The Financial System. Sherif Khalifa. Sherif Khalifa () The Financial System 1 / 74

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1 The Sherif Khalifa Sherif Khalifa () The 1 / 74

2 The financial system consists of those institutions that match saving with investment. The financial system channels funds from those who save to those with investment projects. These investment projects make the economy more productive and increase employment. These projects provide new jobs for workers and introduce new products to consumers. The financial system allows the economy to grow and the living standards to improve. The financial system is comprised of the financial market and the financial intermediaries. Sherif Khalifa () The 2 / 74

3 Financial markets are markets in which people and entities buy and sell securities such as stocks and bonds. Financial Markets are the institutions through which savers can directly provide funds to borrowers. A security is a claim on some future flow of income, and is a type of transferable interest representing financial value. Securities are categorized into either debt or equity securities, and the most familiar ones are stocks and bonds. Sherif Khalifa () The 3 / 74

4 The holder of a debt security, a bond, lends the issuer and is entitled to the payment of principal and interest. The holder of an equity, a stock, is a shareholder, owning a share or a fractional part of the issuer company. For the issuer of a security, securities are a means of raising new capital. They are preferred to bank credit which tends to be expensive and short term. For the holder of the security, securities allows the investor to collect income and capital gains. Securities are also used as collateral by the holders of the security. Sherif Khalifa () The 4 / 74

5 The primary market is that part of the financial market that deals with the issuance of new securities, where issuers can obtain funds through the sale of a new stock or bond issue. The issue of new securities is commonly known as an Initial Public Offering. In the primary market, securities may be offered to the public in a public offer or they may be offered to a limited number of persons in a private placement. The secondary market is the market for trading of securities that have already been issued in an initial private or public offering. In the secondary market, securities are sold by and transferred from one investor or speculator to another. Sherif Khalifa () The 5 / 74

6 A bond is a security issued by a corporation or a government that promises to pay the buyer predetermined amounts of money at certain times in the future. Corporations issue bonds to finance investment projects. Governments issue bonds to cover their budget deficits. The bond issuer is borrowing money from the bond buyers. The bond issuer pays the bond buyers back in the future. Bonds act as a loan and thus called debt securities. Sherif Khalifa () The 6 / 74

7 Bonds A bond issuer defaults if it fails to make coupon payments or pay the face value at maturity. A corporation defaults if it declares bankruptcy, and a government defaults if it does not have enough revenues. The risk is smaller for bonds issued by the government or by well established successful corporations. The risk is larger for new corporations with unknown prospects or those that may go bankrupt. The greater the risk of default, the higher the interest rate that a bond must pay to attract buyers. Sherif Khalifa () The 7 / 74

8 A stock is an ownership in a firm and is a claim to the profits that the firm makes. A stock is an ownership share in a corporation, and is the capital raised by a corporation, through the issuance and sale of shares. A shareholder or a stockholder is any person or organization which owns shares of a corporation s stock. A dividend is the distribution or sharing of parts of profits to a company s shareholders. Sherif Khalifa () The 8 / 74

9 The owners of a company may want additional capital to invest in new projects within the company. They may also wish to lower their holding, freeing up capital for their own private use. By selling shares they can sell part or all of the company to many other part-owners. The purchase shares entitles the holder to share in the ownership of the company. The purchase shares entitles the holder to a fraction of the decision making process. The purchase shares entitles the holder to a fraction of the profits issued as dividends. Sherif Khalifa () The 9 / 74

10 The shares include the right to vote on matters such as elections of the board of directors. The privileges also include the right to purchase new shares issued by the company. Stockholder s rights to a company s assets are subordinate to those of the creditors. Sherif Khalifa () The 10 / 74

11 The profits earned by a company every year are unpredictable, but offer higher return. Stocks are accompanied by a higher risk and potentially offer higher return compared to bonds. After a corporation issues stock by selling shares to the public, these shares trade on stock exchanges. The price at which shares trade on stock exchanges are determined by the supply of and demand for the stock. Supply and demand for the stock reflects people s perception of and optimism about a company s future profitability. Sherif Khalifa () The 11 / 74

