Chapter 8

financial frictions- barrier to channeling funds efficiently from savers to households and firms with productive
investment opportunities.
Credit spread, the difference between the interest rate on loans to businesses and the
interest rate on completely safe assets that are sure to be paid back.
financial crisis occurs when information flows in financial markets experience large disruption, with the result
that financial frictions and credit spreads increase sharply and financial markets stop functioning.

Stage One: Initiation of Financial Crisis

1) Credit Boom and Bust
a) economy introduces new types of loans or other financial products, known as financial innovation
b) countries engage in financial liberalization, the elimination of restrictions on financial markets and
institutions
c) prompt financial institutions to go on a lending spree, called a credit boom
d) Government safety nets, such as deposit insurance, weaken market discipline and increase the moral
hazard incentive for banks to take on greater risk than they otherwise would.
e) lender-savers know that government-guaranteed insurance protects them from losses, they will
supply even undisciplined banks with funds
f) financial institutions can make risky, high-interest loans to borrower-spenders and walk away with
nice profits if the loans are repaid, and rely on government deposit insurance, funded by taxpayers, if
borrower-spenders default.
g) With less capital, these financial institutions cut back on their lending to borrower-spenders, a
process called deleveraging.
h) with less capital, banks and other financial institutions become riskier, causing lender-savers and
other potential lenders to these institutions to pull out their funds
i) Fewer funds means fewer loans to fund productive investments and a credit freeze
j) lending boom turns into a lending crash
k) financial institutions stop collecting information and making loans, financial frictions rise, limiting the
financial system’s ability to address the asymmetric information problems of adverse selection and
moral hazard.
l) As loans become scarce, borrower-spenders are no longer able to fund their productive investment
opportunities and they decrease their spending, causing economic activity to contract.
2) Asset-Price Boom and Bust
a) The rise of asset prices above their fundamental economic values is an asset-price bubble
b) When the bubble bursts and asset prices realign with fundamental economic values, stock and real
estate prices tumble, companies see their net worth decline, and the value of collateral they can
pledge drops.
c) Now these companies have less at stake because they have less “skin in the game” and so they are
more likely to make risky investments because they have less to lose, the problem of moral hazard
d) decline in the value of financial institutions’ assets, thereby causing a decline in their net worth and
hence a deterioration in their balance sheets, which causes them to deleverage, steepening the
decline in economic activity.
3) Increase in Uncertainty
a) With information hard to come by in a period of high uncertainty, financial frictions increase, reducing
lending and economic activity.

Stage Two: Banking Crisis

i) Deteriorating balance sheets and tougher business conditions lead some financial
institutions into insolvency, when net worth becomes negative, some banks go out of business.
ii) bank panic, in which multiple banks fail simultaneously.
iii) Bank run - In panic, depositors withdraw their deposits making banks fail.
iv) Fire sales- force banks to sell off assets quickly to raise the necessary funds, may cause it to become
insolvent.

Stage Three: Debt Deflation

i) debt deflation occurs when a substantial unanticipated decline in the price level sets in, leading to a
further deterioration in firms’ net worth because of the increased burden of indebtedness.
ii) substantial decline in real net worth of borrowers causes an increase in adverse selection and moral
hazard problems facing lenders.
iii) Lending and economic activity decline for a long time.

