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Financial Crises and the Subprime MeltdownChapter 9 1

Problems and
Short-Answer Questions
PRACTICE PROBLEMS
1. Explain how each of the following events affects the state of a
borrowering firms balance sheet, and thus how it affects the
severity of asymmetric information problems in the financial
system.
a. A decline in the stock market
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b. An unanticipated decline in the price level
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c. An unanticipated decline in the value of the domestic
currency
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d. A write-down in the value of assets
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2. The following questions address debt deflation.
a. What is debt deflation?
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b. How does debt deflation affect economic activity? Explain.
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c. What event in U.S. history is the greatest example of debt
deflation?
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d. How much did prices fall during this period? What was the
rate of unemployment during this period?
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3. The following questions address the subprime mortgage crisis.
a. What is a subprime mortgage?
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b. What is a mortgage-backed security?
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c. Explain the agency problem in the originate-to-distribute
business model.
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d. How did the factors described in a, b, and c combine to create
a housing price bubble?
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Financial Crises and the Subprime MeltdownChapter 9 3

e. What happens when an asset bubble pops?


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SHORT-ANSWER QUESTIONS
1. Why does an increase in adverse selection and moral hazard
reduce aggregate economic activity?
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2. Why do financial crises in emerging market economies tend to be
more severe compared to those in developed economies?
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3. How can a governments fiscal imbalance cause a financial crisis?
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4. How can a spike in interest rates cause a financial crisis?
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5. What type of crisis is common to all U.S. financial crises? Why?
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4Chapter 9Financial Crises and the Subprime Meltdown

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6. Why does a financial crisis often begin with financial liberalization
or innovation?
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7. Does a government safety net increase or decrease adverse
selection and moral hazard? Explain.
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8. What was the source of the recent subprime financial crisis?
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Critical Thinking
You are watching a financial news show on CNN with your
roommate. The commentator is discussing the recent subprime
financial crisis in the United States. Your roommate says, I dont
know why we are having difficulty figuring out the causes and cures
for our financial crisis. There was a financial crisis in Russia in 1998
and in Argentina 2001-2002. Why dont we just study their crises
and copy their solutions. All of these financial crises are the same.
1. What is an emerging market economy?
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2. What was the main source of the financial crises in Russia and
Argentina in the late 1990s and early 2000s?
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3. What was the main source of the most recent subprime financial
crises in the United States?
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Financial Crises and the Subprime MeltdownChapter 9 5

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4. Are the sources of financial crises (and therefore the solutions to
financial crises) the same in countries at different levels of
development? Explain.
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Self-Test
TRUE/FALSE QUESTIONS
_____1. An increase in adverse selection and moral hazard in the
credit markets tends to increase bank lending.
_____2. An increase in interest rates tends to drive high risk
borrowers from the loan market, reducing adverse selection
and moral hazard.
_____3. Financial crises often begin with financial liberalization or
innovation.
_____4. An unanticipated decline in the price level raises the real
burden of a firms debt payments when these debt payments
are fixed in nominal terms.
_____5. An increase in adverse selection and moral hazard increases
the lenders screening and monitoring costs, thereby reducing
the amount of loans extended.
_____6. A government safety net in the credit markets that
guarantees a borrowers repayment, causes banks to be more
conservative in their lending practices, and thus reduces their
risk exposure.
_____7. Sooner or later, an asset-price bubble must burst because the
price of an asset cannot stay above its fundamental value
forever.
_____8. The originate-to-distribute business model reduces agency
problems in the mortgage market.
_____9. The securitization of mortgages reduces the risk that the
securitized mortgages will default.

6Chapter 9Financial Crises and the Subprime Meltdown

_____10. A subprime loan is a loan for which the interest rate is below
the prime rate.
_____11. Financial crises in emerging market economies are often
more severe than those in more developed economies.
_____12. In an emerging market economy, the concurrent crises of a
financial crisis and a currency crisis are often referred to as
the twin crises.
_____13. Events that reduce the net worth of a borrowing firm reduce
the firms capital, effectively reducing the borrowing firms
collateral and increasing adverse selection and moral hazard.
_____14. A reduction in the value of a countrys currency improves the
condition of domestic firms balance sheets and reduces the
risk of default on loans.
_____15. Bank panics are a feature of all financial crises in emerging
market economies, but bank panics have never been
associated with a financial crisis in the United States.

