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6.7. What has been done to fight the crisis? New regulation, QE, negative interest rates

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6.7. What has been done to fight the crisis? New regulation, QE, negative interest rates

Week 6, the final week of the Course covers securitization and CMO’s. We will reveal the role of the CMO market in the development of the world financial meltdown that peaked in 2008 and, as many believe, is not yet over. We will study the details of the role of CMO’s in the development of the crisis. We will consider the measures taken by the regulators, the “too big to fail” phenomenon, and will understand why the governments so actively helped the biggest international investment banks found to have been on the verge of bankruptcy. We will also talk about the globalization of capital markets and the first signals of a counter-trend – de-globalization. We will clearly see how modern geopolitical and technological trends contribute to the ascent of moral hazard that is now a global problem. Finally, some clear and useful recommendations are provided. As a result, you will be able to successfully apply the obtained knowledge and skills not only in finance but also in your career and life in general.

Capital Markets and Financial Institutions – How to Survive Them

莫斯科物理科学与技术学院

课程 1（共 5 门，Understanding Modern Finance 专项课程）

Capital markets and financial institutions are all around us. This is an enormous industry in which powerful players oftentimes challenge investors and the public at large and expose them to significant risks. This Course provides for the deep understanding of the core ideas, concepts, and mechanisms of the modern capital market in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests of the market participants, reveal the true meaning of certain financial terms, and uncover credible signals of the likely behavior of economic agents – all that with little math and a lot of fun. The learners will be much better positioned with respect to the financial environment. They will see through the financial news, reveal the risks of the financiers’ wishful thinking promises, and protect themselves against dangerous adventures. The learners will get the opportunity to use the obtained knowledge, skills, and understanding for the successful professional career in the financial and other business areas, as well as in their day-to-day life.

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教学方

Konstantin Kontor
Director and Professor of Finance and Strategy

脚本

Now, when the scale of the crisis became clear to everyone,

then almost immediately, major regulators around

the globe started to think what can be done to alleviate the damage and

to basically change the situation and to start to recover.

Now if we go back to what happened after the Great Depression, we know that for

quite a few years before the introduction of deposit insurance,

the US economy could not recover.

And that happened to a significant extend,

because there was no money injected in the economy.

Because at that time, people were really scared about printing money,

quotedly, because they said that that would result in high inflation.

And in the early 30s, there was deflation in the US and

high cost of credit remediation.

And whenever the economy was about to start to recover then

waves of bank collapses would bury, this positive trend.

Now one of the scholars of the Great Depression was Mr.

Ben Bernanke who at the time of the latest crisis was the Chairman of the Fed,

the United States Central Bank, Federal Reserve system.

Now clearly this understanding of what went wrong 80 something years

ago helped Mr. Bernanke to spearhead the massive program of fighting the crisis.

And the key idea here was basically provision of liquidity.

Because, When it became clear

that the collapse of Lehman resulted in such massive disruption,

then people said that if we do not inject the money into the economy,

we have the presence of these huge toxic assets that are just

nothing because they cost nothing and the value is low.

Therefore, we have to do something, we have to clean the system by

cleaning the balance sheets of the major institutions in the first place and

then by injecting money in the economy.

So when everything is depressed, when the people at least

can borrow cheaply and all these points of growth would not

be really prevented from growing by the lack of cash.

And the important thing is that normally how is this

injection of liquidity implemented?

Well first of all, you can reduce the interest rates.

But by that time, the interest rates were already very low.

And this measure would not be quickly helping the situation and

instead, they just embark on a large scale liquidity provision problem program.

So we'll put it like

a large scale.

I would put quoted money printing.

Program that now is used under the abbreviation of quantitative easing.

There's QE1, QE2, QE3, basically what does that mean that

the federal reserve would buy bonds and mortgages from financial institutions.

They would buy that, they would store it on the fed balance sheet and

will inject the money into the economy.

