C08 Financial Markets

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CHAPTER 8

Why Do FinancialCrises Occur and

Why Are They SoDamaging to the

Economy?



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Chapter Previe

Financial crises are major disruptions infinancial markets characteried !y sharpdeclines in asset prices and firm failures"

#eginning in August $%%&' the ("S" enteredinto a crisis that )as descri!ed as a *once+in+

a+century credit tsunami",



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Chapter Previe

Why did this financial crisis occur?

Why ha-e financial crises !een so pre-alent

throughout )orld history?

Why are financial crises almost al)aysfollo)ed !y se-ere contractions in economic

acti-ity?



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Chapter Previe

.n this chapter' )e de-elop a frame)ork tounderstand the dynamics of financial crises"Topics include/

Asymmetric .nformation and Financial Crises

Dynamics of Financial Crises in Ad-anced

EconomiesDynamics of Financial Crises in Emerging 0arketEconomies



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Asy$$etric %n&or$ation and

'inancial Crises

.n chapter &' )e discussed ho) afunctioning financial system is critical to aro!ust economy"

1o)e-er' !oth moral haard and ad-erseselection are still present" The study of

these pro!lems 2agency theory3 is the !asisfor understanding and defining a financialcrisis"



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)yna$ics o& 'inancial Crises in

Advanced Econo$ies

The dynamics of financial crises inemerging market economies ha-e many ofthe same elements as those found inad-anced countries like (nited States

1o)e-er' there are some important

differences" The ne4t slide outlines the key stages"




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+e,ence o& Events in .+.

'inancial Crises /


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+tage 3ne4 %nitiation

Financial crisis can !egin in se-eral )ays/

mismanagement of financial li!eraliation or

inno-ation

asset price !ooms and !usts

a general increase in uncertainty caused !yfailures of major financial institutions




The seeds of a financial crisis can !egin )ith$is$anage$ent o& &inancial lierali5ation or

innovation/

5 elimination of restrictions

5 introduction of ne) types of loans or other financialproducts

5 Aggregate glo!al CDO issuance totaled (S6 78&!illion in $%%9' (S6 $&$ !illion in $%%8' (S6 88$ !illion

in $%%: and (S6 8%; !illion in $%%&"

< See =lo!al >ool of 0oney




=o-ernment safety nets creates moral haardpro!lem' )eakening incenti-es for riskmanagement" Depositors ignore !ank risk+taking"

E-entually' loan losses accrue' and asset -aluesfall' leading to a reduction in capital"

Financial institutions cut !ack in lending' a

process called deleveraging" #anking fundingfalls as )ell"




As F.s cut !ack on lending' no one is left toe-aluate firms" The financial system lossesits primary institution to address ad-erseselection and moral haard"

Economic spending contracts as loans

!ecome scarce"


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A financial crisis can also !egin )ith an asset

pricing oo$ and st/

A pricing !u!!le starts' )here asset -alues e4ceed their

fundamental prices"

When the !u!!le !ursts and prices fall' corporate net )orthfalls as )ell" 0oral haard increases as firms ha-e little tolose"

F.s also see a fall in their assets' leading again todele-eraging"



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Finally' a financial crisis can !egin )ith a spi6e in

interest rates or an increase in ncertainty/

0any 7th century crises initiated )ith a spike in rates' due

to a li@uidity pro!lem or panics

0oral haard also increases as loan repayment !ecomesmore uncertain

Other periods of high uncertainty can lead to crises' such

as stock market crashes or the failure of a major financialinstitution



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+tage To4 7an6ing Crisis

Deteriorating !alance sheets lead financialinstitutions into insol-ency" .f se-ere enough' thesefactors can lead to a an6 panic"

>anics occur )hen depositors are unsure )hich !anks areinsol-ent' causing all depositors to )ithdra) all fundsimmediately

As cash !alances fall' F.s must sell assets @uickly' furtherdeteriorating their !alance sheet

Ad-erse selection and moral haard !ecome se-ere ittakes years for a full reco-ery



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+tage Three4 )et )e&lation

.f the crisis also leads to a sharp decline in prices'det de&lation can occur' )here asset prices fall'!ut de!t le-els do not adjust' increases de!t

!urdens"De!t le-els are typically fi4ed' not inde4ed to asset -alues

>rice le-el drops lead to an increase in ad-erse selection

and moral haard' )hich is follo)ed !y decreased lendingEconomic acti-ity remains depressed for a long time"



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Case4 The reat )epression

.n 7$B and 7$' stock prices dou!led inthe ("S" The Fed tried to cur! this period ofe4cessi-e speculation )ith a tight monetarypolicy" #ut this lead to a collapse of morethan :% in Octo!er of 7$"

