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Financial Crises and the Subprime Meltdown

Chapter 9

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Financial CrisisFinancial CrisisA financial crisis happens when there is A financial crisis happens when there is

sharp declines in asset prices and sharp declines in asset prices and widespread bankruptcies.widespread bankruptcies.

Financial crises occur when there is a Financial crises occur when there is a sharp increase in adverse selection and sharp increase in adverse selection and moral hazard.moral hazard.

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Financial Crises: A sharp Financial Crises: A sharp increase in asymmetric increase in asymmetric

information that cripples the information that cripples the financial systemfinancial system

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Causes of Financial CrisisCauses of Financial Crisis Increases in interest ratesIncreases in interest rates: Riskier investors : Riskier investors

remain in the market while safer ones exit.remain in the market while safer ones exit.

Increases in uncertaintyIncreases in uncertainty: A major failure increases : A major failure increases the uncertainty and inability of the lenders to the uncertainty and inability of the lenders to gauge the creditworthiness of borrowers.gauge the creditworthiness of borrowers.

Balance sheet deteriorationBalance sheet deterioration: Decline in asset : Decline in asset values, rise in liabilities, decline in net worth.values, rise in liabilities, decline in net worth.

Banking sector problemsBanking sector problems: Deterioration of bank : Deterioration of bank balance sheets.balance sheets.

Government deficitsGovernment deficits: Possibility of default: Possibility of default..

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Balance Sheet DeteriorationBalance Sheet Deterioration Stock market crash lowers the net worth of Stock market crash lowers the net worth of

corporations.corporations. Adverse selection increases because the potential Adverse selection increases because the potential

losses to lenders are higher.losses to lenders are higher. Moral hazard increases because borrowers have more Moral hazard increases because borrowers have more

incentives to engage in risky behavior.incentives to engage in risky behavior.

Unanticipated deflation raises liabilities.Unanticipated deflation raises liabilities. Debt is usually long-term, fixed interest rate.Debt is usually long-term, fixed interest rate. Falling prices raise the real value of nominal debt.Falling prices raise the real value of nominal debt. Assets are usually real, so they do not gain value.Assets are usually real, so they do not gain value. Net worth declines.Net worth declines.

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Balance Sheet DeteriorationBalance Sheet Deterioration Exchange rate risk may deteriorate balance Exchange rate risk may deteriorate balance

sheets. sheets. If contracts are denominated in foreign currency, If contracts are denominated in foreign currency,

any unanticipated devaluation or depreciation of any unanticipated devaluation or depreciation of domestic currency increases real value of debt.domestic currency increases real value of debt.

Assets are usually denominated in domestic Assets are usually denominated in domestic currency.currency.

Rise in interest rates may increase interest Rise in interest rates may increase interest payments by debtors.payments by debtors.Cash flow will fall lowering the liquidity of the firm.Cash flow will fall lowering the liquidity of the firm.

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Deterioration of the balance Deterioration of the balance sheets of the banks impede sheets of the banks impede

intermediationintermediationFinancial institutions provide loans for Financial institutions provide loans for

economic activity.  Deterioration makes economic activity.  Deterioration makes loans less available.  Recession.loans less available.  Recession.

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Banking CrisisBanking Crisis If financial institutions have severe deterioration of If financial institutions have severe deterioration of

balance sheet, bank panic may occur when multiple balance sheet, bank panic may occur when multiple banks fail simultaneously.  In the absence of deposit banks fail simultaneously.  In the absence of deposit insurance asymmetric information about banks loan insurance asymmetric information about banks loan portfolio spurs a panic. portfolio spurs a panic.

When banks fail their accumulated information that When banks fail their accumulated information that allows them to make loans to firms also evaporates. allows them to make loans to firms also evaporates. There is a loss of information production, loss of financial There is a loss of information production, loss of financial intermediation, shrinking of the supply of funds, higher intermediation, shrinking of the supply of funds, higher interest rates, asymmetric information problems, severe interest rates, asymmetric information problems, severe contraction in economic activity.contraction in economic activity.

