What were they thinking? The Federal Reserve in the run-up to the 2008 financial crisis
Stephen Golub, Ayse Kaya, Michael Reay 08 September 2014
Since the Global Crisis, critics have questioned why regulatory agencies failed to prevent it. This column argues that the US Federal Reserve was aware of potential problems brewing in the financial system, but was largely unconcerned by them. Both Greenspan and Bernanke subscribed to the view that identifying bubbles is very difficult, pre-emptive bursting may be harmful, and that central banks could limit the damage ex post. The scripted nature of FOMC meetings, the focus on the Greenbook, and a ‘silo’ mentality reduced the impact of dissenting views.
Financial crises are caused by imprudent borrowing and lending, but as former Federal Reserve chairman William McChesney Martin noted, it is ultimately up to regulators to ‘take away the punch bowl’ when the larger economy is at risk. Indeed, many have criticised regulators for failing to anticipate and prevent the 2008 crash (Buiter 2012, Gorton 2012, Johnson and Kwak 2010, Roubini and Mihm 2010). Little work has been done, however, on why regulatory agencies failed to act despite warnings from prominent commentators (Borio and White 2004, Buffett 2003, Rajan 2005).
Financial markets Global crisis Monetary policy
financial crisis, Federal Reserve, FOMC, global crisis, collateralised debt obligations, Credit Default Swaps, LTCM, CDOs, CDSs, central banking
Structural reform lowers country risk
Christopher Findlay, Silvia Sorescu, Camilo Umana Dajud 29 August 2014
Countries facing rising risk premiums on their debt have recognised the need for structural reform, but some politicians have argued that austerity is necessary in the short run because structural reform takes too long. This column argues that financial markets can bring forward the benefits of structural reform, and therefore that such reforms should be given greater weight in the package of crisis responses.
In late 2008, financial stress became widespread and perceptions of risk hit new highs. Concerns related to contagion among countries also had an increasing effect on premiums and increased the financing cost for many economies. The response to this problem was austerity – to stress the importance of getting the fiscal situation, and thereby the levels of debt of those countries with this problem, under control.
structural reforms, risk premiums, Credit Default Swaps, sovereign debt
Watch the indices! Derivatives and the Eurozone sovereign debt crisis
Anne-Laure Delatte, Julien Fouquau, Richard Portes 17 April 2014
In retrospect, it is striking that the sovereign bond spreads of peripheral Eurozone countries surged while the economic conditions were gradually deteriorating. This column provides a new explanation for this phenomenon. It suggests that the markets in credit default swap indices have exacerbated shocks to economic fundamentals. The same change in fundamentals had a higher impact on the spread during the crisis period than it had previously.
The job of government bond analysts has been tough since the Eurozone crisis started. They’ve had to tell their clients a story behind every single bond spread hike since the fall of 2009. The list includes concerns over peripheral sovereigns’ public finances, deterioration of the fundamentals, financial sector credit risk, and European institutional coordination failures.
Financial markets Global crisis
Credit Default Swaps, Eurozone crisis
The transmission of Federal Reserve tapering news to emerging financial markets
Joshua Aizenman, Mahir Binici, Michael M Hutchison 04 April 2014
In 2013, policymakers began discussing when and how to ‘taper’ the Federal Reserve’s quantitative easing policy. This column presents evidence on the effect of Fed officials’ public statements on emerging-market financial conditions. Statements by Chairman Bernanke had a large effect on asset prices, whereas the market largely ignored statements by Fed Presidents. Emerging markets with stronger fundamentals experienced larger stock-market declines, larger increases in credit default swap spreads, and larger currency depreciations than countries with weaker fundamentals.
The quantitative easing (QE) policies of the US Federal Reserve in the years following the crisis of 2008–2009 included monthly securities purchases of long-term Treasury bonds and mortgage-backed securities totalling $85 billion in 2013. The cumulative outcome of these policies has been an unprecedented increase of the monetary base, mitigating the deflationary pressure of the crisis.
