greed”) behavior of economic agents is just neglecting this basic insight

(despite the fact that irrational and unethical behavior is of course quite widespread and an integral feature of human / societal nature)

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Financial crisis are inherent features of

credit based market economies as economic cycles are

Korea Times, Sep 25, 2013

The GFC is no evidence that capitalism or the market

economy has failed

• Empirical research shows that countries with a higher frequency of

financial/economic crises tend to have higher economic growth

• Despite calamities and crises, market economies have greatly increased economic growth and welfare of societies over the last 200 years

• As for democracy, despite all the shortcomings, there is no better alternative in sight

“It has been said that democracy is the worst form of government except all the others that have been tried.”

Winston Churchill

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The GFC was caused by a credit boom, a drastic rise of leverage

The Economist, Sep 7th 2013

Financial innovation made things worse,

but was not the root problem

• Complex chains of debt between counterparties were vulnerable to just one link breaking

• Financial instruments such as credit-default swaps (in which the seller agrees to compensate the buyer if a third party defaults on a loan) that were meant to

spread risk turned out to concentrate it AIG, an American insurance giant buckled within days of the Lehman bankruptcy under the weight of the expansive credit-risk protection it had sold

• The whole system was revealed to have been built on flimsy foundations:

• banks had allowed their balance-sheets to bloat, but set aside too little

capital to absorb losses

• In effect they had bet on themselves with borrowed money, a gamble that had paid off in good times but proved catastrophic in bad

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It was not at all just an US problem

The Economist, Sep 7th 2013

• although Europeans claimed to be innocent victims of Anglo-Saxon excess, their banks were actually in the thick of things The creation of the euro prompted an

extraordinary expansion of the financial sector both within the euro area and in

nearby banking hubs such as London and Switzerland

• Moreover, Europe had its own internal imbalances that proved just as significant as those between America and China Southern European economies racked up huge current-account deficits in the first decade of the euro while countries in northern Europe ran offsetting surpluses The imbalances were financed by credit flows from the euro-zone core to the overheated housing markets of countries like Spain and Ireland

• The euro crisis has in this respect been a continuation of the financial crisis by other means, as markets have agonised over the weaknesses of European banks loaded with bad debts following property busts

It‘s debt, stupid

• It was the growing rate of default on home mortgages in America that

precipitated the financial crisis five years ago

• These delinquencies, although not enormous in themselves, became impossible

for some investment banks to bear, thanks partly to their own heavy debts

• As the contagion spread throughout the financial sector in 2007-08, nervous or

cash-strapped banks and other creditors stopped lending, thereby infecting

the rest of the economy

• Deep recessions and big financial rescues then led to a surge in

government debt

• That, in turn, raised fears about the solvency of various countries in the euro area, culminating in Greece’s default in 2012

• Debt was, then, both a cause and a consequence of the crisis, and

remains a big reason for its continuance

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It‘s debt, stupid: Total debt as % of GDP

It‘s debt, stupid: Banking Assets as % GDP

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It‘s debt, stupid: Total debt as % of GDP

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Why debt? – The private household perspective

• Most people have a strong preference/desire to own their own house

• Without debt

• many households could only afford to buy a house after a long savings period

at quite old age (e.g when children are already grown up)

• For many people, major consumption (cars, furniture, travel) would have to be postponed to old age too

• Debt = leverage allows to increase investment returns (ROE) [provided things go well, i.e house prices rise or at least do not fall / no unemployment, so that debt can be serviced out of employment income ]

• Mortgages are the only way to do significant leveraged investments for most

private individuals and housing usually is a better and more stable investment

than others (stock markets etc.)

Why debt? – The private household perspective

Equity 100% 50% 40% 30% 20% 10% Debt 0% 50% 60% 70% 80% 90%

Asset Value = House 100 100 100 100 100 100 Asset return = rental yield 5% 5% 5% 5% 5% 5% Cost of Debt 4% 4% 4% 4% 4% 4% ROE 5.0% 6.0% 6.5% 7.3% 9.0% 14.0%

Net asset Value (= Asset Value minus debt) depending on house price change

25% 125 75 65 55 45 35 10% 110 60 50 40 30 20

-5% 95 45 35 25 15 5 -10% 90 40 30 20 10 0 -25% 75 25 15 5 -5 -15 -40% 60 10 0 -10 -20 -30

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Why debt? – The banking perspective

• Banks (traditionally) earn their money from lending = providing loans at a higher rate than they have to pay to refinance themselves (deposits, bank bonds)

• The higher the banks’ leverage, the bigger their business, the higher their profit and ROE [provided things go well, i.e most loans are paid back and continuous refinancing at rates below loan rates is possible)

Why debt? – The banking perspective

Equity 100.0% 25.0% 15.0% 10.0% 8.0% 6.0% 5.0% 4.0% 3.0%

Debt 0% 75% 85% 90% 92% 94% 95% 96% 97%

Leverage Ratio (Assets/Equity) 1.0 4.0 6.7 10.0 12.5 16.7 20.0 25.0 33.3

Asset Value (Loans) 100 100 100 100 100 100 100 100 100

Loan rate 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%

Refinancing rate (+costs) 4.2% 4.2% 4.2% 4.2% 4.2% 4.2% 4.2% 4.2% 4.2%

Return on Assets 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8%

ROE before tax 0.8% 3.2% 5.3% 8.0% 10.0% 13.3% 16.0% 20.0% 26.7%

ROE after tax of 40% 0.5% 1.9% 3.2% 4.8% 6.0% 8.0% 9.6% 12.0% 16.0%

Net asset Value (= Asset Value minus debt) depending on loan default rate

0.5% 100 25 15 10 8 6 5 4 3 1.0% 99 24 14 9 7 5 4 3 2 2.0% 98 23 13 8 6 4 3 2 1 5.0% 95 20 10 5 3 1 0 -1 -2 10.0% 90 15 5 0 -2 -4 -5 -6 -7

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US Investment Bank Leverage

 From 2004-07, the top five U.S investment banks each significantly increased their financial leverage, which increased their

vulnerability to a financial shock These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA

nominal GDP for 2007

As a consequence of the financial crisis

 Lehman Brothers was liquidated

 Bear Stearns and Merrill Lynch were sold at fire-sale prices

 Goldman Sachs and Morgan Stanley became commercial banks, subjecting themselves to more stringent regulation to become

eligible for central bank liquidity

 With the exception of Lehman, these companies required or

received government support

Is debt / are banks bad or

even the „original sin“ of market economies?

• No, it‘s a question of how much debt

• However, we never know how much is too much

• There is a price to pay for both too much or too little debt (as up to a

cerftain degree debt is positively related to economic growth and

prosperity of an economy)

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Economic Importance / Benefits of Debt / Financial Intermediation (FI)

 Financial intermediation facilitates the matching of savings and

investments in an economy by channeling funds from surplus to deficit units

 FI lowers the transaction and agency costs in financial markets

 This results in a lower cost of capital > larger and more efficient

investments > higher economic growth and welfare

 Financial Interrelations Ratio = quotient of financial and tangible assets (like land, buildings etc.)

 Ratio of unity is characteristic of financial maturity of a country

 Financial institutions typically hold between a quarter and a half of all

financial assets

An efficient and deep financial system is essential for economic

prosperity

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However there is no magic: Financial institutions can fail

and create significant social costs

 Financial Intermediation can diversify/transform and mitigate risks of primary

securities However eventually the underlying risks (e.g economic cycle risk,

business risks, agency/fraud risks) can not be fully eliminated

 In addition, Financial Intermediaries create own risks

 Liquidity, maturity mismatches

 Systemic risks (banking crisis)