12 A stock exchange is an organization that provides a marketplace for trading shares, where investors may buy and sell shares in a wide range of companies. Allows companies to raise capital for expansion through selling shares to the investing public. Allows for a rational allocation of resources because funds are redirected to promote business activity. By giving a wide spectrum of people a chance to buy shares, it helps to lower income inequalities. By having a wide scope of owners, companies tend to improve on their effi ciency to satisfy the shareholders. Serves as a barometer of the economy, as the fluctuations of share prices can be an indicator of the general trend in the economy. Sherif Khalifa () The 12 / 74

13 A bull market tends to be associated with increasing investor confidence, motivating investors to buy in anticipation of further capital gains. A bear market tends to be accompanied by widespread pessimism, and negative sentiments by investors. Sherif Khalifa () The 13 / 74

14 A stock market boom is a sudden dramatic gain of value of shares of stock in corporations. A stock market bubble takes place when a wave of enthusiasm, evolving into herd behavior, causes an exaggerated bull market. A stock market crash is a sudden dramatic decline of stock prices. Crashes are driven by panic as much as by underlying economic factors. Crashes often follow speculative stock market bubbles. Sherif Khalifa () The 14 / 74

15 The book value of a stock is the price at which it is originally purchased or acquired. The book value per share is the total book value of a corporation divided by the number of common shares Book value per share = Total book value Number of common shares Sherif Khalifa () The 15 / 74

16 The market value for a corporation is calculated by multiplying the market price per share of the stock by the number of shares outstanding. The market value of one share of stock is the observed current market price. Market capitalization refers to the aggregate value of a firm s outstanding common shares, and reflects the total value of a firm s equity currently available on the market. Market Capitalization = Number of common shares x Current price per share Sherif Khalifa () The 16 / 74

17 When a company earns a profit, some of this money is typically reinvested in the business and called retained earnings. Some of the profits can be paid to its shareholders as a dividend in the form of cash, additional stock shares, or property dividends that are those paid out in form of assets from the issuing corporation. Sherif Khalifa () The 17 / 74

18 The dividend yield is the ratio of the dividend to market price. The dividend yield on a company stock is the company s annual dividend payments divided by its market capitalization, or the dividend per share divided by the price per share The payout ratio indicates the percentage of a firm s earnings paid out in cash to its stockholders. It is the ratio of dividends to earnings Payout ratio = Dividends Earnings Sherif Khalifa () The 18 / 74

19 A risk component represents that portion in the variability of a stock s returns that is associated with overall changes in general economic activity. A specific component representing that portion in the variability of a stock s return that is not related to general economic activity. This nonmarket risk unique to a particular security, is referred to as the unsystematic risk, can be hedged against by diversifying the portfolio. The market risk is referred to as the systematic risk, cannot be hedged against and is undiversifiable. Sherif Khalifa () The 19 / 74

20 Risk Total Risk Unsystematic Risk Systematic Risk Number of Securities in a Portfolio Sherif Khalifa () The 20 / 74

21 Return Risk Sherif Khalifa () The 21 / 74

22 The equity risk premium for stocks is defined as the difference between the return on common stocks and the return on riskless assets. It is the additional return that investors receive for assuming the additional risk of common stock ownership as opposed to risk free assets. As stocks are considered risky, the return to stocks is usually compared to the return on other riskless assets. Taking a risk requires a compensation, which is referred to as the equity risk premium. Required Rate of Return = Risk free Rate + Risk Premium Sherif Khalifa () The 22 / 74

23 Matching Savers and Investors A system of markets and institutions help channel funds from savers to investors. At any time, some people consume less than they earn and save the remainder. Other people know how to use these savings for investments that earn profits.. Financial markets transfer funds from an economy s savers to its investors. Sherif Khalifa () The 23 / 74

