Chapter 8: "Why do Financial Crises Occur and Why Are They So Damaging to the Economy"

What is a credit spread? Why do credit spreads rise during financial crises

- Credit spreads measure the difference between interest rates on corporate bonds and Treasury bonds of similar maturity. The rise of credit spreads during a financial crisis reflects the escalation of asymmetric information problems that make it harder to judge the riskiness of corporate borrowers and weaken the ability of financial markets to channel funds to borrowers with productive investment opportunities

2007-2009 Crisis - global effects

- Europe was the first to raise the alarm of the crisis - the end of credit led to several bank failures - Europe experienced a more sever downturn than the U.S.

Debt Deflation refers to

- a decline in net worth as price levels fall while debt burden remains unchanged

Asset-price boom and bust (stage one)

- a pricing bubble starts, where asset values exceed their fundamental values. - when the bubble bursts and prices fall, corporate net worth falls as well. Moral hazard increases as firms have little to lose - FI's also see a fall in their assets, leading again to deleveraging

What is a credit default swap?

- a type of insurance against bond defaults

2007-2009 Crisis - FI's balance sheets

- as mortgage defaults rose, banks and other FIs saw the value of their assets fall. This was further complicated by the complexity of mortgages, CDOs, defaults swaps, and other difficult-to-value assets - banks began the deleveraging process, selling assets and restricting credit, further depressing the struggling economy

Asymmetric Information

- asymmetric information creates barriers between savers and firms with productive investment opportunities - a financial crisis occurs when information flows in financial markets experience a particularly large disruption.

Stage Two of a financial crisis in an ADVANCED economy usually involves a ____________ crisis

- banking

Why is the originate-to-distribute business model subject to the principal-agent problem?

- because the agent for the investor, the mortgage originator, has little incentive to make sure that the mortgage is a good credit risk

What does the "twin crises" in an EMERGING market financial crisis refer to...

- both the CURRENCY crisis and the FINANCIAL crisis

Financial Crises is NONE of these...

- cause failures of financial intermediaries and leave only securities markets to channel funds from savers and borrowers - are a recent phenomenon that occur only in developing countries - invariably (always) lead to debt inflation

Financial Crises can begin in several ways (stage one)

- credit boom and bust - asset-price boom and bust - increase in uncertainty

Stage Two of a financial crisis in an EMERGING market economy usually involves a ___________ crisis

- currency

The process of deleveraging refers to

- cutbacks in lending by financial institutions

Stage Two: Banking Crisis

- deteriorating balance sheets lead FI's into insolvency. If severe enough, these factors can lead to a bank panic

Stage One: Initiation of Financial Crises - sequence of events

- deterioration of FI's balance sheets - asset-price decline - increase in uncertainty LEAD TO - adverse selection and moral hazard problems worsen and lending contracts

Argentina's 2001-2002 financial crisis was precipitated by....

- difficulty financing a large budget deficit

Why would haircuts on collateral increase sharply during a financial crisis? How would this lead to fir sales on assets

- during a financial crisis, asset prices fall. This leads to the expectation that asset prices may fall further in the future, and increases the uncertainty over the value of assets put up as collateral - firms accepting collateral assets require larger and larger haircuts (discounts on value of collateral in expectation of future lower values) - this requires firms to put up more collateral for the same loans over time - due to the falling asset prices and rising haircuts, it becomes a "buyers market" for these rapidly falling assets - any firm needing to raise funds quickly would then be forced to sell assets at a fraction of their original worth

Mismanagement of Financial liberalization or innovation (stage one)

- elimination of restrictions - introduction of new types of loans or other financial products (such as subprime mortgages/CDOs) * either can lead to a credit boom, where risk management is lacking

What is a credit boom?

- essentially, a lending spree on the part of banks and other financial institutions

Dynamics of Financial Crises in Advanced Economies

- financial crises hit countries like the U.S. every so often, and each event helps economists gain insight into present-day turmoil - these crises usually proceed in 2 or 3 stages: initiation, banking crisis, and debt deflation

Which of the following led to the U.S. financial crisis of 2007-2009?

- financial innovation in mortgage markets - agency problems in mortgage markets (conflict of interest with credit rating agencies but NOT moral hazard)

Institutional features of debt markets in Asia that propelled several countries into financial crises include....

