Principles of Finance

1ST SEMESTER AY 2013-2014

UNIVERSITY OF SANTO TOMAS
FACULTY OF ARTS AND LETTERS

Financial Crisis
US FINANCIAL CRISIS OF 2006-2008
GREECE DEBT CRISIS OF 2009
ASIAN ECONOMIC CRISIS OF 1997

Financial Crisis

US FINANCIAL CRISIS
OF 2006-2008

US FINANCIAL CRISIS OF 2006-2008

Considered as the worst financial crisis since the Great
Depression in the 1930s.

Major effects:
depreciation of US home prices
weaker liquidity position of financial institutions
stricter policies in lending money
devaluation of stocks invested in the housing
sector
weaker capacity of a household to own and retain
a house

Great Depression: this is when the Stock Market Crash happened (aka Black Thursday).
Stock prices went down significantly. The effects of it lasted for over 10 years and it
reached a worldwide effect.
Depreciation means a decrease in an asset's value caused by unfavorable market
conditions. It was first believed that fixed assets such as land or houses will continue to
appreciate in value since demand for it will always go up.

Weaker liquidity position of financial

institutions. Cash is not readily available
on Financial institutions. It affects the
ability of these institutions to lend. And
it also says a lot about the status of the
households in the bank.

FINANCIALPEDIA
1) Mortgages
Obtaining debt secured by a collateral
Borrower is obliged to pay back with a pre determined set of
payments
If the borrower is unable to pay its obligations, the lender has
the right to seize the collateral
2) Residential Mortgages
home buyers pledges their house as a collateral
The lender has a claim on the house should the home buyer
defaults on paying the mortgage.
In case of foreclosure, the bank may evict the home's tenants
and sell the house, using the income from the sale to clear the
mortgage debt.

Mortgages are used by individuals and businesses to make large purchases of real
estate without paying the entire value of the purchase up front.
In the case that we will study, the collateral is the actual house that is bought. The
actual house that is being paid through installment. Therefore, if the buyer of house
defaults , the house will be repossessed by the one who issued or owns the
mortgage. After which, the house will be put into public auction.
Default: The failure to promptly pay interest or principal when due. Default occurs
when a debtor is unable to meet the legal obligation of debt repayment.
Prime Mortgages: most credit-worthy and the prime rate is the rate that a lender will
lend to its high quality borrowers.
The highest ratings assigned by Phil Ratings for short-term and long-term issues are
PRS 1 and PRS Aaa, respectively, while the lowest are PRS 6 and PRS C
Sub prime mortgages: Lending institutions often charge interest on subprime
mortgages at a rate that is higher than a conventional mortgage in order to
compensate themselves for carrying more risk.

FINANCIALPEDIA
3) Prime Mortgages
Consists of borrowing of high quality borrowers.
4) Sub prime Mortgages

type of mortgage that is normally made out to borrowers with lower

credit ratings
conventional mortgage is not offered because the lender views the
borrower as having a larger-than-average risk of defaulting on the loan.

5) Investment grade
A rating that indicates that a security has a low risk level
6) Collateralized Debt Obligations (or CDOs)
investment-grade security backed by a pool of bonds, loans and other
assets.

FINANCIALPEDIA
7) Credit default swaps (or CDS)
insurance to the receivables that you own
premium payment (usually every month) to the issuer of
the CDS is required
the issuer of the CDS will guarantee payment for the
receivable in case of default
This is also called credit protection
8) Frozen Credit Markets or Credit Freeze
A period of time when banks (or other lenders) either do
not have excess money to loan or have implemented
stricter rules regarding loan qualification so that less
lending is approved.

FINANCIALPEDIA
9) Federal Reserve Banks
the bank of the U.S. government and, as such, it
regulates the nation's financial institutions.

10) Foreclosure

A situation in which a homeowner is unable to

make principal and/or interest payments on his or
her mortgage, so the lender, be it a bank or building
society, can seize and sell the property as stipulated
in the terms of the mortgage contract.
9) Controlling Money Supply and Interest
Rates as well. They also provide loan
packages to financial institutions.

