1. Net Worth – The Foundation of Credit
Combating adverse selection and moral hazard:
Collateral
Net Worth (=$Assets - $Liabilities)
Net Worth – The Foundation of Credit

2. Factors Causing Financial Crises
Asset Values Drop: Net Worth Down
Stock market decline  Decreases net worth of corporations.
Unanticipated deflation  Debt burdens up/net worth down
Unanticipated depreciation  $ debts up/net worth down
Asset write-downs (bad debts)  Net worth down
Deterioration in Financial Institutions’ Balance Sheets
Decline in lending.
Interest Rates Rise
Worsens adverse selection (who would pay the high rates?)
Increases business needs for external funds
 worsens adverse selection and moral hazard problems.
Government Fiscal Imbalances
Fears of default on government debt Capital flight
Banking Crises
Loss of information production / disintermediation.
Increases in Uncertainty Decline in lending.

3. The Great Depression, 1929 – 1939 Subprime-triggered crisis
Crises (and Threatened Crises) We Have Known
The Great Depression, 1929 – 1939
Mexican Default, 1982
Continental Illinois, 1984…Oil patch loans…TBTG
Third World Debt Crisis, 1980s  Lost Decade
Savings & Loan Debacle, 1986 – 1990
Black Monday, October 19, 1987
Tequila Crisis, 1994 – 1995
East Asia Financial Crisis,
Long Term Capital Management, 1998
dot.com bust, 2000
911, 2001
Subprime-triggered crisis
 The Great Recession, 2007 –

4. The Great Depression: Mother of all Crises
Stock Market Crash  Spending cutback
Bank Panic  Monetary Contraction
Bank Failures  Reduced Lending
Price Deflation/Deflationary Expectations  Debt Deflation

5. Onset of the Depression: Persistent Deflation…Persistent Job Loss
Manufacturing Employment
$/pound
DJIA

6. $/pound
Producer Price Index

7. New Deal Reflation

8. Stimulus and Retrenchment: Recession in Depression

9. Dynamics of Financial Crises in Emerging Market Economies
Stage one: Initiation of Financial Crisis.
Path one: mismanagement of financial liberalization
Weak supervision and lack of expertise  lending boom.
Domestic banks borrow from foreign banks.
Fixed exchange rates give a sense of lower risk.
Securities markets not well-developed  Banks important
Path two: severe fiscal imbalances:
Governments force banks to buy government debt.
When government debt loses value, bank net worth down .
Additional factors:
Increase in interest rates (from abroad)
Asset price decrease
Uncertainty linked to unstable political systems

10. Dynamics of Financial Crises in Emerging Market Economies
Stage two: currency crisis
Bank losses  currency crises:
Government cannot raise interest rates (doing so forces banks into insolvency)…
… and speculators expect a devaluation.
Foreign and domestic investors sell the domestic currency.
Stage three: Full-Fledged Financial Crisis:
The debt burden in terms of domestic currency up
Banks 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).

11. Financial Crises: Mexico 1994-1995 ...Tequila
Financial liberalization in the early 1990s:
Lending boom/weak supervision/lack of expertise.
Banks accumulated losses/net worth declined.
Rise in interest rates abroad.
Increased uncertainty (political instability).
Domestic currency devaluated Dec. 20, 1994.
Tesobono burden
Rise in actual and expected inflation.

12. Financial Crises: East Asia 1997-1998
Financial liberalization in the early 1990s:
Lending boom/weak supervision/lack of expertise.
Banks accumulated losses/net worth declined.
Uncertainty increased
stock market declines and failure of prominent firms
Domestic currencies devaluated (1997).
Rise in actual and expected inflation.

13. Financial Crises: Argentina 2001-2002
Currency board: 1 Peso = $1
Fiscal imbalance
banks coerced to absorb government debt
Appreciation of $  Argentine recession
Rise in interest rates abroad.
Uncertainty increased (ongoing recession).
Domestic currency devaluated, Jan. 6, 2002
Rise in actual and expected inflation.

