Top 10 British Banks

In recent years, the British Banking system has become highly concentrated due to the wave of mergers following the credit crunch. Top 5 British Owned banks Bank Market value (£bn) As of October 2013 Assets (£bn) As of 31 March 2017 1. HSBC 126 1,936 2. Lloyds Banking Group (Bank of Scotland/Halifax) 53.5 817 3. …

Read moreTop 10 British Banks

Pros and cons of Financialisation

Financialisation is a term used to describe the increased role of the financial sector in a modern economy. Source: NYT 2013 Financialisation also refers to particular trends in the financial sector of the economy. This includes: Increased use of financial intermediaries Increased use of futures markets. For example future contracts for bonds, shares, currencies and …

Read morePros and cons of Financialisation

Benefits of Central Bank Independence

cpi-inflation-latest

Monetary policy (mainly interest rates) used to be managed by the government. However, in recent years, there has been a trend to give monetary policy to independent Central Banks. The idea is that Central Banks will be more independent of political considerations and willing to keep inflation low – even if there are political costs …

Read moreBenefits of Central Bank Independence

Credit Default Swaps Explained

Definition of Credit Default Swap – CDS are a financial instrument for swapping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage-backed securities, corporate bonds and local government bond

  • The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument defaults.
  • The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap.

Example of Credit Default Swap

  • An investment trust owns £1 million corporate bond issued by a private housing firm.
  • If there is a risk the private housing firm may default on repayments, the investment trust may buy a CDS from a hedge fund. The CDS is worth £1 million.
  • The investment trust will pay interest on this credit default swap of say 3%. This could involve payments of £30,000 a year for the duration of the contract.
  • If the private housing firm doesn’t default. The hedge fund gains the interest from the investment bank and pays nothing out. It is simple profit.
  • If the private housing firm does default, then the hedge fund has to pay compensation to the investment bank of £1 million – the value of the credit default swap.
  • Therefore the hedge fund takes on a larger risk and could end up paying £1million

The higher the perceived risk of the bond, the higher the interest rate the hedge fund will require.

Example of Credit Default Swap

  • Example, suppose that Lloyds TSB has lent money to riskymortgage.co.uk in the form of a £1,000 bond.
  • Lloyds TSB may then purchase a credit default swap from another company e.g. a Hedge Fund.
  • If the firm (Riskymortgage.co.uk) default on the loan, then the hedge fund will pay Lloyds TSB the value of the loan.
  • Thus Lloyds TSB has insurance against loan default. The hedge fund has the opportunity to make a profit, so long as the firm does not default on the loan.
  • The riskier the loan, the higher will be the premium required on buying a credit default swap.

Why Would People Buy Credit Default Swaps?

1. Hedge against risk. Suppose an investment fund owned mortgage bonds from riskymortgage.co.uk. It might be worried about losing all its investment. Therefore, to hedge against the risk of default, they could purchase a credit default swap from Lloyds TSB. If riskymortgage.co.uk defaulted, they will lose their investment, but receive a pay-off from Lloyds to compensate. If they don’t default, they have paid a premium to Lloyds but have had security.

2. Speculation e.g. risk is underpriced.

Suppose a hedge fund felt risky mortgage was very likely to default because of a rise in home repossessions. They would buy a credit default swap. If the debt defaulted, then they would make a profit from Lloyds TSB. Note you don’t have to actually own debt to take a credit default swap.

The riskier a bond is the higher premium will be required from a buyer of a credit default swap. It is argued that credit default swaps provide an important role in indicating the riskiness/creditworthiness of a firm.

3. Arbitrage

If a company’s financial position improves, the credit rating should also improve and therefore, the CDS spread should fall to reflect improved rating. This makes CDS more attractive to sell CDS protection. If the company position deteriorated, CDS protection would be more attractive to buy. Arbitrage could occur when dealers exploit any slowness of the market to respond to signals.