24 Risk Sharing If a person s wealth is tied to one company, the person loses a lot if the company is not successful. If the person buys the securities of many companies, the person diversifies the portfolio. Diversification lets savers earn healthy returns from securities while minimizing the risk. Sherif Khalifa () The 24 / 74

25 Asymmetric information is a situation in which one participant in an economic transaction has more information than other participant. In financial markets, asymmetric information occurs because the sellers of securities have more information than the buyers. Two types of asymmetric information exist in financial markets: adverse selection and moral hazard. Sherif Khalifa () The 25 / 74

26 Adverse selection means that people or firms that are most eager to make a transaction are the least desirable to parties on the other side of the transaction. In securities markets, a firm is most eager to issue stocks and bonds if the values of these securities are low. This is the case if the firm s prospects are poor as earnings on its stocks are likely to be low and default risk on its bonds is high. Adverse selection is a problem for buyers of securities because they have less information than issuers about the securities value. Sherif Khalifa () The 26 / 74

27 Moral hazard is the risk that one party to a transaction will act in a way that harms the other party. In securities markets, issuers of securities may take actions that lowers the value of the securities. The buyers can not prevent this because they lack information on the issuer s behavior. Sherif Khalifa () The 27 / 74

28 Asymmetric Information Adverse Selection Moral Hazard Prior to a transaction, savers lack Information about investors characteristics After a transaction, savers do not observe investors behavior Investors with worst projects are most eager to sell securities Investors have incentives to misuse savers funds Savers won t buy securities Financial markets cannot channel funds from Savers to investors Sherif Khalifa () The 28 / 74

29 Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. A financial intermediary is an entity that acts as the middleman between two parties in a financial transaction, such as commercial banks, investment banks, mutual funds, hedge funds and others. Sherif Khalifa () The 29 / 74

30 A bank is a financial institution that raises funds by accepting deposits, and uses these funds to make loans to companies and individuals. A bank is an institution that takes in deposits from those who want to save and use these deposits to make loans to those who want to borrow. Sherif Khalifa () The 30 / 74

31 Banks channel funds from savers to investors indirectly, and act as an intermediary between them. Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. The difference between these rates of interest covers the banks costs and returns some profits to the owners. Banks analyze the creditworthiness of the borrower to ensure their ability to repay the loan. Banks combat adverse selection by screening potential borrowers to ensure creditworthiness. Banks combat moral hazard by including covenants on how the borrower is expected to behave. Sherif Khalifa () The 31 / 74

32 Asset Prices Asset prices are the prices of stocks and bonds. As the prices of stocks and bonds fluctuate, the owners of these assets see their wealth increase and decrease. As prices increase, asset owners increase consumption spending contributing to an expansion. As prices decrease, asset owners decrease consumption spending contributing to a contraction. Sherif Khalifa () The 32 / 74

33 Asset Prices The future value of a dollar is how many dollars it can produce in some future year. The present value of a future dollar is how much a future dollar is worth today. $ (1 + i) n in n years = $1 Today $ (1 + i) n $1 (1 + i) n in n years = (1 + i) n Today Present Value of $1 in n years = $1 (1 + i) n Today Sherif Khalifa () The 33 / 74

34 Asset Prices X Example Present Value = $X (1 + i) n Compute the present value of one future payment of $100 after 3 years, where i = 4%. Present Value = $100 ( ) 3 = $88.9 Sherif Khalifa () The 34 / 74

35 Asset Prices X 1 X 2 X 3 X T Example Present Value = $X 1 (1 + i) + $X 2 (1 + i) $X T (1 + i) T Compute the present value of finite future payments of $23 where i = 4% and n = 7. $X 1 = $X 2 =... = $X 7 = $23 Present Value = $23 (1.04) + $23 $ (1.04) (1.04) 7 = $138 Sherif Khalifa () The 35 / 74

36 Asset Prices Example X X X Present Value = $X (1 + i) + $X (1 + i) = $X i Compute the present value of infinite future payments of $100 where i = 4%. Present Value = $ = $2500 Sherif Khalifa () The 36 / 74