Now how did that help and why wasn't that the problem of inflation here?

Because you know that whenever you hear about printing money,

the immediate reaction is maybe it will result in inflation.

Well here, and the important thing is to realize is when people talk about

inflation, you have to distinguish between inflation in consumer prices.

So this is basically what people buy when we go to the supermarket or

when we buy gasoline or that's the one thing.

And the other thing is that when we go from consumption to investing.

And now it can be seen right away that the inflation in the one segment

does not necessarily mean that there is the inflation in the other sector.

Now let's talk about that in some greater detail.

So normally, when we talk about inflation,

it's standard measure is CPI, the consumer price index.

That's exactly why I said, when you go the super market and you see that the basket

of food that you use to buy every week, then it basically cost the same.

More over, if there is a large scale crisis in the economy,

if the growth is undermined.

And therefore it will be indeed be very difficult to actually try to sell

your products at higher prices.

Because now people can not afford to spend as much as they used to,

and oftentimes people shift to cheaper offers.

And therefore, the trend in this consumer area is maybe even deflationary,

which is quite bad as we know for their recovery.

At the same time, over these waves of QEs,

the US government has injected trillions of dollars in the US economy.

The question goes, where did this money go?

And the answer is very simple, that was output at quoted

inflation, Of assets.

So all this money went to the stock market, to the commodities market,

to the bond market.

So we can see the unprecedented growth in the prices of stocks,

Commodities, Well mainly here, oil and gold.

So we went all the way from 2008 until 2013,

when it comes to gold and until 2014

with some troughs when it comes to oil.

So that was actually the case, so

here we can see that the story about this

printing money can be easily explained by that.

But there is another story here, and

[COUGH] this story is about what can be done when some of this

cash does come into the economy in whatever form.

Now the question of the cumulation of these large amounts,

we're not talking about sterilization is just the way to buy something.

And when people see that the money is getting printed,

then they can easily go ahead and get used to it.

So to some extent there was a significant recovery in these markets.

But then people said, well, if you stopped or suspended QE,

then there's a threat that the stock market will tumble.

And you know that QE was started in the United States, but

then later, a couple of years later, it was also followed

by the similar program by the European Central Bank.

That resulted in currency wars, because everyone would like to

see its country's currency to devalue in order to get some competitive advantage.

So what was supposed to bring growth to first of all,

the US economy and to the global economy,

did not go without some less clear or negative byproducts.

So that's quite normal, but that is not all what has been done.

There's another thing that happened here,

and this thing is negative interest rates.

Well, you know that just before QE,

the rates in some economies were really close to zero.

But now we observe in some European countries, in Switzerland,

in Germany, some of the least risky assets, certain bonds,

government bonds, they are traded at negative interest rates.

So basically if you buy this bond,

it does not give you any interest, you pay to the issuer.

And it sounds very strange, specifically because

the architecture of capital markets, it has been based for

a lot of time on the idea of the absence of the riskless arbitrage.

But here, if we go deeper in that, there's not that much of a contradiction,

because we talk about specific, very low risk assets.

So people say, well indeed, now the market is so volatile.

There is so much turmoil there,

that we're willing to pay some money to buy the least risky asset.

That by know means implies that the returns on risky

assets are inevitable, they are positive.

Or otherwise, indeed, if all returns started to be negative,

then the infrastructure of the market would collapse, this is not the case.

It's a funny example that I read a couple weeks ago,

when they said that said that one European reinsurance company

was thinking about that to store it's reserve in cash may be

cheaper than to store them in a bank in terms of certain bonds.

And that physical cash, stacks of 200 Euro notes, so

that would be a couple of hotel rooms, well it would have a cost of.

You have to really hire bodyguards,

you have to ensure that there is an alarm system, you have to ensure all that.

But these total costs were comparable with this negative interest or

the amount that they have to pay to a bank, if you held them there.