FLOW OF MORTGAGE: US FINANCIAL CRISIS OF 20062008

Household plans
to buy a house
through
mortgage

Investors
bought the
CDOs because
of its high
returns and its
level of security

A Mortgage
broker helps
them in getting
in touch with
Mortgage
Lender
Investment
bankers pooled
these
mortgages and
came up with a
security for it
called CDOs.
Secured with a
Credit Default
Swap (CDS)

The Mortgage
Lender allows
the household
to mortgage a
house

Investment
bankers offered
to purchase
these
mortgages from
the Mortgage
Lenders
PURCHASED
WITH DEBT

1) Household buys through mortgage because they do not want to pay in full right away maybe
because they do not have enough funds.
2) Through the mortgage issues by the Mortgage Lender, the households are able to purchase the
house. The collateral will be the actual house that the households plan to purchase. If they default,
the ownership right of the house will be transferred to the mortgage lender.
3) The investment banker gets into the act. They offered to purchase these mortgages from the
mortgage lenders. Usually, the fee is lower than the actual value of mortgages. In order to buy more
mortgages, the investment banks borrow money. The monthly payments for these mortgages are
now directed to the investment bankers.
4) Now the investment bankers classified these mortgages according to its capacity to be paid. They
call this CDOs. The safe CDOs are the first recipients of the monthly payments of the homeowners.
And it will trickle down into the OK and risky investments. Higher rate of return given to the riskier
CDOs. To make the safe CDOs more attractive, the investment bankers insured this CDOs thru
credit default swap. This is basically insurance to the receivables that you own.

US FINANCIAL CRISIS OF 2006-2008

(Key points)
Investors are looking for a new security to invest to.
Government Bonds (issued by the Fed) became
unattractive because of low returns.
Since the banks can secure cheap loan from the Fed,
they are able to offer low interest loans as well.
The result: abundance of cheap credit in the market
A major usage of credit by households is in the
purchasing of a house.
Residential mortgages increased dramatically during
this period.
If the mortgage borrowers default, the house will be
seized by the mortgage lenders.

1) Traditionally they go after the bonds issued by the Federal Reserve. The reason for this is
this is the safest form of investment.
Because of the DOTCOM bust and the 9/11 attacks, the FED lowers interest rates to 1%. Thus,
making T-bills issued by the FED a low earning and unattractive financial instrument. Their
earning out of their investments in the Fed will be base from the earning that the Fed will
generate from the 1% borrowing rate that it will impose to the banks. This was made by Alan
Greenspan. But this became very attractive to the banks.
2) And then other developed countries flooded the US Economy with more money that can be
borrowed. There is then an abundance of cheap credit. This makes borrowing for money easy
for banks.
3) Because normally, it is difficult for them to pay a house a purchase in full right away.
It was a no lose situation for them because they feel that even if they will no get paid, they will
have an asset which is projected to appreciate in value.
4) The mortgages were transformed into securities making the risk difficult to see. In
order to buy these mortgages, these investment bankers also borrows. Once they
receive their mortgage payment, they are able to use this as well as payment for these
loans.
5) Secured and high returns security. Some CDOs were rated as AAA by reputable
credit rating agencies like Standard and Poors (S&P) and Moodys.
6) The securities were sold to investors around the world (US spread the risk)

US FINANCIAL CRISIS OF 2006-2008

(Key points)
Investment bankers offered to buy these mortgages.
The monthly payments for the mortgage are now
directed to the investment bankers
Investment bankers created a security out of these
mortgages and called it CDOs.
CDS was given to the CDOs to make it more
secured and attractive.

Investors bought into it.

Investors asked for more CDOs.

It became difficult already to find households who

will avail of mortgage.

US FINANCIAL CRISIS OF 2006-2008

(Key points)
Mortgage Lenders lend to sub prime borrowers.
no downpayment and no proof of income.
Lender issues sub prime mortgages. Sells the mortgage
to investment banks which turned into CDOs. These
banks then sell it to the investors.
The subprime borrowers defaulted.
fewer funds to be allocated to the CDOs.
banks acquire more houses
1) 40% Subprime mortgages with reduced
documentation; 55% Share of subprime
mortgages that were cashout refinances

US FINANCIAL CRISIS OF 2006-2008

(Key points)
House prices plummeted
more supply than demand
good mortgage payers decide to forsake their
mortgage payments as well.
default payments swept the US
Drop in mortgage payments
fewer funds to be allocated to the CDOs.
banks acquire more houses which are now
depreciated and difficult to sell
Issuers of CDS were also unable to finance the
insurance meant for the defaulted debts.
1) Because they are still paying high amount of mortgages for their house
whereas it is now valued less than what they are paying for now.

US FINANCIAL CRISIS OF 2006-2008

(Key points)
CDOs became unattractive to investors
Investment banks became illiquid
unable to pay off their loans

Mortgage lender is unable to sell mortgages to

Investment banks.
Credit markets became frozen.
Firms reliant on debt are unable to finance its
operations.
either lay off or closed down
Financial institutions declared bankruptcy
1) They have already incurred losses thru their investments of CDOs.

