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18 Week 8 Financial Crisis Notes1. “A key question: how the original loss of several hundred billion dollars in the mortgage marketwas sufficient to trigger such an extraordinary series of worldwide financial and economicconsequences.” Answer: A run, or panic, in the “shadow baking system” consisting of repoand other overnight financing, brokerage accounts, and derivatives counterparties. The sourceof the losses didn’t really matter. It’s the fragility of the financial structures that held thelosses. Compare to the dot-com bust. Anyway, that’s the main lesson I take away.2. (Duffie p. 51) Background: how an old-fashioned bank run works.(a) The keys: 1) Illiquid assets (mortgages), limited cash reserves, 2) liabilities (demanddeposits) that promise a fixed value, 3) first-come first serve payment. 4) m y redemptionmakes the institution worse off,raisingyourincentivetorun. Thelastinlinewillnotget full value, so if ev eryone else runs, you should run too. Bank deposits are a “systemiccontract,” they leave an “externality”, a “multiple equilibrium.”(b) Is this a problem? If the 5) liquidation of assets is socially inefficient, the run is unde-sirable. In models (Diamond and Dybvig), the bank m ust liquidate real projects, i.e.having built the basement stop building the house. This is bad, and a reason for policyintervention. If we’re just selling financial assets howev er, the case is much weaker. Youhave to argue that liquidation “depresses prices” and this price depression is sociallyinefficient, not just a transfer. A run per se is not a bad outcome.(c) Runs are not a policy problem if it’s only a transfer. People forget this all the time. Weneed to abandon real projects, or your fire sale is m y buying opportunity. Bankruptcyper se is not a problem: There is no crater. Debt becomes equit y, keeps firm running ifit makes sense to do so. You need some social (not just transfers) “costs” People forgetthis too!(d) Runs are a problem if you get an overall financial crisis. (Not in Duffie, but in Gorton).It doesn’t matter if you’re all alone (MF Global.) When your bankruptcy makes peopleworry about the other bank (Gorton, E. Coli), leading to “systemic insolvency” (reallyilliquidity) then it’s potentially a problem. And only then.(e) Our challenge: understand how each of brokerage, derivatives ,andovernight debt havean incentive to “run,” and how those runs precipitate firm demise. Then, how to fixthese features! See Duffie.Fornow,thisiswhathappened.3. Bailouts/bankruptcy/equity sales/debt overhang(a) Why not just raise new equity? The debt overhang problem gets in the way. Once a firmhas taken a lot of losses, it’s clear that if broken up debt will only get, say, 60 cents onthe dollar. Equity is still not worthless, as it’s an option on things getting better. Now,if you sell new equity, t he first thing that happens is the value of bondholder claims getbetter. New equit y holders don’t want to subsidize current bond holders. This is thestory, anyway. It also has holes in it, and we see new equity coming in to firms afterlosses all the time. For this or other reasons, though, it’s often hard to sell new equityto a company right on the edge of bankruptcy, or find a suitor willing to come in.(b) A sale is really a “recapitalization”. The FDIC/Fed hope that the merged company hasenough extra value to then pay off bondholders and escape debt overhang. Plus thego vernment chips in.365(c) Bankruptcy is just a recapitalization, avoiding debt overhang. Current equity loseseverything, old debt turns in to new equity worth less than the face value of that debt,and the firm can issue equity again and get going. Debt holders don’t like this of course,they’d rather be bailed out. The newspapers and policy wonks alwa y s think banks canonly be recapitalized from taxpayer money.(d) This motivates some policy proposals. Forms of con vertible debt that would allow adebt/equit y conversion without bankruptcy, for example. However, it is the righ t ofbondholders to seize assets that makes bonds worthwhile, so it’s not a panacea.(e) Motivated at least b y this story, the Fed provided credit guarantees, i.e. a subsidy andbailout to the deal. Thus, bondholders made money at the expense of taxpayers, andthen new equity came in4. While we’re at it “financial crises are always and everywhere a result of short-term debt.”(Diamond)(a) Consider the example of a project, coming due in 10 years, financed by 10 year zero vs.financed by rolling over debt.(b) Gov ernment (Greece) crises are all at the m omen t of roll over.(c) “Illiquidity” vs. “insolvency” (meaning, here, the present value is really less than zeroand it won’t be paid at maturity) is not so easy to tell(d) Runs as “multiple equilibrium”(e) Leading to my question — why is short term funding so vital? More later5. Duffie p. 51, “Standard policy tools” a) Deposit insurance — removes incentive to run. b)“Regulatory supervision, risk based capital,” Deals with moral hazard of deposit insurancec) “Regulatory resolution mechanism” this means FDIC. Don’t get the impression that thisis all working so great!18.1 Duffie failure mechanicsThis is a brilliant paper for outlining why short term repo, derivativ es, and brokerage accountsare “run-prone” and hence “systemically dangerous” contracts. It’s also useful as investors need tounderstand the operation and risks of these markets. Another big picture: it’s all about cash in theend.• Definitions of words / how stuff works. Rules for today: We’ll stop and define everything andnot pretend everyone knows all this gobbledygook.1. Bank Run2. Debt overhang3. Repurc h ase agreement (repo)4. OTC derivatives. Don’t confuse notional with exposure. Master agreement, and nettingof collateral.5. Credit Default Swaps6. ‘Off Balance Sheet Financing” “Special Purpose Entity”3667. Repurc h ase agreement8. “Re-Hypothecation”9. Keep adding to this list.....• p. 51 Traditional bank run.• p. 51 “Standard policy tools”• p. 52 Alpha bank = Bear Stearns / Lehman story. Fundamentally, bankruptcy comes whenyou run out of cash, so he’s following how events drain cash. (And we have to think whywon’t/can’t the company get more cash)1. Lose money.2. Obvious answer: raise new equity capital? a) “Debt overhang” b) “uninformed” story.Note: Efforts to sell the firm = new


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Chicago Booth BUSF 35150 - Financial Crisis Notes

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