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Financial Crises and theSubprime Meltdown

Chapter 9

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Financial Crisis

A financial crisis happens when there issharp declines in asset prices and

widespread bankruptcies.

Financial crises occur when there is asharp increase in adverse selection and

moral hazard.

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Financial Crises: A sharp

increase in asymmetric

information that cripples the

financial system

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Causes of Financial Crisis

Increases in interest rates: Riskier investors

remain in the market while safer ones exit.

Increases in uncertainty: A major failure increasesthe uncertainty and inability of the lenders togauge the creditworthiness of borrowers.

Balance sheet deterioration: Decline in assetvalues, rise in liabilities, decline in net worth.

Banking sector problems: Deterioration of bankbalance sheets.

Government deficits: Possibility of default.

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Balance Sheet Deterioration

Stock market crash lowers the net worth of

corporations.

Adverse selection increases because the potential

losses to lenders are higher.

Moral hazard increases because borrowers have more

incentives to engage in risky behavior.

Unanticipated deflation raises liabilities.

Debt is usually long-term, fixed interest rate.

Falling prices raise the real value of nominal debt. Assets are usually real, so they do not gain value.

Net worth declines.

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Balance Sheet Deterioration

Exchange rate risk may deteriorate balance

sheets.

If contracts are denominated in foreign

currency, any unanticipated devaluation or

depreciation of domestic currency increasesreal value of debt.

Assets are usually denominated in domestic

currency.

Rise in interest rates may increase interest

payments by debtors.

Cash flow will fall lowering the liquidity of the

firm.

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Deterioration of the balance

sheets of the banks impede

intermediation Financial institutions provide loans for

economic activity. Deterioration makesloans less available. Recession.

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Banking Crisis

If financial institutions have severe deterioration ofbalance sheet, bank panic may occur when multiplebanks fail simultaneously. In the absence of depositinsurance asymmetric information about banks loan

portfolio spurs a panic. When banks fail their accumulated information that

allows them to make loans to firms also evaporates.There is a loss of information production, loss of financialintermediation, shrinking of the supply of funds, higher

interest rates, asymmetric information problems, severecontraction in economic activity.

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Increases in Uncertainty

Failure of a prominent institution,

recession, stock market crash make it

hard for lenders to screen good from bad

credit risks. Asymmetric information leadsto contraction.

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Increases in Interest Rates

Higher interest rates eliminates low riskventures and keeps the high riskones. Adverse selection.

Increases in interest rates squeezes cashflow: receipts down, payments up. Highcash flow firms can finance projectsinternally, low cash flow requires outsidefinancing. Adverse selection and moralhazard increase, less lending, recession.

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Government Fiscal

Imbalances: sovereign

risk increases

Increase government debt,

especially foreign debt, raisesfears of default

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Government can't find

lenders and forces banks to

buy the bonds If government default fears emerge,

government bonds lose value, theirinterest rate rise. Institutions holding

these bonds see their asset value decline

Balance sheets deteriorate

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Foreign exchange crisis

Banks liabilities in foreign currency expand

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Mexican Financial Crisis of 94-95

Deregulation of financial markets led to alending boom.

Unperforming loans increased causing a

decline in net worth of banks.

Weak supervision of regulators

Inability to monitor borrowers

Lending slowed (tight credit market).

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

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

moral hazard.

Assassinations and uprisings increased

uncertainty.

Stock market crashed reducing net worth.

Firms had incentives to undertake risky investments

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

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

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

removed.

Inflation in 1990-95 period had fallen to 15.5%from 70.4% during 1980-90 period but it still was

significantly higher than the US to which the

peso was pegged.

From 1980 to 1995 trade as a percentage of

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 Crises

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Third World Financial Crises

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http://timeline.stlouisfed.org/

http://timeline.stlouisfed.org/http://timeline.stlouisfed.org/

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ABCP Asset-Backed Commercial Paper

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Amartya Sen: http://www.nybooks.com/articles/22490?

Martin Wolf: http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-

0000779fd2ac.html?nclick_check=1

Brooksley Born:

http://www.pbs.org/wgbh/pages/frontline/warning/view/?utm_campaign=homepa

ge&utm_medium=top5&utm_source=top5

Paul Krugman: http://www.nytimes.com/2009/09/06/magazine/06Economic-

t.html?_r=1&pagewanted=all

http://www.nybooks.com/articles/22490http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-0000779fd2ac.html?nclick_check=1http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-0000779fd2ac.html?nclick_check=1http://www.pbs.org/wgbh/pages/frontline/warning/view/?utm_campaign=homepage&utm_medium=top5&utm_source=top5http://www.pbs.org/wgbh/pages/frontline/warning/view/?utm_campaign=homepage&utm_medium=top5&utm_source=top5http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1&pagewanted=allhttp://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1&pagewanted=allhttp://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1&pagewanted=allhttp://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1&pagewanted=allhttp://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1&pagewanted=allhttp://www.pbs.org/wgbh/pages/frontline/warning/view/?utm_campaign=homepage&utm_medium=top5&utm_source=top5http://www.pbs.org/wgbh/pages/frontline/warning/view/?utm_campaign=homepage&utm_medium=top5&utm_source=top5http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-0000779fd2ac.html?nclick_check=1http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-0000779fd2ac.html?nclick_check=1http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-0000779fd2ac.html?nclick_check=1http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-0000779fd2ac.html?nclick_check=1http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-0000779fd2ac.html?nclick_check=1http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-0000779fd2ac.html?nclick_check=1http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-0000779fd2ac.html?nclick_check=1http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-0000779fd2ac.html?nclick_check=1http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d-0000779fd2ac.html?nclick_check=1http://www.nybooks.com/articles/22490