ch9.ppt

Chapter 9Financial Crises

2013 Pearson Education, Inc. All rights reserved. 9-*

Today were going to examine Financial Crises Definition ofHow they formWhat can be done/what has been done to abate themThe Great Recession:A once-in-a-century credit tsunami Former Fed Chairman Alan Greenspan (or as I call him, AG)


Alan Greenspan


What is a Financial Crisis?A financial crisis occurs when there is a particularly large disruption to information flows in financial markets, with the result that financial frictions (ex: asymetric info) increase sharply and financial markets stop functioning Asset Markets Effects on Balance SheetsStock market declineDecreases net worth of corporations.Unanticipated decline in the price level Liabilities increase in real terms and net worth decreases.Unanticipated decline in the value of the domestic currencyIncreases debt denominated in foreign currencies and decreases net worth.Asset write-downs.


Factors Causing Financial CrisesDeterioration in Financial Institutions Balance SheetsDecline in lending.Banking CrisisLoss of information production and disintermediation.Increases in UncertaintyDecrease in lending.


Factors Causing Financial Crises (contd)Increases in Interest RatesIncreases adverse selection problem (only get those most needy to borrow, possibly more risky)Increases need for external funds and therefore adverse selection and moral hazard. Government Fiscal ImbalancesCreate fears of default on government debt.Investors might pull their money out of the country.


Dynamics of Financial Crises in Advanced EconomiesStage One: Initiation of Financial Crisis

Stage two: Banking Crisis

Stage three: Debt Deflation


Stage 1: Initiation of CrisisUsually begin when new types of loans or new debt instruments are createdCalled Financial Innovation Can also occur when countries get involved in Financial LiberalizationCauses lenders to go on lending sprees (credit booms) Lack the experience to correctly filter credit risks


Stage 1: Initiation of CrisisUsually happen in one of three ways:Financial liberalization/innovationAsset-price boomsGeneral increase in uncertainty caused by the failure of major financial institutions


Stage 1: Financial liberalization/innovation

Govt safety nets encourage moral hazardFor example due to deposit insurance, banks take on greater risks than normalBecause lenders/savers know FDIC insurance protects them from losses they are willing to supply even undisciplined banks with loansMoral Hazard (for banks):Engage in risky loans: make nice profit if risky loans works, rely on FDIC insurance if loans default.Eventually losses begin to mount


Stage 1: Financial liberalization/innovation

Losses mount, assets fall relative to liabilities on balance sheetsBanks cut back on lending to borrowers (deleveraging)Banks with low capital stocks are now perceived as risky, lender/savers pull out funds from themFewer funds mean fewer loans Credit FreezeWith fewer institutions making loans/screeing risks:Financial frictions increaseProblems due to asymmetric information increase


Stage 1: Asset Price Boom and BustPrices of assets can be driven by psychology rather than rationalityHerd behaviorIrrational exuberance (AG)People place values on assets well above their true value dictated by the assets economic fundamentalsResults in an asset-price bubbleLate 1990s tech bubbleRecent housing bubble


Stage 1: Asset Price Boom and BustWhen bubble bursts, the net worth of companies plummets Value of the collateral that they pledge fallsNow these companies, with less let worth, feel they have little to lose (less skin in the game)More likely to take on risky investments moral hazard increases In response lenders tighten policies, make less loans, slowing financial system


Stage 1: Increase in Uncertainty Whenever a large institution fails there is a large increase in uncertaintyEx: Bear Sterns, Lehman Brothers, and AIG in 2008Such uncertainty can send a scare though the financial system enduing panicThis panic slows the financial system also there is less credible info, so asymmetric information problems increase


Stage 2: Banking CrisisAs balance sheets deteriorate, institutions net worth goes negative they become insolvent If the problem gets really bad, bank panics occur multiple banks fail simultaneously Partially arises from asymmetric infoPeople, observing banks are failing, cant tell good banks from badTo protect their assets they pull assets out of banks (banks runs)Unable to meet this pressure, banks experience fire sales where the decline in their assets is so severe that they become insolvent and failThese firms are liquidated