The Great Depression

1) Stock Market Crash

a) To curb speculation, they pursued a tightening of monetary policy to raise interest rates to limit the
rise in stock prices. Stock markets crashed.
2) Bank Panics
a) severe droughts in the Midwest led to a sharp decline in agricultural production, with the result that
farmers could not pay back their bank loans
b) The weakness of the economy and the banks in agricultural regions in particular prompted substantial
withdrawals from banks, building to a full-fledged panic
c) US President declared a bank holiday, a temporary closing of all banks while 1/3 commercial Banks
failed.
3) Continuing Decline in Stock Prices
a) increase in uncertainty from the unsettled business conditions created by the economic contraction
worsened adverse selection and moral hazard problems in financial markets.
b) With a greatly reduced number of financial intermediaries still in business, adverse selection and
moral hazard problems intensified even further.
c) lenders began charging businesses much higher interest rates to protect themselves from credit
losses causing high credit spread.
4) Debt Deflation
a) 25% decline in the price level causing debt deflation
b) This deflation short-circuited the normal recovery process that occurs in most recessions
c) resulting increase in adverse selection and moral hazard problems in the credit markets led to a
prolonged economic contraction in which unemployment rose to 25% of the labor force.
5) International Dimensions
a) Bank panics in the United States also spread to the rest of the world, and the contraction of the U.S.
economy sharply decreased the demand for foreign goods.
b) resulting discontent led to the rise of fascism and World War II

2007–2009 Financial Crisis

1) Financial Innovation in the Mortgage Markets

a. Advances in computer technology and new statistical techniques, known as data mining,
however, led to enhanced, quantitative evaluation of the credit risk for a new class of risky
residential mortgages
b. New Credit Scoring System FICO covered CC customers also.
c. by lowering transactions costs, computer technology enabled the bundling of smaller loans (like
mortgages) into standard debt securities, a process known as securitization.
d. These factors made it possible for banks to offer subprime mortgages to borrowers with less-
than stellar credit records.
 e. cheaply quantify the default risk of the underlying high-risk mortgages and bundle them in
standardized debt securities (mortgage backed securities).
f. Financial engineering, the development of new, sophisticated financial instruments, led to
structured credit products that pay out income streams from a collection of underlying assets,
designed to have particular risk characteristics that appeal to investors with differing preferences.
E.g. collateralized debt obligations (CDOs)
g. Structured products like CDOs, CDO2s, and CDO3s can get so complicated that it can be hard to
value cash flows of the underlying assets for a security or to determine who actually owns these
assets
2) Agency Problems in the Mortgage Markets
a. The original mortgage brokers do not make a strong effort to evaluate whether the borrower
could pay off the loan as they want to sell of the loans to investors in the form of mortgage-
backed securities.
b. This originate-to-distribute business model was exposed to principal–agent (agency) problems.
c. Risk-loving investors lined up to obtain loans to acquire houses that would be very profitable if
housing prices went up, knowing they could “walk away” if housing prices went down.
d. principal–agent problem also created incentives for mortgage brokers to encourage households
to take on mortgages they could not afford or to commit fraud by falsifying information on a
borrower’s mortgage applications in order to qualify them for mortgages.
e. lax regulation of originators, who were not required to disclose information to borrowers that
would have helped them assess whether they could afford the loans.
f. Commercial and investment banks, which were earning large fees by underwriting mortgage-
backed securities (credit default swaps) and structured credit products like CDOs, also had
weak incentives to make sure that the ultimate holders of the securities would be paid off.
3) Asymmetric Information and Credit-Rating Services
a. The rating agencies advised clients on how to structure complex financial instruments while
doing rating.
b. subject to conflicts of interest as they got good fees for advising.
c. result was wildly inflated ratings that enabled the sale of complex financial products that were far
riskier than investors recognized

Effects of the 2007–2009 Financial Crisis

1. Residential Housing Prices: Boom and Bust

2. Deterioration of Financial Institutions’ Balance Sheets
3. Run on the Shadow Banking System
a. The sharp decline in the value of mortgages and other financial assets triggered a run on
the SBS (hedge funds, investment banks, and other non -depository financial firms,
which are not as tightly regulated as banks).
b. These securities were funded primarily by repurchase agreements (repos), short-term
borrowing that, in effect, uses assets like mortgage-backed securities as collateral
c. Rising concern about the quality of a financial institution’s balance sheet led lenders to
require larger amounts of collateral, known as haircuts
4. Global Financial Markets
5. Failure of High-Profile Firms