Read moreCredit Default Swaps Explained

Types and causes of financial bubbles

us-house-prices

Readers Question: In finance and economics, there are such things as “bubbles” in the economy. And when bubbles start forming, it normally isn’t a good thing. My question is, how many different kinds of “bubbles” are there? Such as the property bubble or stock market bubble. And how do they form and what are their economic impacts?

Bubbles typically refer to a situation where assets or financial instruments see a rapid increase in price – an increase in price which is driven by speculative demand and are unsustainable in the long run. At a certain price, the bubble ‘bursts’ and prices come down to a level which more closely reflects the fundamental economic value. A bubble strongly implies that psychological factors such as irrational exuberance and over-confidence play a role in increasing the value of the asset.

Different Types of Bubbles

  • Market Bubble. When a particular market sees a rapid increase in price. For example, this could be a housing bubble.
  • Commodity bubble. When the price of one commodity or several commodities increases in price. For example, we might see a speculative bubble in the price of gold, e.g. in the 1970s and 1980.gold
  • Stock market bubble. When the value of stocks and shares increase rapidly, e.g. prices increase faster than earnings. A stock market bubble is vulnerable to a crash, where market traders come to feel the bubble prices are over-inflated.
  • Credit bubbles. A rapid growth in consumer and business credit to finance higher consumer spending.
  • Economic boom/bubble. Related to the concept of market bubbles is the idea of a general economic boom. A boom implies that the economy expands at an unsustainably fast rate, leading to inflation (e.g. aggregate demand grows faster than productive capacity). Ultimately an economic boom usually proves unsustainable. There may be a strong link between market bubbles and an economic boom. For example, a house price bubble may cause rising wealth and confidence leading to higher consumer spending and economic growth. In turn, the higher economic growth feeds the housing boom.

Examples of Bubbles

south-sea-bubble

  • South Sea Bubble 1711-1720  A company set up to profit from British trade with South America. The price of shares rose rapidly, but with the company failing to make any real profit, share prices collapsed in 1720 and returned to pre-issue levels.
  • Tulip mania of the 1630s. When the price of tulips rose to over 500 times their previous price before collapsing when buyers stopped entering the market.
  • 1920s credit and the housing bubble in U.S. In the 1920s, there was a rapid growth of credit in the US. This financed a boom in house building and also a boom in the stock market. This rise in credit and share prices came to an abrupt end in 1929 with prices crashing.
  • Dot Com Bubble. A rapid growth in the share value of internet shares in 1997-2000.
  • Credit bubble of 2000s, which saw a rise in asset prices and bank lending.
secured-lending-individuals-b-e
Secured lending to individuals fell dramatically in 2008.
  • Bitcoin bubble the latest bubble?
  • Bond bubble? Some argue there is a bond bubble with bond prices over-inflated by quantitative easing. Others argue it isn’t a bubble but reflection of a liquidity trap.

House price bubble

us-house-prices

Between 2000 and 2006, house prices rose 80% and house price to earning ratios rose above long-term averages. This was partly fuelled by a growth in mortgage lending to subprime customers. When interest rates rose a modest amount in 2004/05, the housing market started to turn and prices fell 2006-12.

Read moreTypes and causes of financial bubbles

Global funds manager

Readers Question: Who really is a global funds manager? A global funds manager is person who looks after different investment trusts / pension funds. He will decide where and how to invest the fund of money in different markets. Individuals with savings may wish to seek better returns than just saving in a bank with …

Read moreGlobal funds manager

Why Fed Tapering caused a rise in bond yields

Readers Question Why did bond yields in the USA rise at news of the Fed Tapering back in August?

The Federal Reserve has been engaged in a policy of quantitative easing. This involves:

  • Creating money electronically
  • Using this created money to buy assets, such as government bonds.

The aim of quantitative easing is to stimulate economic activity – increase economic growth and avoid inflationary pressure. QE aims to stimulate economic growth through increasing the money supply and reducing interest rates in the economy.