- firms with debt denominated in U.S. dollars

Deleveraging (stage one)

- government safety nets weaken incentives for risk management. Depositors ignore bank risk-taking - eventually, loan losses accrue, and asset values fall, leading to a reduction in capital (liabilities become greater) - financial institutions cut back in lending (so firms can no longer expand/get loans to grow), which is a process called deleveraging. Banking funding falls as well - As FI's cut back on lending, no one is left to evaluate firms. The financial system loses its primary institution to address asymmetric information - economic spending contracts as loans become scarace

When we refer to the shadow banking system, what are we talking about?

- hedge funds, investment banks, and other nonbank financial firms that supply liquidity

Stage Three: Debt Deflation

- if the crisis also leads to a sharp decline in prices, debt deflation can occur - Debt deflation - where asset prices fall, but debt levels do not adjust, increasing debt burdens - this leads to an increase in adverse selection and moral hazard, which is followed by decreased lending - economic activity remains depressed for a long time

The Great Depression

- in 1928 and 1929, stock prices doubled in the U.S. The Fed tried to curb with tight monetary policy, but this lead to a collapse in October of 1929 - turned far worse when droughts in 19390 led to sharp decline in agricultural products - between 1930-1933, 1/3 of U.S. banks went out of business - for more than 2 years, the Fed sat idly by through one bank panic after another - credit spreads increased dramatically - deflation led to decline in price levels - high unemployment rate

Factors that lead to worsening conditions in financial markets include...

- increases in interest rates (also indicates a decline in price level) - increasing uncertainty in financial markets - declining stock prices (ALL of these!)

2007-2009 Crisis - U.S. residential housing

- initially, the housing boom was lauded by economics and politicians. The housing boom helped stimulate growth in the subprime market as well - however, underwriting standard fell. People were clearly buying houses they could not afford, except for the ability to sell the house for a higher price - lending standards allowed for near 100% financing, so owners had little to lose by defaulting when the housing bubble burst

The Global Financial Crisis of 2007-2009 - Financial innovation in mortgage markets

- less-than-credit worthy borrowers found the ability to purchase homes through subprime lending (new practice) - financial engineering developed new financial products (CDOs - derivatives backed by subprime mortgages/housing market) to further enhance and distribute risk from mortgage lending

Financial Crises

- major disruptions in financial markets characterized by sharp declines in asset prices and firm failures. Beginning in August 2007, the U.S. entered into a crisis that was described as a "once-in-a-century credit tsunami"

The Global Financial Crisis of 2007-2009 - agency problems in mortgage markets

- mortgage originators did not hold the actual mortgage, but sold the note in the secondary market - mortgage originators earned fees from the volume of the loans produced, not the quality - in the extreme, unqualified borrowers bought houses they could not afford through either creative mortgage products or outright fraud

Bank Panic (stage two)

- panics occur when depositors are unsure which banks are insolvent, causing all depositors to withdraw all funds immediately - as cash balances fall, FIs must sell assets quickly, further deteriorating their balance sheet - adverse selection and moral hazard become sever - it takes years for a full recovery

Increase in Uncertainty (stage one)

- periods of high uncertainty can lead to crises, such as stock market crashes or the failure of a major financial institution. - with information hard to come by, asymmetric problems increase, reducing lending and economic activity

The Global Financial Crisis 07-09 - rating agencies

- rating agencies consulted with firms on structuring products to achieve the highest rating, creating a clear conflict - further, the rating system was hardly designed to address the complex nature of the structured debt designs (layered with subprime loans - very risky, along with less risky securities) - the result was meaningless ratings that investors had relied on to assess the quality of their investments

In an EMERGING market economy, there are typically two paths to a financial crisis: financial liberalization/globalization and....

- severe fiscal imbalances

2007-2009 Crisis - collapse of high-profile firms

- the collapse of several high-profile U.S. investment firms only further deteriorated confidence in the U.S. - Bear Sterns, Freddie and Fannie, Lehman Brothers, Merrill Lynch, AIG

The impact of the 2007-2009 financial crisis was widespread, including

- the first major bank failure in the UK in over 100 years - the failure of Bear Stearns, the fifth-largest U.S. investment bank - the bailout of Fannie Mae and Freddie-Mac by the U.S. Treasury (ALL of these!)

The shadow banking system (2007-2009 crisis)

- the hedge funds, investment banks, and other liquidity providers in our financial system - when the short-term debt markets seized, so did the availability of credit to this system. This lead to further "fire" sales of assets to meet higher credit standards

What is the shadow banking system, and why was it an important part of the 2007-2009 financial crisis?