Stage 3: Debt DeflationSometimes after the liquidation of firms, the economy can begin to recover:Asymmetric info lessensProblems abateLending resumesHowever, if the economic downturn is associated with a large decline in the price level, this can stymie recoveryDebt deflation: deflation HURTS borrowers, so an unanticipated sharp decline in the price level only works to increase indebtedness


Stage 3: Debt DeflationMost debt contracts (bonds) have fixed interest rates and last for long maturities So nominal payments are fixedIf deflation occurs the real value of those nominal payments increaseThe real net worth of the borrowing firm declinesHarms recovery, keeps economy in a slow-downIncreases in moral hazard resultThis was the major problem in the Great Depression


Stage 3: Debt Deflation


Figure 1 Sequence of Events in Financial Crises in Advanced Economies


APPLICATION The Mother of All Financial Crises: The Great DepressionHow did a financial crisis unfold during the Great Depression and how it led to the worst economic downturn in U.S. history?This event was brought on by: Stock market crashBank panicsContinuing decline in stock pricesDebt deflation


Figure 2 Stock Price Data During the Great Depression Period Source: Dow-Jones Industrial Average (DJIA). Global Financial Data; www.globalfinancialdata.com/index_tabs.php?action=detailedinfo&id=1165.


Figure 3 Credit Spreads During the Great Depression Source: Federal Reserve Bank of St. Louis FRED database; http://research.stlouisfed.org/fred2/categories/22.


Cause 1: Financial innovations emerge in the mortgage marketsNew quantitative techniques for evaluating credit risks developedFICO score (Fair Isaac Corporation score, named after developing company)Score predicted likelihood of defaulthowever, only as good as the underlying model Securitization: Lower transaction costs allowed bundling of loans (ex: mortgages) into standard debt securities

Application: The Global Financial Crisis of 2007-2009


Application: The Global Financial Crisis of 2007-2009

1) ContinuedIncreased securitization made it possible for banks to offer subprime mortgages to those with poor credit recordsBundle them into a security with good credit risks to diversity riskThus mortgage-backed securities were createdAdditionally increased financial engineering led to the creation of new debt instruments and increased liberalization


Application: The Global Financial Crisis of 2007-2009Cause 2: Agency problems in the mortgage marketNINJA Loans (no-job-no-income/assets)Banks made little effort to evaluate credit risksOnce loan was made they could bundle it as a mortgage-backed-security (MBS) and sell it off to investorsCalled originate-to-distribute modelRife with principal-agent problem: Once mortgage broker, the agent, (ex: bank) earns fee and sells MBS why should they care if investor (principal) makes good on the payment?


Credit NINJA!


Application: The Global Financial Crisis of 2007-2009Cause 2:The market became adversely selectedRisk loving investors flocked to housing market investments (MBS) because they could always walk away and still come out on topCredit default swaps developedEssentially insurance contracts, paying holders of MBS if they defaultedThis drove insurance companies like AIG to write HUNDREDS OF BILLIONS OF $$$$ worth of theseBut nobodys going to default, right??? =(


Application: The Global Financial Crisis of 2007-2009Cause 3: Asymmetric Information and Credit-Rating AgenciesRating agencies had conflicts of interest:Advising clients on how to structure the new financial instruments and at the same time were responsible for rating them Resulted in inaccurate ratings, much higher than the underlying economic fundamentals would dictate


Application: The Global Financial Crisis of 2007-2009Effect 1: Residential Housing Prices: BOOM and BUSTSAided by international cash flows (India, China) the subprime mortgage market took off and became a trillion dollar industry by 2007Interest rates were kept lowDemocratization of Credit everyone could buy a house and pursue the American DreamHouse prices appreciating rapidly, so even if borrowers defaulted homes could be sold for more than when purchased Sometimes almost no cash was put down, as 2nd and 3rd mortgages were approves on the same houseYou can imagine the damage when the bubble burstMortgage lenders went underwater due to defaults