US FINANCIAL CRISIS OF 2006-2008

(US Government Solution)
$700 billion bailout
Emergency Economic Stabilization Act of 2008
established the Troubled Assets Relief Program
(TARP) which was created so that the US Treasury can
purchase "troubled assets" from institutional investors.
Taking over the two largest players in the mortgage
market
Fannie Mae and Freddie Mac
Bailing out of one of the largest insurance company in
the world
AIG
1) Particularly Mortgaged-backed securities
2) Total Disbursed: Fannie Mae:$116B and Freddie Mac: $71B
3) One financial institution was not bailed out. The US Government let the
company go bankrupt: The Lehman Brothers (4th largest investment bank)

US FINANCIAL CRISIS OF 2006-2008

(LEARNINGS)
1) High levels of debt, uncertain ability of borrowers to
repay debt, and an expectation that housing prices will
always increase (among other factors) created a
comfort level that was misguided.
2) Spreading risk outside of the insured banking system
and use of insurance policies such as credit default
swaps did not result in risk diversification.

Financial Crisis

GREECE DEBT CRISIS

OF 2009
----- Meeting Notes (8/22/14 12:41) ----What industry/sector anchored the US Crisis of 2007?
What kind of payment was defaulted that became the root cause of the problem?
Who did they offered this mortgages to?
What is that security that investment banks created that includes mortgages in it?
Why is CDS touted to be a safe and secure investment?
What happened in the prices of houses? Why?
What happened in the lending activities of the US?
What did the US do to aid the problem?

FINANCIALPEDIA
1) Sovereign default
failure or refusal of the government to pay back its debt in full.
2) Budget Deficit
A status of financial health in which expenditures exceed revenue
3) Debt to GDP Ratio
the ratio between a country's government debt and its gross domestic product (GDP).
A low debt-to-GDP ratio indicates an economy that produces and sells goods and services sufficient
to pay back debts.

4) European Union (EU)

politico-economic union of 28 member states that are primarily located in Europe.
independent institutions and intergovernmental negotiated decisions by the member states

The EU has developed a single market through a standardised system of laws that apply in all member
states. EU policies aim to ensure the free movement of people, goods, services, and capital, enact
legislation in justice and home affairs, and maintain common policies on trade, agriculture, fisheries, and
regional development.

The monetary union was established in 1999 and came into full force in 2002. It is currently composed of
18 member states that use the euro as their legal tender.

FINANCIALPEDIA
5) Credit rating
the assessment of an entities ability to repay its debts
6) Junk bond
rated below investment grade
higher risk of default
typically pay higher yields than better quality bonds in order to make them
attractive to investors
7) Bailout
A situation in which an entity offers money to a failing entity in order to
prevent the consequences that arise from an economic downfall
Can be in the form of loans, bonds, stocks or cash
5) Big three credit rating agencies include Standard and Poors (S&Ps), Moodys
and Fitch Group

GREECE DEBT CRISIS OF 2009

(Overview)

In late 2009, fears of sovereign default surfaced concerning Greece's ability to meet its debt
obligations

Greeces debt crisis indicators

National Debt: $413B
Budget Deficit: $32B
13% higher than the countrys revenue
High Debt to GDP ratio

The European Union (EU) has been implementing measures to aid Greece in this crisis
Reasons:
The crisis will reflect badly to the credibility and valuation of the Euro
The crisis will also have a drastic effect on the economies of low end EU countries
such as Portugal and Ireland

1) In late 2009, fears of sovereign default developed among investors concerning Greece's ability to
meet its debt obligations. This led to a crisis of confidence
2) Even if Greece has breached numerous economic standards set by the EU, the EU still
recognizes the importance of helping the country to protect the Euro and other less stable EU
member countries that could also experience the ripple effect of the crisis.
3) The funds that will be used as aid will be sourced primarily from Europe and the IMF

GREECE DEBT CRISIS

(Causes)
1)Government deficit
Huge fiscal imbalances developed during the six years 2004 to 2009
GDP increased by 40%, while Government expenditures increased by 87%
against an increase of only 31% in tax revenues
Greeces debt to GDP ratio:
2010: 138.8%
2011: 159.1%
Greeces spending to non-growth economic sectors contributed greatly to this deficit
run large deficits to finance enormous military expenditure
the second-biggest defense spender among the 27 NATO countries
Greece also suffered from enormous tax evasion cases

GREECE DEBT CRISIS

(Causes)
2) Economic Data unreliability
to keep within the guidelines of EU, Greece had for many years misreported the
country's official economic statistics
through the assistance of numerous financial institutions, financial products were
developed which enabled the governments of Greece, Italy and many other European
countries to hide their borrowing
as a result, Greece was able to borrow and spend more while hiding its actual deficit
levels
3) Eurozone crisis caused by the Global Economic Recession of 2009