Further' !et)een 7;% and 7;;' one+thirdof ("S" !anks )ent out of !usiness asagricultural shocks led to !ank failures




+toc6 9ar6et Prices )ring

The reat )epression





Ad-erse selection and moral haard in creditmarkets !ecame se-ere" Firms )ithproducti-e uses of funds )ere una!le to getfinancing" As seen in the ne4t slide' creditspreads increased from $ to nearly Bduring the height of the Depression"




Credit +preads )ring

The reat )epression





The deflation during the period lead to a$8 decline in price le-els"

The prolonged economic contraction lead toan unemployment rate around $8"

The Depression )as the )orst financial crisis

e-er in the ("S" .t e4plains )hy the economiccontraction )as also the most se-ere e-ere4perienced !y the nation"




:i54 The 200*;200

'inancial Crisis

ist and pro-ide a !rief e4planation of $ of the; central factors that led to the %&+% crisis"



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Case4 The 200*;200

'inancial Crisis

We !egin our look at the $%%&$%% financialcrisis !y e4amining three central factors/

financial inno-ation in mortgage marketsagency pro!lems in mortgage markets

the role of asymmetric information in thecredit rating process



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Case4 The 200*;200

'inancial Crisis

Financial inno-ation in mortgage marketsde-eloped along a fe) lines/

ess+than+credit )orthy !orro)ers found the a!ilityto purchase homes through su!prime lending' apractice almost none4istent until the $%%%s

Financial engineering de-eloped ne) financial

products to further enhance and distri!ute risk frommortgage lendingaggra-ates A.



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Case4 The 200*;200

'inancial Crisis

Agency pro!lems in mortgage markets also reachedne) le-els/

0ortgage originators did not hold the actual mortgage'

!ut sold the note in the secondary market0ortgage originators earned fees from the -olume ofthe loans produced' not the @uality>A pro!lem

.n the e4treme' un@ualified !orro)ers !ought housesthey could not afford through either creati-e mortgageproducts or outright fraud 2such as inflated income3ad-erse selection



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Case4 The 200*;200

'inancial Crisis

Finally' the rating agencies made asym" info )orse

Agencies consulted )ith firms on structuring productsto achie-e the highest rating' creating a clear conflict

aggra-ates A.Further' the rating system )as hardly designed toaddress the comple4 nature of the structured de!tdesigns

The result )as meaningless ratings that in-estorshad relied on to assess the @uality of their in-estments



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Case4 The 200*;200

'inancial Crisis

0any suffered as a result of the $%%&$%%financial crisis" We )ill look at fi-e areas/

("S" residential housing

F.s !alance sheets

The *shado), !anking system

=lo!al financial markets

The failure of major financial firms




Case4 The 200*;200

'inancial Crisis

.nitially' the housing !oom )as lauded !yeconomics and politicians" The housing!oom helped stimulate gro)th in thesu!prime market as )ell"

1o)e-er' under)riting standard fell" >eople

)ere clearly !uying houses they could notafford' e4cept for the a!ility to sell thehouse for a higher price"

C




Case4 The 200*;200

'inancial Crisis

ending standards also allo)ed for near7%% financing' so o)ners had little to lose!y defaulting )hen the housing !u!!le!urst"

The ne4t slide sho)s the rise and fall of

housing prices in the ("S" The num!er ofdefaults continues to plague the ("S"!anking system



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Hosing Prices4 2002;2010

< th ' d t 7l & th




<as the 'ed to 7la$e &or the

Hosing Price 7le=

Some argue that lo) interest rates from$%%; to $%%: fueled the housing !u!!le"

.n early $%%' 0r" #ernanke re!utted thisargument" 1e argued rates )ereappropriate"

1e also pointed to ne) mortgage products'rela4ed lending standards' and capitalinflo)s as more likely causes"

C Th 200* 200




Case4 The 200*;200

'inancial Crisis

As mortgage defaults rose' !anks andother F.s sa) the -alue of their assets fall"This )as further complicated !y thecomple4ity of mortgages' CDOs' defaultss)aps' and other difficult+to+-alue assets"

#anks !egan the dele-eraging process'selling assets and restricting credit' furtherdepressing the struggling economy

C Th 200* 200



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Case4 The 200*;200

'inancial Crisis

The shado an6ing syste$ alsoe4perienced a run" These are the hedgefunds' in-estment !anks' and other li@uiditypro-iders in our financial system" When theshort+term de!t markets seied' so did thea-aila!ility of credit to this system" This

lead to further *fire, sales of assets to meethigher credit standards

C Th 200* 200



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Case4 The 200*;200

'inancial Crisis

As seen on the ne4t t)o slides' the fall inthe stock market and the rise in creditspreads further )eakened !oth firm andhousehold !alance sheets"