14. Sequence of Events in Emerging Market Financial Crises

15. U.S. Financial Crises Stage One
Mismanagement of financial liberalization and innovations
Asset price boom & bust
Spikes in interest rates
Increase in uncertainty
Stage two: Banking Crisis
Stage three: Debt Deflation

16. Financial Crisis of
Financial innovations in mortgage markets:
Subprime and Alt-A mortgages
Mortgage-backed securities
Collateralized debt obligations (CDOs)
Housing price bubble forms
World savings glut
Increase in liquidity from cash flows surging to the US
Subprime mortgage market  housing demand and prices up.
Agency problems arise
“Originate to distribute”
 principal (investor) agent (mortgage broker) problem.
Commercial and investment banks/rating agencies …weak incentives to assess quality of securities
Information problems surface…A “Minsky Moment”
Housing price bubble bursts/Crisis spreads globally

17. A “Global Saving Glut”
The best
of times
Capital Inflows
Escalating
House Prices
Easy Money
Policy
Eager Home Buyers
Ambitious
Mortgage Brokers
Developer Clout
Innovative
Banks
Rating
Agencies
Securitization
MBSs
Bank Regulators
Gov’t Sponsored
Enterprises

18. The best
of times
Capital Inflows
Escalating
House Prices
Easy Money
Policy
Eager Home Buyers
Ambitious
Mortgage Brokers
Developer Clout
Innovative
Banks
Rating
Agencies
Securitization
MBSs
Bank Regulators
Gov’t Sponsored
Enterprises

19. Deleveraging – Debt Deflation Macroeconomic Linkages and
Vicious Spirals Unleashed
Demand –
Jobs –
Wages –
Income –
Spiral
House Price –
Foreclosure
Spiral
Deleveraging – Debt Deflation
Spiral
Government
Revenue –
Cutback
Spiral
Global Repercussion
Spiral
Macroeconomic Linkages and
Feedbacks

20. Financial Crisis of 2007 - 2009 (cont’d)
Banks’ balance sheets deteriorate
Write downs
Sale of assets and credit restriction
High-profile firms fail
Bear Stearns (March 2008)
Fannie Mae and Freddie Mac (July 2008)
Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (MMMF) and Washington Mutual (September 2008).
Fed pumps up bank reserves: TARP/TALF,etc.
Lend and lend freely
Bailout package enacted
House votes down the $700 billion bailout package (9/29/08)
 Stock market slumps  Bailout passes on October 3.
Congress approves a $787 billion economic stimulus plan on February 13, 2009.
Recession deepens

21. Responses Lender of Last Resort / Spender of Last Resort
Tax Rebate $124 bil.
Fed Fund Rate Cuts
Fannie/Freddie $200 bil.
Bear-Stearns $29 bil.
AIG $174 bil.
Fed “Facilities”
Primary Dealer Credit Facility (PDCF) $58 bil.
Treasury Security Loan Facility (TSLF) $133 bil.
Term Auction Facility (TAF) $416 bil.
Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.
Money Market Investor Funding Facility (MMIFF) $540 bil.
More Fed Fund Rate Cuts … Hold At ~0%
Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.
Term Asset-Backed Securities Loan Facility (TALF) $200 bil.
Emergency Economic Stabilization Act/TARP $700 bil.
Government Loans
Government Equity
Stimulus Package $787 bil.
aka The American Recovery and Reinvestment Act
TARP II
Stress Tests

22. Vicious Spirals Unleashed
Vicious Spirals Reversed? Tackle them all together!
Vicious Spirals Unleashed
Refinance
Mortgages
Stimulus
Program
Infrastructure
Spending
Tax Cuts
Demand –
Jobs –
Wages –
Income –
Spiral
House Price –
Foreclosure
Spiral
Deleveraging – Debt Deflation
Spiral
Revive dual banking system
Cash for Trash
Recapitalize banks
Revive securitization
Government
Revenue –
Cutback
Spiral
Federal Aid
To States
Global Repercussion
Spiral
G – 20
Coordinated Stimulus
Macroeconomic Linkages and
Feedbacks
Macroeconomic Linkages
and
Feedbacks

23. FIGURE 2 Treasury Bill–to–Eurodollar Rate (TED) Spread
Source: 23