1. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 9 Financial Crises and the Subprime Meltdown

2. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-2 Financial Crisis Continuing with the ideas from Chapter 8. Occurs when an increase in asymmetric information from a disruption of the financial system causes severe adverse selection and moral hazard problems that hinder the ability of financial markets to channel funds efficiently.

3. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-3 Factors Causing Financial Crises 1.Asset Markets Effects on Balance Sheets 2.Deterioration in Financial Institutions’ Balance Sheets 3.Banking Crisis 4.Increases in Uncertainty 5.Increases in Interest Rates 6.Government Fiscal Imbalances

4. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-4 Factors Causing Financial Crises 1. Asset Markets Effects on Balance Sheets –Stock market decline Decreases net worth of corporations. Lenders less willing to lend (note net worth ≈ collateral) Less protection for lenders  losses on loans likely to be more severe  lending decrease –Unanticipated decline in the price level Liabilities increase in real terms and net worth decreases  this increases the burden of debt Recall that real i = nominal i – inflation rate –Unanticipated decline in the value of the domestic currency Increases debt denominated in foreign currencies and decreases net worth. –Asset write-downs.

5. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-5 Factors Causing Financial Crises 2. Deterioration in Financial Institutions’ Balance Sheets –Fewer resources to lend, decline in lending. 3. Banking Crisis –Could be caused by a bank panic When multiple banks fail simultaneously because depositors fear the safety of their deposits (contagious) –Loss of information production when banks fail –Supply of funds down  interest rates up 4. Increases in Uncertainty –Major failure of big institutions  harder to screen credit risks  decrease in lending.

6. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-6 Factors Causing Financial Crises 5. Increases in Interest Rates –Increases adverse selection problem Only riskier borrowers are willing to borrow –Increases firms’ need for external funds B/c their interest payments increase; can’t cover all w/ internal funds  need to borrow; interest rates high 6. Government Fiscal Imbalances –Create fears of that government may default on its debt. D for gov’t bonds down  Gov’t may force financial institutions to purchase  weaken their balance sheets. –Investors might pull their money out of the country. Value of domestic currency could decline sharply. Bad for firms with debt denominated in foreign currency.

7. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-7 Factors Causing Financial Crises What do the six factors have in common? They increase adverse selections and moral hazard problems. They make borrowing and lending harder. –Only riskier borrowers tend to stay in the market. When lending declines, investment and aggregate output decline  GDP declines. Economic activities contract  economic growth declines. We don’t want contraction in lending and spending (inhibit economic growth).

8. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-8 Dynamics of past U.S. Financial Crises Stage One: Initiation of Financial Crisis –Mismanagement of financial liberalization/innovation –Asset price boom and bust –Spikes in interest rates –Increase in uncertainty Stage two: Banking Crisis Stage three: Debt Deflation

9. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-9 Stage One: Initiation of Financial Crisis 1.Mismanagement of financial liberalization/innovation –Liberalization: elimination of restrictions –Innovation: e.g., subprime residential mortgages, CDOs –Beneficial b/c they enhance financial development process –If managed improperly: excessive risk taking –Restrictions lifted  more intense competition  harder to earn profit  firms have to innovate  may lead to a lending spree/credit boom –Information and risk management may not be able to keep up with the rapid growth of credit; stretching gov’t supervision resources –Gov’t provide safety net  banks discipline down  moral hazard up –Bust  value of loans drop  net worth (capital) of banks falls –Deleveraging (when banks cut back due to loss in capital)  banks become riskier investment  less funds  fewer loans  credit freeze

10. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-10 Stage One: Initiation of Financial Crisis 2.Asset price boom and bust –In an asset-price bubble, asset prices can be driven above their fundamental economic values (“irrational exuberance”) –Example: tech bubble of the late 1990s, housing bubble of the 2000s –Driven by credit boom: credit used to fund asset purchases, driving up their price beyond the “rational” price –When the bubble bursts: price corrected downward  net worth down  asymmetry of information up  contraction in lending and spending –Asset price bust also deteriorate banks’ balance sheets  deleveraging

11. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-11 Stage One: Initiation of Financial Crisis 3.Spikes in interest rates –Higher interest rates  Decrease in household and businesses cash flow 4.Increase in uncertainty -Usually triggered by a failure of major financial institution(s) -Information harder to come by in periods of high uncertainty

12. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-12 Stages Two and Three Stage two: Banking Crisis –Depositors begin to withdraw their funds  banking panic (contagious) –Number of banks decline  loss of their information capital  adverse selection and moral hazard problems worsen  the economy spirals down –Typical U.S. crisis: insolvent firms sorted out (through bankruptcy proceedings)  once completed, uncertainty declines  stock market recovers  interest rates fall (credit spread not as bad)  recovery

13. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-13 Stages Two and Three Stage three: Debt Deflation –If recovery is short-circuited by a sharp decline in price levels  debt deflation (increased burden of indebtedness)  deterioration of net worth – Lending, investment spending, and aggregate output stay low/negative –The great depression: by 1930 stock market has rebounded and credit market remained stable, but credit shocks in agriculture led to bank failures  reduced amount of financial intermediation –Price levels fell by 25%  debt deflation  depression prolonged

14. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-14 FIGURE 1 Sequence of Events in U.S. Financial Crises

15. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-15 The Subprime Financial Crisis of 2007 - 2008 Financial innovations emerge in the mortgage markets: –Subprime and Alt-A mortgages Subprime: for borrowers with less-than-stellar credit records Alt-A: for borrowers with higher expected default risk than prime, but better credit records than subprime –Mortgage-backed securities Bundled and quantified the default risk of the underlying high-risk mortgages in a standardized debt (a form of securitization) –Collateralized debt obligations (CDOs) A form of structured credit products (derived from cash flows of underlying assets; can be tailored to have different risk characteristics) Paid out the cash flow from subprime mortgage-backed securities in different trenches based on risk exposure

16. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-16 The Subprime Financial Crisis of 2007 - 2008 Housing price bubble forms –Increase in liquidity from cash flows surging to the United States from emerging markets like China and India –Development of subprime mortgage market fueled housing demand and housing prices “Democratization of credit”: raised homeownership rates to all time high, led to asset price boom in housing Higher housing prices  subprime borrowers could refinance their houses for even larger loans (home values appreciated during the bubble)  could sell their houses to pay off the loan Investors happy because securities backed by cash flows from subprime mortgages had high returns

17. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-17 The Subprime Financial Crisis of 2007 - 2008 Agency problems arise –“Originate to distribute” model: Mortgage originated by a separate party, then distributed to investors as an underlying asset in a security Subject to principal (investor) & agent (mortgage broker) problem Agent has little incentive assess the mortgages’ credit risks Mortgage broker makes money through fees (more volume, more fees) –Borrowers had little incentive to disclose information about ability to pay Encouraged to take on mortgages they could not afford –Lax regulations: mortgage brokers not required to disclose to borrowers information to help them assess their ability to repay the loan –Banks earned large fees by underwriting mortgage-backed securities and CDOs  have little incentive to assess the quality and risk of the securities –Credit rating agencies were subject to conflicts of interest

18. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-18 The Subprime Financial Crisis of 2007 - 2008 Information problems surface –Structured products like CDOs get so complicated  hard to value the cash flow of the underlying assets or to determine who actually owns the assets –More complexity  information asymmetry worsen Housing price bubble bursts –Prices and profits rose: underwriting standards went down –Riskier borrowers able to obtain mortgages –Loan-to-value ratio (LTV) rose: mortgage amount relative to value of house –Borrowers have little money down (less of a stake  moral hazard) –Many borrowers found themselves “underwater” once prices dropped –Struggling homeowners have the incentive to walk away from their houses –Defaults on mortgages up: over 1 million mortgages in foreclosure

19. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-19 The Subprime Financial Crisis of 2007 - 2008 Crisis spreads globally –Sign of the globalization of financial markets –TED 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 Banks’ balance sheets deteriorate –Defaults up, value of mortgage-back securities and CDOs down  huge write downs at banks because of losses –Structured investment vehicles failed: these are like CDOs but sold as asset-back short-term commercial paper instead of as long-term debt –Banks deleveraged: sold assets and restricted availability of credit

20. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-20 The Subprime Financial Crisis of 2007 - 2008 High-profile firms fail –Bear Stearns (March 2008) 5 th largest investment bank at the time, sold to JP Morgan for less than 5% its worth the year before –Fannie Mae and Freddie Mac (July 2008) Insured $5 trillion mortgages or mortgage-backed assets; put into conservatorship (in effect run by the government) –Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (mutual fund) and Washington Mutual (September 2008). Lehman Brothers (4 th largest investment bank): largest bankruptcy Merrill Lynch: Sold to Bank of America AIG: Had $400 billion in credit default swaps that had to make payouts on possible losses from subprime mortgage securities; received $173 billion in bailout)

21. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-21 The Subprime Financial Crisis of 2007 - 2008 Bailout package debated –House of Representatives voted down the $700 billion bailout package on September 29, 2008 –It passed on October 3: Emergency Economic Stabilization Act –October 6: worst weekly decline in the history of US stock market Recovery in sight? –Congress approved a $787 billion economic stimulus plan on February 13, 2009 after the stock market declined over 40% from its peak Troubled Asset Relief Plan (TARP) –Authorized the treasury to spend $700 billion to purchase subprime mortgage assets from troubled banks or inject capital into banking –To enable financial institutions to start lending again –FDIC insurance limit temporarily raised from $100,000 to $250,000

22. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-22 Dynamics of Financial Crises in Emerging Market Economies Emerging Markets: economies in earlier stages of market development (usually more vulnerable to shocks). Stage 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.

23. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-23 Dynamics of Financial Crises in Emerging Market Economies –Path two: severe fiscal imbalances: Governments in need of funds due to budget deficits) 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 decrease: decrease net worth of firms Uncertainty linked to unstable political systems

24. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-24 Dynamics of Financial Crises in Emerging Market Economies Stage two: currency crisis –Deterioration of bank balance sheets triggers currency crises: Government cannot raise interest rates (doing so forces banks into insolvency) Speculators expect a devaluation Domestic currency subject to speculative attacks –How severe fiscal imbalances triggers currency crises: Foreign and domestic investors sell the domestic currency

25. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-25 Dynamics of Financial Crises in Emerging Market Economies 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).

26. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-26 Financial Crises: Mexico 1994-1995 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.

27. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-27 Financial Crises: East Asia 1997-1998 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.

28. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-28 Financial Crises: Argentina 2001-2002 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, 2002 Rise in actual and expected inflation.

29. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 9-29 FIGURE 3 Sequence of Events in Emerging Market Financial Crises