GREECE DEBT CRISIS

(Effects)
1) Greeks credit rating downgraded to the lowest among EU members
Greeces Government bonds was downgraded to junk bond status
In 2010, Standard and Poors (S&Ps) slashed Greece's sovereign debt rating to BB+
2) Economic and Social unrest
GDP declined by 7.1% (2011)
111,000 Greek companies going bankrupt (2011)
25% unemployment rate (2012)
Government spending cuts
Tax increases and other social measures
Multi-sector strikes

GREECE DEBT CRISIS

(Solution)
1)First bailout loan (May 2010)
International Monetary Fund agreed to a three-year 110 billion loan retaining
relatively high interest rates of 5.5% In 2010
2) Second bailout loan (July 2011 - present)
Extend loan repayment periods from a minimum of 7 years to a maximum of 15 years
Cut interest rates to 3.5%
approved the construction of a new 109 billion support package
accept a 50% write-off of Greek debt, the equivalent of 100 billion

GREECE DEBT CRISIS

(Solution)
Bailout Conditions
1)Privatization of government assets worth 50bn by the end of 2015
2)Implement austerity measures to restore fiscal balance

1)All private creditors holding Greek government bonds should sign a deal accepting
lower interest rates and a 53.5% face value loss

GREECE DEBT CRISIS OF 2009

(LEARNINGS)
1) Borrowing is not necessarily bad. Debt can be used to
finance growth. However, if growth is outweighed by
debt, then this can lead to financial crises.
2) Governments may pass the burden of settling its debt
to its people through unpopular austerity measures
3) Securing financial aide from global agencies entails
numerous conditions that the borrower needs to comply
with

Financial Crisis
ASIAN ECONOMIC
CRISIS OF
1997

FINANCIALPEDIA
1) Exchange Rate
exchange rate is the rate at which one currency can be exchanged for another
2) Floating Exchange Rate
an exchange rate method where its currency is set by the foreign-exchange
market through supply and demand for that particular currency relative to
other currencies.
if the demand of a currency in the foreign exchange market is low, the
currency depreciates.
if the demand of a currency in the foreign exchange market is high, the
currency appreciates.
Ultimately, the value of a currency in this method is dependent whatever
buyers are willing to pay for it.

FINANCIALPEDIA
3) Fixed Exchange Rate
an exchange rate method in which the exchange rate is set and maintained by
the government
The rate will not fluctuate from day to day. Also known as Pegged Exchange
Rate.
The rate will be fixed to some other country's dollar, usually the U.S. dollar
Fixed rates provide greater certainty and a stable environment for investors
Central banks need to have enormous levels of foreign currency reserves (such
as dollar) to maintain the rate.
4) Asset bubbles
formed when the prices of asset, such as housing, stocks or
gold, become over-inflated
Prices rise quickly over a short period of time, and are not supported by
underlying demand for the product itself.

FINANCIALPEDIA
5) Speculators
An entity who trades securities with a higher-than-average risk in return for a
higher-than-average profit potential
attempt to profit from fluctuations in the market value of a security
6) Soros Fund Management
An investment management firm founded by George Soros
An active speculator in the foreign exchange market
Speculated that the Thai Baht will lose its value or even collapse
This speculation sent an uncertain market signal in the Thailands Financial
Market
7) Asian Economic Miracle
Period of time in which the region experienced high growth rates, 812% GDP,
in the late 1980s and early 1990s.

FINANCIALPEDIA
8) Hot money
the flow of funds (or capital) from one country to another in order to earn a
short-term profit on interest rate differences and/or anticipated exchange
rate shifts
can move very quickly in and out of markets, potentially leading to market
instability.
9) Crony capitalism
is a term describing an economy in which success in business depends on
close relationships between business people and government officials.

ASIAN ECONOMIC CRISIS OF 1997

(Overview)

In mid-1997, a series of currency devaluations and other events spread through

many Asian countries.

This is also known as the Asian Contagion

The crisis started in Thailand with the collapse of the Thai baht

Aside from Thailand, the countries most affected were South Korea and Indonesia

The crisis spread throughout the region as Malaysia and the Philippines were
drastically affected as well.

ASIAN ECONOMIC CRISIS OF 1997

(Causes)
I.

Asset Bubbles

Thailands real estate properties were valued exorbitantly even if it did not have
enough supporting demand

Most of Thailands spending (including those in the real estate sector) was funded
largely by heavy borrowing from banks.