37 Asset Prices X X(1+g) X(1+g) 2 X(1+g) 3 Present Value = $X $X (1 + g) $X (1 + g)2 + (1 + i) (1 + i) 2 + (1 + i) = $X i g Example Compute the present value of a future payment of $100 where i = 4% that grows at a rate of g = 2% infinitely. Present Value = $ = $5000 Sherif Khalifa () The 37 / 74

38 Asset Prices Asset Price = Present Value of Expected Asset Income People purchase an asset because it yields a future stream of income. If an asset price is below the present value of its expected income stream, buyers pay less than the asset is worth. Lots of savers will purchase the asset, and high demand will push the price up. If an asset price exceeds the present value of expected income, then sellers receive more than the asset is worth. The asset s owners will rush to sell it, and the increase in supply will push down the price. Sherif Khalifa () The 38 / 74

39 Asset Prices If a bond has a face value F, an annual coupon payment C, and a maturity T. Example Bond Price = C (1 + i) + C (1 + i) C + F (1 + i) T Compute the bond price if F = $100, C = $5, T = 4 years, i = 4% Bond Price = 5 ( ) + 5 ( ) ( ) ( ) 4 = $ Sherif Khalifa () The 39 / 74

40 Asset Prices The prices of outstanding bonds change inversely with changes in the interest rate prevalent in the market. Assume an investor sells a bond few years after purchase and before it reaches its maturity, and that interest rate on comparable bonds has risen. Potential buyers of this bond will not pay the original purchaser the par value for the bond when they can buy new bonds with comparable features yielding a higher interest rate. The price of this bond must decline below its par value allowing the purchaser to receive a return equivalent to what they receive on a newly issued bond. Therefore, the bond will be sold at a discount. Sherif Khalifa () The 40 / 74

41 Asset Prices If a stock pays dividends D 1 after one year, D 2 after two years, and so on. Stock Price = D 1 (1 + i) + D 2 (1 + i) Sherif Khalifa () The 41 / 74

42 Asset Prices An asset price is the present value of expected future income from the asset. Present value changes if expected income changes or if interest rates change. Changes in interest rates affect asset prices, as it represents the safe return. Expectations change when there are news about a company s prospects or about economic conditions. Higher expected earnings means larger expected dividends for stockholders, so the stock price increases. Lower expected earnings means lower expected dividends for stockholders, so the stock price decreases. Sherif Khalifa () The 42 / 74

43 Asset prices increase even though there is no change in interest rates or expected income to justify it. When a bubble occurs, an asset price increases simply because people expect it to increase. People would like to hold assets as long as prices increase but sell before the bubble bursts. A few asset holders get nervous and decide to start selling at one point in time. Others also sell hoping to dump their assets before prices fall. Panic sets as asset holders try to sell at the same time and prices plummet. Sherif Khalifa () The 43 / 74 Asset Prices An asset price bubble is trade in an asset at a price or price range that strongly exceeds the asset s intrinsic value. Bubbles are a self fulfilling prophecy.

44 Yield to Maturity If a bond has a face value F, an annual coupon payment C, and maturity T. Example Bond Price = C (1 + i) + C (1 + i) C + F (1 + i) T Compute the yield to maturity if F = $100, C = $5, T = 4 years, and bond price= $95 $95 = 5 (1 + i) + 5 (1 + i) (1 + i) (1 + i) 4 i = Sherif Khalifa () The 44 / 74

45 Rate of Return P 0 : initial price of the security. P 1 : the price of a security after a year. X : direct payment. Example Rate of Return = (P 1 P 0 ) P 0 + X P 0 Compute the rate of return if P 0 = $80, C = $4, P 1 = $82 Rate of Return = (82 80) = Sherif Khalifa () The 45 / 74