With the Federal Reserve buying bonds, other investors are also keener to buy bonds. The Fed is pushing up the price of bonds so whilst this is occurring other investors may be encouraged to also buy bonds and benefit from the rising prices.

Fed Tapering

Fed Tapering means that the Federal Reserve will begin to stop buying bonds, and no longer continue to create money and buy bonds. This tapering could also be seen as a preliminary to reversing quantitative easing and selling the bonds that have been accumulated.

A decision that the Fed would be beginning to end quantitative easing, will encourage investors to start selling bonds.

If the Fed stops buying bonds, the price is likely to stop rising; and if quantitative easing is reversed,  bond prices could fall. This expectation of falling bond prices will encourage investors to sell. Markets are always trying to anticipate future movements. Therefore, even a weak signal that bond purchases may start to be tapered was seen as a signal that now would be a good time to sell bonds and move into something else.

As bond prices fell, the yield started to rise (the inverse relationship again)

Read moreWhy Fed Tapering caused a rise in bond yields

Securitisation

Securitisation involves changing loans into tradeable bonds.

Securitisation can increase the liquidity of banks and enable banks to engage in more lending than previously.

Securitisation was a factor in the credit crunch because it enabled banks to lend more than usual. When there was a shortage of credit in the banking system, banks became over-exposed and faced a shortage of cash (liquidity)

The difference between loans and bonds.

Loans are viewed as assets on a banks balance sheet. Loans cannot generally be sold on or traded. Bonds can be traded and sold to other financial institutions.

What is involved in the process of securitisation?

Any asset with a predictable income stream can be securitised, e.g. mortgage loans have a predicted income stream from the mortgage repayments over the term of the mortgage.

A financial institution (often called Special Purpose Vehicle SPV) sells bonds to investors and uses the proceeds of these bond sales to buy the loans off the bank.

  • The bank gains cash from the sale of its loan assets.
  • Investors gain a bond and the promise of income from the bonds. (e.g. bondholders will effectively gain income from the mortgage repayments)
  • The intermediary makes money from selling bonds at a higher price than the cost of buying the loan bundles
  • Customers who took out loans from the bank won’t notice any difference. They still make their loan repayments to the bank. It is just that now, the bank doesn’t have the loans on its balance sheet. And as soon as the bank receives loan repayment, it passes it onto the SPV.

Why do banks want to pursue securitisation?

Banks have to keep a certain percentage of deposits in cash (liquid). This is to ensure the banks can repay savers who wish to withdraw their deposits at any moment from the bank. (If a bank couldn’t meet depositors demands for cash, it could cause a run on the banks and a loss of confidence.

Keeping a certain percentage of deposits in cash reduces profitability of a bank. Because a bank can’t lend this money gaining fees and a higher interest rate on the loan. Instead, they have to keep cash which earns nothing.

However, if a bank securitises its loans into bonds, the loans are no longer on its balance sheet (it could be described as off-balance sheet finance)

The bank has exchanged loans for cash. With this cash, it can now lend more, making more profitability.

The problem with securitisation

Securitisation enables banks to effectively lend a higher percentage of their deposits. This was fine when market conditions were good. However, there were two major problems.

In the US, customers began defaulting on mortgage repayments. Therefore, banks didn’t have income to pass onto SPVs and onto bondholders.

Previously secure mortgage bonds became worthless and so investors lost money. This led to a shortage of liquidity. No one wanted to lend. But, banks which had lent more than usual now faced real capital shortages. They couldn’t raise money by selling bonds to meet deposit requirements. This was a significant factor in the credit crunch.

Note: the primary cause of credit crunch was the large scale defaults on sub-prime mortgages. But, the process of securitisation meant that many banks and financial institutions lost money indirectly, and banks were much more exposed to these failed mortgage repayments.

Read moreSecuritisation

Item added to cart.
0 items - £0.00