MULTIPLE-CHOICE QUESTIONS
1. Borrowers with risky investment projects have the greatest
desire to borrow, creating a problem known as
a. uncertainty.
b. interest rate risk.
c. adverse selection.
d. moral hazard.
2. After a borrower receives a loan, the borrower has an incentive
to use the loan in a riskier fashion than specified in the loan
contract, creating a problem known as
a. financial engineering.
b. deleveraging.
c. adverse selection.
d. moral hazard.
3. Which of the following does not cause a reduction in the net
worth of the borrowing firm in a loan market?
a. a decline in the stock market that reduces the value of the
firm
b. an unanticipated increase in the price level that reduces the
value of the firms liabilities
c. an unanticipated decline in the value of the domestic
currency when the firms debt is denominated in terms of a
foreign currency
d. asset write-downs on the firms balance sheet
4. Financial crises

Financial Crises and the Subprime MeltdownChapter 9 7

a.
b.
c.
d.

are prevalent in all industrial economies.


only occur in emerging market economies.
rarely have an impact on aggregate economic output.
tend to be more severe in financially advanced countries.

5. Which of the following is an example of debt deflation?


a. A credit boom deflates into a credit crunch.
b. An unanticipated decrease in the price level increases the
burden of indebtedness.
c. There is a write-down in the value of assets.
d. An asset-price bubble bursts and deflates.
6. A subprime mortgage is
a. a loan with a lower-than-prime interest rate.
b. a securitized loan.
c. denominated in a foreign currency.
d. a loan to someone with less-than-excellent credit.
7. The recent subprime financial crisis began with
a. mismanagement of financial innovations in the subprime
residential mortgage market.
b. a spike in interest rates for subprime borrowers.
c. an excessive government fiscal imbalance where the
government forced banks to buy its subprime bonds.
d. the bailout of subprime Wall Street firms.
8. Financial crises in emerging market economies tend to be more
severe than in financially advanced economies because
a. there is weaker financial supervision in emerging market
economies.
b. bankers in emerging market economies are less experienced
with screening and monitoring for adverse selection and
moral hazard.
c. bank panics are more crippling to an emerging market
economy because the financial markets are less developed.
d. all of the above
9. Securitization is a process by which
a. deposits are insured by the FDIC against default.
b. loans are insured against default.
c. loans are bundled into standardized securities.
d. securities are rated as investment grade or less-thaninvestment grade.
10. The main problem with the originate-to-distribute business model
for mortgage lending is that
a. the interest rate is driven so high that borrowers default.
b. it reduces funds flowing into the mortgage market.
c. it is subject to a significant principle-agent problem.
d. it only works efficiently when packaging subprime mortgages.
11. What economic process is believed to have caused the Great
Depression to last so long?

8Chapter 9Financial Crises and the Subprime Meltdown

a.
b.
c.
d.

debt deflation
securitization
the stock market crash
the bursting of the asset-price bubble

12. Regardless of the original source of the financial crisis, all credit
booms end in a credit crash because of
a. corruption in the mortgage industry.
b. an increase in adverse selection and moral hazard in the loan
market.
c. massive government deficits.
d. collateralized debt obligations.
13. Why does a financial crisis ultimately cause a substantial
reduction in economic activity?
a. The government responds to the crisis with excessive
regulation.
b. Only corrupt bankers survive the crisis.
c. The financial crisis causes a fiscal deficit.
d. The resulting credit crash severely reduces investment for
productive activities.
14. Which of the following is unlikely to cause a reduction in lending?
a. a decline in the stock market
b. a bank panic
c. a decrease in interest rates
d. an unanticipated decline in the price level
15. In an emerging market economy, what two types of financial
crises are often referred to as the twin crises?
a. a banking crisis and a currency crisis
b. a fiscal crisis and a monetary crisis
c. an asset crisis and a liability crisis
d. a lending crisis and a borrowing crisis
16. Which of the following is one of the main sources of a financial
crisis in an emerging market economy?
a. excessive government regulation
b. a restriction on the extension of credit
c. severe government fiscal imbalances
d. all of the above
17. Which of the following has not been a source of past financial
crises in the United States?
a. severe government fiscal imbalances
b. mismanagement of financial liberalization or innovation
c. a spike in interest rates
d. the bursting of an asset-price bubble
18. Deleveraging occurs when banks
a. increase their lending.
b. contract their lending.
c. increase their capital.

Financial Crises and the Subprime MeltdownChapter 9 9

d. reduce the interest rates they charge on loans.


19. Which of the following statements is true when there is an
increase in adverse selection and moral hazard in the loan
market?
a. Banks tend to lend more, which generates an asset-price
bubble.
b. Banks tend to reduce interest rates.
c. Banks tend to reduce lending because fewer firms want to
borrow.
d. Banks tend to reduce lending because they cannot separate
good credit risks from bad ones as efficiently.
20. Severe government fiscal imbalances may cause a financial crisis
because the fiscal imbalance may cause the government to
a. increase taxes.
b. decrease spending.
c. sell high-risk government securities to domestic banks.
d. restrict financial innovations.