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Increases in UncertaintyIncreases in Uncertainty

Failure of a prominent institution, Failure of a prominent institution, recession, stock market crash make it recession, stock market crash make it hard for lenders to screen good from bad hard for lenders to screen good from bad credit risks.  Asymmetric information leads credit risks.  Asymmetric information leads to contraction.to contraction.

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Increases in Interest RatesIncreases in Interest Rates

Higher interest rates eliminates low risk Higher interest rates eliminates low risk ventures and keeps the high risk ones.  ventures and keeps the high risk ones.  Adverse selection.Adverse selection.

Increases in interest rates squeezes cash Increases in interest rates squeezes cash flow: receipts down, payments up. High flow: receipts down, payments up. High cash flow firms can finance projects cash flow firms can finance projects internally, low cash flow requires outside internally, low cash flow requires outside financing. Adverse selection and moral financing. Adverse selection and moral hazard increase, less lending, recession.hazard increase, less lending, recession.

Government Fiscal Government Fiscal Imbalances: sovereign Imbalances: sovereign

risk increasesrisk increases

Increase government debt, Increase government debt, especially foreign debt, raises especially foreign debt, raises

fears of defaultfears of default

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Government can't find Government can't find lenders and forces banks to lenders and forces banks to

buy the bondsbuy the bonds If government default fears emerge, If government default fears emerge,

government bonds lose value, their government bonds lose value, their interest rate rise.  Institutions holding interest rate rise.  Institutions holding these bonds see their asset value declinethese bonds see their asset value declineBalance sheets deteriorateBalance sheets deteriorate

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Foreign exchange crisisForeign exchange crisis

Banks liabilities in foreign currency expandBanks liabilities in foreign currency expand

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Mexican Financial Crisis of ‘94-95Mexican Financial Crisis of ‘94-95Deregulation of financial markets led to a Deregulation of financial markets led to a

lending boom.lending boom.Unperforming loans increased causing a Unperforming loans increased causing a

decline in net worth of banks.decline in net worth of banks.Weak supervision of regulatorsWeak supervision of regulators Inability to monitor borrowersInability to monitor borrowers

Lending slowed (tight credit market).Lending slowed (tight credit market).

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Tequila Crisis of ‘94-95Tequila Crisis of ‘94-95 Interest rate hikes in the US forced Mexico to raise Interest rate hikes in the US forced Mexico to raise

its interest rates to keep the value of peso.its interest rates to keep the value of peso. Higher interest rates increased adverse selection and Higher interest rates increased adverse selection and

moral hazard.moral hazard.

Assassinations and uprisings increased Assassinations and uprisings increased uncertainty.uncertainty. Stock market crashed reducing net worth.Stock market crashed reducing net worth. Firms had incentives to undertake risky investments Firms had incentives to undertake risky investments

because the value of their collateral fell.because the value of their collateral fell. Adverse selection and moral hazard problems rose.Adverse selection and moral hazard problems rose.

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Tequila Crisis of ‘94-95Tequila Crisis of ‘94-95Expected value of Mexican peso dropped Expected value of Mexican peso dropped

forcing the spot value downward as well.forcing the spot value downward as well.Due to NAFTA, tariffs and quotas were to be Due to NAFTA, tariffs and quotas were to be

removed.removed. Inflation in 1990-95 period had fallen to 15.5% Inflation in 1990-95 period had fallen to 15.5%

from 70.4% during 1980-90 period but it still was from 70.4% during 1980-90 period but it still was significantly higher than the US to which the significantly higher than the US to which the peso was pegged.peso was pegged.

From 1980 to 1995 trade as a percentage of From 1980 to 1995 trade as a percentage of GDP doubled from 24% to 48%.GDP doubled from 24% to 48%.

Source: The World Bank, World Development Report 1997, pp. 219, 235, 245

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U.S. Financial CrisesU.S. Financial Crises

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Third World Financial CrisesThird World Financial Crises

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Amartya Sen: Amartya Sen: http://www.nybooks.com/articles/22490??Martin Wolf: Martin Wolf: http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-0000779fd2ac.html?nclick_check=1

Brooksley Born: Brooksley Born: http://www.pbs.org/wgbh/pages/frontline/warning/view/?utm_campaign=homepage&utm_medium=top5&utm_source=top5

Paul Krugman: Paul Krugman: http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1&pagewanted=all