Application: The Global Financial Crisis of 2007-2009Effect 2: Deterioration of Financial Institution's Balance SheetsDue to defaults in housing mkt the value of instruments like MBS plummeted Banks and other lenders experienced a sharp decline in net worth began to deleverage and sell off assetsStopped lending credit freezeFewer banks less screening increased asymmetric info and financial frictions


Application: The Global Financial Crisis of 2007-2009Effect 3: Run on the Shadow Banking SystemShadow banking system: Hedge funds, investment banks, other nondepository institutions (all not as regulated as banks)Funds from shadow banks supported the issuance of low interest mortgage and auto loansThese securities were funded by repurchase agreements (repos)Short term borrowing using assets like MBS as collateral


Application: The Global Financial Crisis of 2007-20093 ContinuedRising concern about financial institutions stability led to lenders requiring increased collateral (known as haircuts)As MBS value fell due to mortgage defaults, haircuts increased (as high as 50%!) Ex: $100 repo loan backed by a $150 MBS as collateral To increase assets institutions engaged in fire sales flooded the market prices decline value of assets on balance sheets falls further Run on shadow banking system increased panic and credit spreads increased


Application: The Global Financial Crisis of 2007-2009Effect 4: Global Financial MarketsAs financial markets have become globalized other markets (Europe had its own problems) felt the effects of the US crisisFreeze of international funds flowing into USDespite Central Bank interventions (large cash injections) banks refused to lendUK had first major bank failure in over 100 years (Northern Rock Bank)


Application: The Global Financial Crisis of 2007 - 2009 (contd)Crisis spreads globallySign of the globalization of financial marketsTED spread (3 months interest rate on Eurodollar minus 3 months Treasury bills interest rate) increased from 40 basis points to almost 240 in August 2007.


Application: The Global Financial Crisis of 2007-2009Effect 5: Failure of High-Profile FirmsBear Stearns (5th largest US investment bank) failed, due to heavy investments in MBSForced to sell itself to JP Morgan for less than 5% of what it was worth a year earlierTo broker the deal the FED took over $30 billion of Bear Stearns assets (toxic assets that nobody knew the value of bundling MBS)Fannie Mae & Freddie MacTwo privately owned, yet government sponsored entities, ensured over $5 trillion in mortgagesHad to be propped up by Treasury and FedPut into conservatorship in Sept.. 2008 (run by govt)


Application: The Global Financial Crisis of 2007-2009Effect 5 Continued: TOO BIG TO FAILSeptember 12th, 2008 Merrill Lynch (3rd largest investment bank) sold itself to Bank of America for 60% less than what it was worth a year beforeSeptember 15th, 2008 Lehman Brothers Fails (4th largest investment bank)$600 billion in assets, over 25,000 employeesWas not bailed-outSeptember 16th, 2008 AIG (assets over $1 trillion)Had to pay out over $400 billion in insurance contracts, which it could notFED intervened, loaned AIG $85 billion (bail-out)


Application: The Global Financial Crisis of 2007 - 2009 (contd)Bailout package debatedHouse of Representatives voted down the $700 billion bailout package on September 29, 2008.It passed on October 3. Extraordinary FED actionMassive liquidity injectionsGovt ActionTroubled Asset Relief Program (TARP): Treasury spent $800 billion to purchase subprime mortgages from institutions FIDC limits temporarily raised to help prevent bank runsBush Administration Econ Stimulus Act of 2008: One-time tax rebates of $78 billion (sent $600 checks to taxpayers)Obama: American Recovery and Reinvestment Act 2009 ($787 billion stimulus bills)


Recovery in sight?Congress approved a $787 billion economic stimulus plan on February 13, 2009.


Figure 4 Housing Prices and the Financial Crisis of 20072009Source: Case-Shiller U.S. National Composite House Price Index; www.macromarkets.com/csi_housing/index.asp.