Investors realized that Thailands property market was unsustainable

Enormous amount of investments were pulled out from Thailand particularly from
the real estate sector

Huge amount of debts was accounted from the real estate sector

Thailand was greatly exposed on foreign exchange risk

ASIAN ECONOMIC CRISIS OF 1997

(Causes)
II. Depleted Foreign Currency Reserves
From 1985-1996, Thailand implemented a fixed exchange rate against the US Dollar.
$1 = 25 baht
Along the way, the US Dollar appreciated in value globally. Thus, in reality, Thailand should
be paying more in baht in order to acquire $1.
However, the Government stuck to its fixed exchange rate policy.
As more US Dollars were traded in the foreign exchange market using the Baht, Thailands
Foreign Currency Reserves (particularly the US Dollars) plummeted in quantity.
Exports also dropped during this period mainly because of the sudden global
competitiveness of China.

With fewer US Dollar inflows and reserves, the Thai Government will be less able to pay
off its foreign debts.

ASIAN ECONOMIC CRISIS OF 1997

(Causes)
III. Failure to defend the Baht against speculative attacks
In early 1997, Soros Fund Management led by George Soros, speculated that the Thai
Baht will have to be devaluated soon or even collapse.
Since its foreign currency reserves plummeted, the US Dollar became a scarce
commodity. Because of this, it was speculated that the value of the US Dollar against
the Thai Baht will increase. It means that an investor would need more Baht to
purchase a dollar.

Soros Fund Management, together with other investments houses, started to send
market signals that investors should let go of their Baht right now in exchange for US
dollars since the former will be devaluated soon.
Investors followed this advise. Huge amounts of investment on the Thai Baht were
sold off which resulted to the devaluation of the currency.

ASIAN ECONOMIC CRISIS OF 1997

(Causes)
III. Failure to defend the Baht against speculative attacks
Uncertainty occurred in Thailand as more and more foreign investors are cashing out.
Investor confidence took a large hit.

On July 2, 1997, the Thai Government lost its battle against speculators.
Because of further reduction Thailands foreign currency reserves, the Government
was forced to adopt a floating exchange rate system.

By July 1998, the exchange rate dropped to $1 = 41 baht which is 40% devaluation.
With a devalued Baht, Thailands debt ballooned even more in value.

ASIAN ECONOMIC CRISIS OF 1997

(Causes)
IV. Generalization of foreign investors in other countries in the region

Investors thought that neighboring countries also possess the same financial
faults.

Foreign capital was pulled out as well in this region. In 1997, $117B was pulled out
of South East Asia.

With fewer foreign capital, the flow of US Dollars into the financial system took a
hit in these countries as well.

The currencies of neighboring countries such as Indonesia, Malaysia, Philippines

and South Korea depreciated as well.

ASIAN ECONOMIC CRISIS OF 1997

(Effects)
I. Significant devaluation of several Asian currencies

ASIAN ECONOMIC CRISIS OF 1997

(Effects)
II. Huge drop in Gross National Product (GNP)

ASIAN ECONOMIC CRISIS OF 1997

(Effects)
III. Massive unemployment and social unrest
Unemployment was on an all time high in Thailand and South Korea
Social unrest was rampant in Indonesia

IV. Downgrading of the countrys credit rating

South Koreas credit rating became A3 from A1

Securities in Malaysia and Indonesia where deemed as junk.

ASIAN ECONOMIC CRISIS OF 1997

(Solutions)
I.

Bailout packages for Thailand provided by the IMF:

$21B bail out package (August 1997)

II.

Bailout package for South Korea by the IMF

$55B bail out package (December 1997)

Conditions by IMF:

Reduce Government spending

Increasing interest rates
Eradicating corruption

ASIAN ECONOMIC CRISIS OF 1997

(Quotable Quotes)
"Popular enthusiasm about Asia's boom deserves to have some cold water thrown on
it." - Paul Krugman, The Myth of Asia's Miracle, 1994
The public blames the doctor why the patient is sick where in fact the patient is sick
already to begin with. IMF Official
Presently, we see a well planned effort to undermined the economic efforts of all
ASEAN countries by destabilizing their currencies. Before, conquering a country can be
done through military force. But now you can just destabilize a country to make it poor
and they will ask for help. And for the help that is given, you gain control to the
policies of the country. This is another form to colonize. PM Mahathir Mohamad of
Malaysia

ASIAN ECONOMIC CRISIS OF 1997

(LEARNINGS)
1) Pegging the value of a currency to another currency
requires huge amount of foreign currency reserves
which can be secured through trade and investments.
2) The risk of financial speculation from financial
companies cannot be underestimated
3) A relatively small economy (such as Thailand) can
instigate massive economic collapse.
4) Oftentimes, an economic crisis can reveal what is really
faulty in the country.