46 Term Structure Term Structure of Interest Rates refers to the relationship between time to maturity and yields for bonds at a particular point in time. The term structure is plotted as a yield curve, which is a depiction of the relationship between yields and time for bonds that are identical except for maturity. The yield curve shows interest rates on bonds of various maturities at a given point in time Sherif Khalifa () The 46 / 74

47 Term Structure Yield curves are usually upward sloping where the longer the maturity, the higher the yield. Investors anticipate a rise in the risk free rate, and thus a higher return to their investment in the future. The longer maturities entail greater risks for the investor, hence the need for a risk premium. Investors need to be compensated for the anticipated rise in rate, thus the higher interest rate on long term investments. The opposite situation where the short term interest rates are higher than longer term rates can also occur. This is almost always due to the market s anticipation of falling interest rates. Strongly inverted yield curves have historically preceded economic downturns. Sherif Khalifa () The 47 / 74

48 This positive slope reflects investor expectations for the economy to grow in the future and for this growth to be accompanied by a rise in inflation in the future. This expectation for higher inflation in the future than the present generates both an expectation that the central bank will tighten monetary policy by raising short term interest rates in the future to slow economic growth and dampen inflationary pressure. In addition to the need for a risk premium associated with the uncertainty about the future rate of inflation and the risk this poses to the future value of cash flows. Investors include these risks into the yield curve by demanding higher yields for maturities further into the future. Sherif Khalifa () The 48 / 74 Term Structure The yield curve is described as normal when yields rise as maturity lengthens, that is when the slope of the yield curve is positive.

49 Term Structure A flat curve is when all maturities have the same yields, whereas a humped curve results when short term and long term yields are equal and mid term yields vary from those of the short term and long term. A flat curve sends signals of uncertainty in the economy. This mixed signal can revert back to a normal curve or could later result into an inverted curve. Sherif Khalifa () The 49 / 74

50 Term Structure An inverted curve occurs when long term yields fall below short term yields. An inverted yield curve is viewed as an indicator of an impending worsening economic conditions. An inverted yield curve has an impact on homebuyers financing their properties with mortgages that have interest rate schedules that are updated based on short term interest rates. When short term rates are higher than long term rates, payments tend to rise. Therefore, consumers dedicate a larger portion of their incomes toward servicing their debt. This reduces consumer expenditure and thus has an adverse effect on the economy as a whole. Sherif Khalifa () The 50 / 74

51 A yield curve inversion also has an impact on fixed income investors. In normal circumstances, long term investments have higher yields to reward investors who are risking their money for longer periods of time. An inverted curve eliminates the risk premium for long term investments. The inverted yield curve has an impact on the equity market as well. When the yield curve becomes inverted, profit margins fall for companies that borrow cash at short term rates and lend at long term rates. Sherif Khalifa () The 51 / 74

52 Financial Crisis A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. A financial crisis is a major disruption of the financial system, and involves sharp falls in asset prices and failures of financial institutions. Sherif Khalifa () The 52 / 74

53 Financial Crisis Bubble Burst A crisis may be triggered by large decreases in the prices of assets or real estate. Economists interpret these decreases as the end of asset price bubbles. A bubble occurs when asset prices increase above the present value of the expected income. As sentiment shifts, people begin to worry and start selling the assets pushing prices down. Falling prices shake confidence further, leading to more selling causing the bubble to burst. Sherif Khalifa () The 53 / 74

54 Financial Crisis Insolvencies An institution becomes insolvent when its assets fall below its liabilities and its net worth becomes negative. An institution may fail because it becomes insolvent. Insolvencies can spread from one institution to another. Because financial institutions have debts to one another. If one institution fails, its depositors and lenders suffer losses. Sherif Khalifa () The 54 / 74

55 Financial Crisis Liquidity Crises A financial institution can fail because it does not have enough liquid assets to make payments it promised. Depositors lose confidence in the bank, and try to withdraw large amounts from their accounts. This exhausts the bank s reserves and liquid securities, and the bank must sell its illiquid assets at low prices. If a bank experience a run, depositors at other banks start worrying about the safety of their own funds. The depositors start making withdrawals triggering an economy wide bank panic. Sherif Khalifa () The 55 / 74

