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Financial Crises and the Subprime Meltdown

Chapter 9

Financial Crisis
A financial crisis happens when there is sharp declines in asset prices and widespread bankruptcies. Financial crises occur when there is a sharp increase in adverse selection and moral hazard.

Financial Crises: A sharp increase in asymmetric information that cripples the financial system

Causes of Financial Crisis

Increases in interest rates: Riskier investors remain in the market while safer ones exit. Increases in uncertainty: A major failure increases the uncertainty and inability of the lenders to gauge the creditworthiness of borrowers.

Balance sheet deterioration: Decline in asset values, rise in liabilities, decline in net worth.
Banking sector problems: Deterioration of bank balance 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.
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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Unanticipated deflation raises liabilities.


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 increases real 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.

Deterioration of the balance sheets of the banks impede intermediation

Financial institutions provide loans for economic activity. Deterioration makes loans less available. Recession.

Banking Crisis

If financial institutions have severe deterioration of balance sheet, bank panic may occur when multiple banks fail simultaneously. In the absence of deposit insurance 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 financial intermediation, shrinking of the supply of funds, higher interest rates, asymmetric information problems, severe contraction in economic activity.

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 leads to contraction.

Increases in Interest Rates


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

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Government Fiscal Imbalances: sovereign risk increases


Increase government debt, especially foreign debt, raises fears of default

Government can't find lenders and forces banks to buy the bonds

If government default fears emerge, government bonds lose value, their interest 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 a lending 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/

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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-b87d0000779fd2ac.html?nclick_check=1 Paul Krugman: http://www.nytimes.com/2009/09/06/magazine/06Economict.html?_r=1&pagewanted=all Brooksley Born: http://www.pbs.org/wgbh/pages/frontline/warning/view/?utm_campaign=homepa ge&utm_medium=top5&utm_source=top5 29