- the shadow banking system is composed of hedge funds, investment banks, and other non-depository financial firms that are not subject to the tight regulatory frameworks of traditional banks - due to the light regulation, they had lower capital requirements and were able to take on significantly more risk than other financial firms - they are important because a large amount of funds flowed through the shadow banking system to support low interest rates, which fueled some of the housing bubble - because of their large presence in financial markets, when credit markets began tightening, funding from the shadow banking system decreased significantly, which further reduced access to needed credit

Agency Theory

- the study of moral hazard and adverse selection problems

In addition to having a direct effect on increasing adverse selection problems; increases in interest rates also promote financial crises by _______________ firms' and households' interest payments, thereby ________________ their cash flow

1. increasing 2. decreasing

How can a decline in real estate prices cause deleveraging and a decline in lending

A decline in real estate prices lowers the net worth of households or firms that are holding real estate assets. Makes borrowers less credit-worthy and causes a contraction in lending and spending

How does a general increase in uncertainty as a result of a failure of a major financial institution lead to an increase in adverse selection and moral hazard problems?

A failure of a major financial institution which leads to a dramatic increase in uncertainty, makes it hard for lenders to screen good from bad credit risks. Thus, lenders are less willing to lend

How does an unanticipated decline in the price level cause a drop in lending

An unanticipated decline in the price level leads to firms' real burden of indebtedness increasing while there is no increase in the real value of their assets.

How does the concept of asymmetric information help to define a financial crisis?

Asymmetric information problems are always present in financial transactions. During a financial crisis, however, the problems intensify to such a degree that the resulting financial frictions lead to flows of funds being halted or severely disrupted, with harmful consequences for economic activity

What causes bank panics?

Bank panics occur because of asymmetric information which results in depositors being unable to tell whether their bank is a good bank - if they worry that some banks might be insolvent, they will want to be first in line to get their money out of the bank - the run on banks can force banks to sell assets quickly to raise funds (fire sales), and the resulting fall in prices may cause other banks to become insolvent - the resulting contagion can lead to multiple bank failures and a full scale panic

How does a deterioration in balance sheets of financial institutions cause a decline in economic activity?

If FI's suffer a deterioration in their B/S, they have a substantial contraction in their capital. They will have fewer resources to lend which will lead to a decline in investment spending.

Why are more resources not devoted to adequate, prudential supervision of the financial system to limit excessive risk taking?

Regulation and supervision end up being weak because powerful domestic business interests want it that way so they can take more risk, allowing them to earn higher returns, but pass of the losses to the taxpayers if the loans go sour

How did a decline in housing prices help trigger the subprime financial crisis starting in 2007?

The decline in housing prices led to many subprime borrowers finding that their mortgages were "underwater" - when this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender - defaults on mortgages shot up sharply, causing losses to FIs which then deleveraged, causing a collapse in lending

How did the global financial crisis promote a sovereign debt crisis in Europe?

The global financial crisis lead to a sharp contraction in the economies of Europe that led to a decline in tax revenue and government efforts to boost their economies by increasing spending and lowering taxes - In addition, many governments had to absorb losses of banks - the result was that budget deficits surge raising doubts about the ability of European governments to pay back their sovereign debt, causing a collapse in sovereign debt prices and a surge in their interest rates

What technological innovations led to the development of the subprime mortgage market?

The use of data mining to give households numerical credit scores which can be used to predict defaults, and the use of computer technology to bundle together many small mortgage loans cheaply and package them into securities - together, both enable the origination of subprime mortgages which then can be sold off as securities

What role do weak financial regulation and supervision play in causing financial crises?

Weak regulation and supervision mean that financial institutions will take on excessive risk because market discipline is weakened by the existence of a government safety net

How can a bursting of an asset-price bubble in the stock market help trigger a financial crisis?

When an asset-price bubble bursts and asset prices realign with fundamental economic values, the resulting decline in net worth means that businesses have less skin in the game and so have incentives to take on risk at the lender's expense. Also, lower net worth means there is less collateral and so adverse selection increases - the bursting of an asset-price bubble makes borrowers less credit-worthy and causes a contraction in lending and spending. It can lead to a deterioration in FI's balance sheets, causing them to deleverage

Why do bank panics worsen asymmetric information problems in credit markets?

With fewer banks operating, information about the creditworthiness of borrowers will shrink, so that there will be more severe moral hazard and adverse selection problems

How can financial liberalizations lead to financial crises?

With restrictions lifted or new financial products, financial institutions often go on a lending spree and expand their lending at a rapid pace. - unfortunately, the managers of these financial institutions may not have the expertise to manage risk appropriately, leading to risky lending - regulation and government supervision may not keep up with the new activities - when loans eventually go sour, this causes a deterioration in financial institution balance sheets, a decrease in lending, and therefore a decrease in economic activity