56 Financial Crisis Regulators encourage banks to be conservative in lending to avoid large losses. Banks deny credit to those who are likely to default, those with low income or poor credit scores. People who cannot borrow from banks turn to subprime lenders or finance companies. Government regulates finance companies less heavily as they do not accept deposits. So the government does not owe insurance payments if a finance company fails. Sherif Khalifa () The 56 / 74

57 Financial Crisis Subprime lending refers to loans to people who may have diffi culty maintaining the repayment schedule. These loans are characterized by higher interest rates, poor quality collateral, and less favorable terms in order to compensate for higher credit risk. Light regulation allows finance companies to make loans that regulators deem risky. Finance companies made loans to people who were likely to have trouble paying them back. Finance companies could offset expected losses from defaults by charging high interest rates. This led subprime lenders to neglect traditional safeguards against default like down payments. Sherif Khalifa () The 57 / 74

58 Financial Crisis The house price bubble was a key factor behind the subprime lending boom. House prices increased by more than 70% from 2002 to People believed that prices would continue to increase indefinitely. Increasing house prices made it easier for homeowners to cope with high mortgage payments. Someone can take out another mortgage because the higher value of the house offered more collateral. Someone can sell the house for more than he paid for it, pay off the mortgage, and earn a capital gain. Sherif Khalifa () The 58 / 74

59 Financial Crisis Banks sold many of the loans they make rather than holding them as assets. Banks sell loans because the possibility of default makes it risky to hold them. Banks and finance companies sold loans to a financial institution, the securitizer. By selling loans, the bank shifts default risk to the ultimate holders of the loan. The securitizer pays the bank for reducing asymmetric information problems. The bank earns a profit from the sale and avoids the likelihood of debt default. Sherif Khalifa () The 59 / 74

60 Financial Crisis Securitization is the process of taking an asset, or group of assets, and transforming them into a security. Securitization is the practice of pooling various types of contractual debt such as mortgages, auto loans or credit card debt obligations and selling their related cash flows to investors as securities. Investors are repaid from the principal and interest cash flows collected from the underlying debt. Securities backed by mortgage receivables are called mortgage-backed securities, while those backed by other types of receivables are asset-backed securities. Sherif Khalifa () The 60 / 74

61 Financial Crisis The securitizer purchase home mortgage loans from the original lenders. The securitizer bundle a pool of mortgage loans with similar characteristics. The securitizer issue securities, referred to as mortgage backed securities. The securities entitle an owner to a share of the payments on the loan pool. The buyers became entitled to shares of the interest and principal payments. These are payments that borrowers made on mortgages they borrowed. Sherif Khalifa () The 61 / 74

62 As an underwriter, an investment bank helps companies issue new stocks and bonds. A firm becomes public by making a sale of stock, which is called an initial public offering. Investment banks advise companies, and markets the securities to potential buyers. Investment banks practice financial engineering, or the development and marketing of new types of securities. Sherif Khalifa () The 62 / 74 Financial Crisis An investment bank is an institution that provides financial services to individuals, corporations, and governments such as raising financial capital by underwriting or acting as the client s agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions and provide ancillary services such as market making, trading of derivatives and equity securities, and fixed income instruments, currencies, and commodities.

63 Financial Crisis In the early 2000s, the investment banks started to issue mortgage backed securities. The securities issued by investment banks had mortgages that were subprime. Subprime borrowers pay higher interest rates than traditional mortgage borrowers. Securities backed by subprime mortgages promised high returns to their owners. Securitization provided more funds for subprime lenders to issue more mortgage loans. This increased the demand for housing fueling the increase in the house prices. Sherif Khalifa () The 63 / 74

64 Financial Crisis Securities firms hold securities, trade them, or help others trade them. A large amount of mortgage backed securities were purchased by securities firms. Examples of securities firms include mutual funds, hedge funds, and index funds. Sherif Khalifa () The 64 / 74

