Pricing and yields of European sovereign debt, post the 2007-2008 global financial crisis

Abstract

This dissertation aims to illustrate whether the Global Economic Crisis of 2007-2008 has influenced the pricing, and therefore yields, of the European sovereign debt market and to what extent has this scenario prevailed to date. This research will investigate this impact by analyzing data sets of selected European countries mostly affected and discuss how the capital markets are still adjusting post the Global Contraction. The financial crisis of 2007-2008, also known as the subprime crisis or the credit crunch, affected the capital markets on a global scale. Subprime mortgage lending refers to the principal cause of the crisis whereby loans were being given to subprime borrowers, that is borrowers of low credit worthiness. Here, it was typical that the balance of the loan would increase over time, unlike a normal loan, as successive revaluations by unscrupulous lenders, gave collateral overvalue on the same real estate, on the premise that these loans would eventually be securitized and end up in portfolios of third parties. In the beginning of 2003-2004, interest rates were relatively low, house properties were increasing and everything seemed to be right. Such low-quality loans were being securitized and traded between banks and the international markets as asset-backed securities of high quality and holders failed to see that the collateral values given were fundamentally flawed because, as interest rates increased, some borrowers started to default on their loans. These borrowers were the low credit worthy borrowers who, with a slight change in the financial economy, would default on their loans. Banks started to take on the property of these borrowers and sold these properties which led to a decrease in property prices, which further led to more defaults. This was the start of the Global Economic Crisis. Many countries are still feeling the effects of this crisis till today. Such countries include Italy, Greece, Portugal and Spain. The study will be focusing on sovereign debt, that is government bonds, and the European sovereign debt markets. I will be exploring this topic through the effects of interest rates on the prices and yields of sovereign debt. I will examine the role of the European Central Bank in providing liquidity in times of crises, that is the Long-Term Refinancing Operation program (‘LTRO’). The study also explores the role Hedge Funds have played during this period of uncertainty and volatility.