Inside the Fed Was the Fed to Blame for the Housing Price Bubble?Some economists have argued that the low rate interest policies of the Federal Reserve in the 20032006 period caused the housing price bubble

Taylor argues that the low federal funds rate led to low mortgage rates that stimulated housing demand and encouraged the issuance of subprime mortgages, both of which led to rising housing prices and a bubble


Inside the Fed Was the Fed to Blame for the Housing Price Bubble? (contd)Federal Reserve Chairman Ben Bernanke countered this argument, saying the culprits were the proliferation of new mortgage products that lowered mortgage payments, a relaxation of lending standards that brought more buyers into the housing market, and capital inflows from emerging market countries

The debate over whether monetary policy was to blame for the housing price bubble continues to this day.


Figure 5 Stock Prices and the Financial Crisis of 20072009Source: Dow-Jones Industrial Average (DJIA). Global Financial Data; www.globalfinancialdata.com/index_tabs.php?action=detailedinfo&id=1165.


Figure 6 Credit Spreads and the 20072009 Financial CrisisSource: Federal Reserve Bank of St. Louis FRED database; http://research.stlouisfed.org/fred2/categories/22.


Dynamics of Financial Crises in Emerging Market EconomiesStage one: Initiation of Financial Crisis.Path one: mismanagement of financial liberalization/globalization:Weak supervision and lack of expertise leads to a lending boom.Domestic banks borrow from foreign banks. Fixed exchange rates give a sense of lower risk.Banks play a more important role in emerging market economies, since securities markets are not well developed yet.


Dynamics of Financial Crises in Emerging Market Economies (contd)Path two: severe fiscal imbalances:Governments in need of funds sometimes force banks to buy government debt. When government debt loses value, banks lose and their net worth decreases. Additional factors:Increase in interest rates (from abroad)Asset price decreaseUncertainty linked to unstable political systems


Dynamics of Financial Crises in Emerging Market Economies (contd) Stage two: currency crisisDeterioration of bank balance sheets triggers currency crises:Government cannot raise interest rates (doing so forces banks into insolvency) and speculators expect a devaluation. How severe fiscal imbalances triggers currency crises:Foreign and domestic investors sell the domestic currency.


Dynamics of Financial Crises in Emerging Market Economies (contd)Stage three: Full-Fledged Financial Crisis:The debt burden in terms of domestic currency increases (net worth decreases).Increase in expected and actual inflation reduces firms cash flow.Banks are more likely to fail:Individuals are less able to pay off their debts (value of assets fall).Debt denominated in foreign currency increases (value of liabilities increase).


Figure 7 Sequence of Events in Emerging Market Financial Crises


APPLICATION Financial Crises in Mexico, 19941995; East Asia, 19971998; and Argentina, 20012002Mexico: Financial liberalization in the early 1990s: Lending boom, coupled with weak supervision and lack of expertise.Banks accumulated losses and their net worth declined.Rise in interest rates abroad.Uncertainty increased (political instability).Domestic currency devaluated on December 20, 1994. Rise in actual and expected inflation.


APPLICATION Financial Crises in Mexico, 19941995; East Asia, 19971998; and Argentina, 20012002 (contd)East Asia: Financial liberalization in the early 1990s: Lending boom, coupled with weak supervision and lack of expertise.Banks accumulated losses and their net worth declined.Uncertainty increased (stock market declines and failure of prominent firms).Domestic currencies devaluated by 1997. Rise in actual and expected inflation.


APPLICATION Financial Crises in Mexico, 19941995; East Asia, 19971998; and Argentina, 20012002 (contd)Argentina: Government coerced banks to absorb large amounts of debt due to fiscal imbalances. Rise in interest rates abroad.Uncertainty increased (ongoing recession).Domestic currency devaluated on January 6, 2002Rise in actual and expected inflation.

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ch9.ppt

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