Exchange rates International finance Monetary policy
exchange rates, Federal Reserve, asset prices, emerging markets, stock markets, Credit Default Swaps, tapering
A first look at the structure and dynamics of the UK credit default swap (CDS) market
Evangelos Benos, Anne Wetherilt, Filip Zikes 02 December 2013
Like all other over-the-counter derivatives markets, the UK credit default swap (CDS) market has traditionally been opaque, and important questions have been largely unanswered: How do UK CDS market participants trade? Who are the main players? And how did they behave during the financial crisis? Based on newly available transactions data, this column gives some first answers to these questions.
The financial crisis of 2007–08 gave rise to widespread concerns that over-the-counter derivatives contributed to the build-up of systemic risk. As such, regulators have been quick to request and gain access to more information about activity in these markets. This information is crucial for the supervision of financial institutions and for designing more effective prudential policies (see for example Brunnermeier et al. 2013 and Peltonen et al. 2013). Equally importantly, it is invaluable for understanding the structure and dynamics of these hitherto opaque markets.
Credit Default Swaps, derivatives markets, over-the-counter derivatives
The European ban on naked sovereign credit default swaps: A fake good idea
Anne-Laure Delatte 23 July 2012
Uncovered sovereign credit default swaps will be permanently prohibited in the EU by November 2012. While empirical evidence on their destabilising role is mounting, this column argues that the EU regulation will have only a limited effect, as a number of inconsistencies create regulatory arbitrage and opportunities to circumvent the ban.
The European debt crisis has raised concerns regarding the use of credit default swaps (CDSs). CDSs are a derivative financial product used to hedge against the default risk of any entity. From the outset, it has been suspected that the crisis has been exacerbated by a few investors driving up the prices in the CDS market. This issue has attracted much interest in policy circles and has led to the adoption of new European regulation, including the ban of naked sovereign CDSs.
EU institutions Financial markets
Credit Default Swaps, EU regulation, over-the-counter derivatives
Credit default swaps: Useful, misleading, dangerous?
Richard Portes 30 April 2012
Once upon a time, credit default swaps were a form of insurance held by investors who also owned the underlying asset. But this column argues that the market has now become overwhelmed by ‘naked CDSs’ that allow speculators to make bets on the future of corporates and sovereigns – bets that can be wildly destabilising. This column calls for a ban on naked CDSs.
Credit default swaps (CDSs) are derivatives, financial instruments sold over the counter. They transfer the credit risk associated with corporate or sovereign bonds to a third party, without shifting any other risks. European politicians have blamed the CDS market for destabilising Greece, and as a result, there is a new EU Regulation that restricts the use of ‘naked’ CDSs on sovereign (but not corporate) debt.1 These contracts offer payment on default of a financial instrument even if the buyer of the contract does not hold the underlying bonds.
Global governance International finance
financial regulation, Credit Default Swaps
Economic consequences of speculative side bets: The case of naked CDS
Yeon-Koo Che, Rajiv Sethi 04 September 2010
The role of naked credit default swaps in the global crisis is an ongoing source of controversy. This column seeks to add some formal analysis to the debate. Its model finds that speculative side bets can have significant effects on economic fundamentals, including the terms of financing, the likelihood of default, and the scale and composition of investment expenditures.
There is arguably no class of financial transactions that has attracted more impassioned commentary over the past couple of years than naked credit default swaps. Robert Waldmann has equated such contracts with financial arson, Wolfgang Münchau with bank robberies, and Yves Smith with casino gambling. George Soros argues that they facilitate bear raids, as does Richard Portes (2010) who wants them banned altogether, and Willem Buiter considers them to be a prime example of harmful finance.
Financial markets Global crisis
financial regulation, Credit Default Swaps, global crisis
Stormy Weather in the Credit Default Swap Market
Mathieu Gex , Virginie Coudert 13 October 2008
Credit default swaps (CDSs) – bilateral insurance contracts against bond default – are now in the eye of the storm. Worries about counterparty risk are mounting among market players and is multiplied by the lack of global netting. This column discusses lessons from the 2005 crisis in CDSs.
Are credit derivatives markets particularly prone to speculation and contagion? The answer is certainly yes if we take a look at the credit default swaps (CDSs), which are the most widely traded credit derivatives.
financial meltdown, Credit Default Swaps