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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/
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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