65 Each shareholder owns a small part of the portfolio of securities in a fund. The shareholder of the mutual fund accepts the risk and return associated with the portfolio. If the value of the portfolio increases shareholders benefit, otherwise the shareholders suffer a loss. Allow people with small amounts of money to diversify their investments and face less risk. Give ordinary people access to the skills of professional fund managers. The government limits the risks that mutual funds can take with shareholders money. Sherif Khalifa () The 65 / 74 Financial Crisis Mutual funds is a financial institution that holds a diversified set of securities and sell shares to savers. A mutual fund is a professionally managed fund that pools money from many shareholders to purchase securities.

66 Financial Crisis Hedge funds raise pools of money to purchase securities. Hedge funds cater mainly to wealthy people and institutions. Hedge funds are largely unregulated as the fund s wealthy customers can look out for themselves. Light regulation means that hedge funds can make risky bets on asset prices. These bets sometimes produce large earnings and sometimes large losses. Sherif Khalifa () The 66 / 74

67 Financial Crisis A derivative is a contract that derives its value from the performance of an underlying entity. A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The payoffs from the derivative is tied to the prices of other assets. That is the value of the security is derived from other assets. Common types of derivatives are credit default swaps. A credit default swap buyer pays premiums as an insurance policy. Payments on credit default swaps are triggered by defaults on the original securities. Sherif Khalifa () The 67 / 74

68 Financial Crisis Many credit default swaps issued in the 2000s were tied to subprime mortgage backed securities. The sellers of CDS on mortgage backed securities promised to pay CDS buyers. If the market prices of the underlying securities fell even if the securities had not yet defaulted. Other firms used credit default swaps to speculate as they foresaw trouble in the housing market. They bet against mortgage backed securities by purchasing CDS on securities they did not own. As the financial crisis unfolded, insurance companies had to make payments to holders of its CDS. Sherif Khalifa () The 68 / 74

69 Financial Crisis The real estate price increases were an unsustainable asset price bubble. The house price bubble burst, and house prices fell by 33% from 2006 to When house prices fell, homeowners found themselves with mortgage payments they could not afford. They could not borrow more and they could not sell their houses for enough to pay their mortgages. The decline in house prices caused defaults on subprime mortgages as borrowers could not make payments. As defaults on subprime mortgages increase, institutions that made subprime loans suffered large losses. Other financial companies that held securities backed by subprime mortgages lost billions of dollars. Participants in financial markets realized that subprime mortgage backed securities would produce less than expected. Sherif Khalifa () The 69 / 74

70 Financial Crisis The direct costs of financial crises include losses to asset holders when asset prices fall, and losses from financial institution failures. Owners of a failed institution lose their equity, and the institution s creditors lose funds they have lent. The indirect cost is that a crisis can set off a chain of events that plunges the whole economy into a recession. Falling asset prices cause a sharp fall in aggregate demand, as asset holders decrease consumption as they suffer loss of wealth. Falling asset prices shake the confidence of firms and consumers as signs that the overall economy is in trouble. Sherif Khalifa () The 70 / 74

71 Financial Crisis Uncertain of the future, they put off major decisions about consumption and investment spending. A fall in asset prices makes it harder for individuals and firms to borrow. Lower house prices decreases the value of the borrowers collateral. The outcome is a credit crunch, or a sharp decrease in bank lending. Failures of financial institutions also cause a credit crunch, as when commercial banks fail they stop lending. Surviving banks may fear failure and become more conservative in approving loans. This also means less spending by firms and individuals who rely on credit. Sherif Khalifa () The 71 / 74

72 Financial Crisis This decrease in consumption and investment decreases aggregate demand. A fall in aggregate demand lowers output, and a crisis can cause a deep recession. The recession can exacerbate the crisis, as asset prices are likely to fall further. A financial crisis can trigger a vicious circle, and once a crisis starts it can sustain itself for a long time. Sherif Khalifa () The 72 / 74

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