#oth consumption and real in-estment fell'

causing a sharp contraction in theeconomy"



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+toc6 Prices4 2002;2010



C Th 200* 200



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Case4 The 200*;200

'inancial Crisis

Europe )as actually first to raise the alarmin the crisis" With the do)ngrade of 67%!illion in mortgage related products' shortterm money markets froe' and in August$%%&' a French in-estment housesuspended redemption of some of its

money market funds"

#anks and firms !egan to horde cash"

C Th 200* 200




Case4 The 200*;200

'inancial Crisis

The end of credit lead to se-eral

!ank failures"

Gorthern Hock )as one of the first'

relying on shortAterm creditmarkets for funding" Others soon

follo)ed"

#y most standards' Europe

e4perienced a more se-eredo)nturn that the ("S"

C Th 200* 200



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Case4 The 200*;200

'inancial Crisis

Finally' the collapse of se-eral high+profile("S" in-estment firms only furtherdeteriorated confidence in the ("S"

0arch $%%B/ #ear Sterns fails and is sold to I>0organ for 8 of its -alue only 7 year ago

Septem!er $%%B/ !oth Freddie and Fannie put intoconser-atorship after hea-y su!prime losses"

Case The 200* 200



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Case4 The 200*;200

'inancial Crisis

Finally' the collapse of se-eral highprofile("S" in-estment firms only furtherdeteriorated confidence in the ("S"

Septem!er $%%B/ ehman #rothers files for!ankruptcy" 0errill ynch sold to #ank of America at*fire, sale prices" A.= also e4periences a li@uidity

crisis"

Case4 The 200* 200




Case4 The 200*;200

'inancial Crisis

The crisis and impaired credit markets ha-ecaused the )orst economic contraction sinceWorld War .." The fall in real =D> andincrease in unemployment to o-er 7% in$%% impacted almost e-eryone"

loal4 %reland and the





200*;200 'inancial Crisis

From J8K%&' .reland had a !oomingeconomy' )ith :"; a-erage annual real=D> gro)th"

#ut' rising real estate prices and a !oom inmortgage lending )ere laying theground)ork for a recession"

1ousing prices dou!led t)ice from 78 to$%%&' )hile construction )as 7; of =D>




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1ouses prices then fell !y $% in $%%&

#anks )ere hit hard' )ith high e4posure to

real estate and reliance on short+termfunding from money markets

The .rish go-ernment nationalied a large

!ank' and guaranteed all deposits in aneffort to control the recession




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(nemployment rose from 9"8 to 7$"8

=D> fell !y more than 7%' and aggregate

price le-els fell ike the ("S"' !udget deficits rose' and ta4

increases follo)ed to offset the increase in

spending




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E$erging 9ar6et Econo$ies

The dynamics of financial crises inemerging market economies ha-e many ofthe same elements as those found in

ad-anced countries like (nited States

1o)e-er' there are some important

differences" The ne4t slide outlines the key stages"

E$erging 9ar6et 'inancial



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Crisis4 +e,ence o& Events /a




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Crisis4 +e,ence o& Events /





Financial crises in emerging market countriesde-elop along t)o !asic paths/

the mismanagement of financialli!eraliation or glo!aliation

se-ere fiscal im!alances



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Crisis initiation in-ol-ing the mismanagementof financial li!eraliation or glo!aliationusually proceeds as follo)s/

The country often starts )ith a solid fiscal policy

A )eak credit culture and capital inflo)s e4asperate

the credit !oom that follo)s li!eraliation' leading torisky lending

1igh loan losses e-entually materialie



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Crisis initiation in-ol-ing the mismanagementof financial li!eraliation or glo!aliationusually proceeds as follo)s/

As !ank !alance sheets deteriorate' lending is cut!ack 2more se-ere here since the rest of theeconomy is not as de-eloped3

A lending crash fully materialies





Why does prudential regulation fail to stema !anking crisis? .s this different than the("S" and other de-eloped economies?

The story is similar to the ("S"' )ith -ariousinterests trying to pre-ent regulators from

doing their jo!s" 1o)e-er' in de-elopingeconomies' these interest 2!usiness3pro!a!ly ha-e more po)er





Crisis initiation can also in-ol-e se-ere fiscalim!alances/

The go-ernment faces a large deficit and eithercajoles or forces !anks to !uy go-Kt !onds

.f confidence falls' the go-Kt !onds are sold !yin-estors' leading to a price decline

As a result' !ank !alance sheets deteriorate' andthe usual lending freee follo)s



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Crisis initiation can also in-ol-e other factors/

A rise in rates in de-eloped economies can spillo-er into risk taking in de-eloping countries2e"g"' the 0e4ican crisis3