Well that may be sort of a funny example and a little bit egregious example,

but in the end, it was just thought of and that never happened.

But on the other hand, you can see that sometimes people say that having cash,

paper cash maybe even more profitable.

But that is not consistent with the global trend of pushing cash out of

payment services.

You know that in many countries the percent of cash

used in regular payments is very low.

And that goes specifically for the global European countries and some other, so

we can see some trends here too.

Now there is another thing that happened in response to

the challenge of the crisis.

In 2013, there was an acute phase of the Cyprus banking crisis.

So Cyprus was at the time, a very special economy,

it had two major sources of income.

One of them was tourism, because of a nice sea and nice weather.

But it was also a special jurisdiction in which a lot of

companies would hold significant balances in Cyprus banks.

So the majority of depositors in the biggest Cyprus banks,

those were deposits of foreigners.

And then there's the liquidity crisis, and

some of these banks were on the verge of collapse and see what happened.

So for normal bank balance sheet, we know that this is equity or capital, and

here we have deposits, demand deposits, time deposits in something else.

Now, there was a procedure called bail-in,

because now you know that the procedure called bailed-out.

This is when, let's say there's a problem with a bank, and another bank or

the government comes, buys all its poor assets and assumes all its liabilities.

That's called a bail-out, but what is a bail-in?

This is the situation in which the bank goes to the depositors and say,

you know what?

We will forcefully make you shareholders of this bank,

so you will not get your deposits back.

Those will be frozen, but you will have a proportional share of equity.

So to exaggerate is all deposits were converted into equity.

So clearly, well the banking crisis as you know is a situation where the assets go

like this, so we have actual negative equity.

So basically, all these deposits, they're at least shrunk to this.

But not only that, maybe there's no liquidity.

So the question is was that fair?

Well, probably not.

Did people lose money?

Well indeed, they did.

But who lost money?

The small depositors in these banks, they were insured, and

they were covered by the government.

But the money was lost by large investors and many of who were foreigners.

So this story seems to be very strange, but now for example,

if you open an account in the European Bank.

You can see that when you sign off all these documents,

you see that says that you have been informed about the fact

that there may be the case when the bank is billed in.

And you might find yourself in the shoes of these poor depositors.

Now again, I'm stressing that this is not fair, this is kind of bad.

This is to an extent contradicts to what we talked about before.

But the idea is that this bail-in normally at least in practice,

it has been applied only to the people who are in our terminology not

the ones who need umbrellas, but the ones who own palaces and tents.

So these people, that was their choice to hold large

deposits to realize that they were not insured, and

that's why these people really got significantly damage.

Now so we can see that quite the bit has been done, but

all these measures, they did not result in the complete recovery.

Well some success as always has been achieved here,

but unfortunately there are quite a few open questions, I'll put them in red.

And these open questions are,

first of all, accumulated debt.

Because as a result of all these QE operations and

a similar version in Europe, debt is accumulating.

And the question is, who, when and how will be able to redeem this debt?

Yeah, this is an open question.

The amount of depth is surprisingly and

really, it's frightening.

And as a result, we can see that this is sort of an open question.

Now, and the next thing is that some people say,

well you don't have to worry about that.

The market recovers, there is growth, and when there's enough growth,

you have significant resources to be able to retire this debt.

But growth,

Is still, I wouldn't say low, I would say unsustainable.

And, Every now and

then we see some reports about the recovery in the US economy, for example.

And we've seen that the unemployment rate has gone down significantly.

But still, most of these achievements are kind of vulnerable.

And there is another thing that unfortunately is on the horizon that,

and here I'm kind of wrapping up this episode and move to another one.

This is that I would put that signs and challenges,

Of the globalization.

We've seen lately that the universal trend of

globalization that we talked about in the previous episode,

that this generation has lived with, it's now being challenged.

And that is again, a big global open question that sometimes

casts doubt on the ability to recover from this crisis completely

without some major fundamental structural changes.

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