Asset price declines are less se-ere' !ut certainlyincrease pro!lems

(nsta!le political systems create high le-els ofuncertainty' increasing agency conflicts



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+tage To4 Crrency Crisis

The FL markets )ill soon start taking !etson the depreciation of the currency of theemerging market' in )hat is called aspeclative attac6" O-er supply !egins'the -alue of the currency falls' and acurrency crisis ensues"



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The go-ernment can attempt to defend thehome currency !y raising interest rates"That should encourage capital inflo)s"

1o)e-er' !anks must pay more to o!tainfunds' decreasing !ank profita!ility' )hichmay lead to insol-ency"

Speculators in the FL market kno) this"0ass sell+offs of the currency continue"



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The currency crisis can also result from alarge fiscal im!alance" .f in-estors in acountryKs de!t suspect its ina!ility to repay

the loans' sell+offs )ill occur" This isaccompanied !y selling the domesticcurrency' again leading to a speculati-e

attack on the currency"

+tage Three4



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+tage Three4

'll 'inancial Crisis

0any emerging market firm denominatetheir de!t in ("S" dollars or yen" Anune4pected currency de-aluation increases

their de!t !urden' leading to a decline intheir net )orth"

This crisis' along )ith the currency crisis'leads the country into a fullfledgedfinancial crisis"

+tage Three4




+tage Three4


The currency collapse can also lead tohigher inflation" The increase in interestrates again leads to lo)er firm cash flo)s

and increased agency pro!lems"

#ank losses are ine-ita!le as de!tors areno longer a!le to meet interest o!ligations"#anks )ill likely fail as )ell"

+tage Three4



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+tage Three4


With this frame)ork in mind' )e no) turn tothree actual financial crises in emergingeconomies/

0e4ico' 7978

East Asia' 7&7B

Argentina' $%%7$%%$

Case4 'inancial Crises in



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E$erging 9ar6et Contries

9e>ico? East Asia? and Argentina

The three countries sho) ho) a country can

shift from a path of high gro)th just !efore afinancial crises"

An important factor )as the deterioration in

!anksK !alance sheets due to increasing loanloses"







The 0e4ican and Argentine crises )erealso preceded !y rising internationalinterest rates" This lead to increased rates

in these countries' and an accompanyingincrease in information pro!lems" Stockmarket declines )ere also in the mi4M

although in Asia' it occurred simultaneouslyinstead of !efore the crisis"







Argentina )as particularly interesting" .t hada )ellsuper-ised !anking system 2unlike0e4ico and East Asia3" The fiscal pro!lems

of the go-ernment )eakened the !ankingsystem !alance sheet )hen the go-ernmentforced !anks to take on go-Kt de!t"

Confidence in the go-ernment failed' andthe !anksK de!t -alues 2assets3 felldramatically"




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Full!lo)n speculati-e attacks de-eloped in theforeign e4change for each of these countries/

5 0e4ico tried to inter-ene !y raising interest rates' !ut

)as forced to de-alue the peso 5 The speculati-e attack on the !aht successfully lead to

its de-aluation

Foreign denominated de!t )orsened the situation" And a rise in inflation played out as )e descri!ed"




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The institutional structure of de!t markets in0e4ico and East Asia interacted )ith thecurrency de-aluations to propel the

economies into fullfledged financial crises"This negati-e shock )as especially se-erefor .ndonesia and Argentina' )hich sa) the

-alue of their currencies fall !y more than&%




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The sharp decline in lending helped lead to acollapse of economic acti-ity' )ith real =D>gro)th falling sharply" Further deterioration in

the economy occurred !ecause the collapsein economic acti-ity and the deterioration inthe cash flo) and !alance sheets of !oth

firms and households )orsened !ankingcrises"




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0e4ico !egan to reco-er in 7:

The crisis countries in East Asia tentati-ely

!egan their reco-ery in 7' )ith astronger reco-ery later"

Argentina )as still in a se-ere depression

in $%%;' !ut su!se@uently the economy!ounced !ack



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Chapter +$$ary

Asymmetric .nformation and FinancialCrises/ )e re-isited the ideas of em!odiedin agency theory as a frame)ork to

e4amine )orld financial crises"

Dynamics of Financial Crises in Ad-ancedEconomies/ We e4amined the stages of acrisis in an ad-anced economy" We furthere4amined the J%&K% ("S" Financial Crisis"



Chapter +$$ary /cont.

Dynamics of Financial Crises in Emerging0arket Economies/ Finally' )e alsoe4amined the stages of a crisis in emerging

economies' contrasting those )ithad-anced economies" We e4amined actualcrises in 0e4ico' East Asia' and Argentina"

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C08 Financial Markets