C. 9 Financial Crises Flashcards
Financial frictions
Asymmetric information problems which act as a barrier to efficient allocation of capital
Financial crisis
When information flow in financial markets experience a particularly large disruption, which the result that financial frictions increase sharply and financial markets stop functioning. Then, the economy collapses
Financial liberization
The elimination of restrictions on financial markets and institutions
Credit boom
When financial institutions go on a lending spree
Stages of financial cresis
1) Initial Phase
2)
3) (sometimes)
Deleveraging
When financial institutions with reducing capital cut back on their lending to borrower-spenders
Stages of financial cresis
1) Initial Phase
2) Banking Crisis
3) (sometimes) Debt Deflation
Consequences of the initial phase
- Adverse Selection
- Moral hazard problems worsen
- Lending contracts
Loans become scarce, so borrower-spenders aren’t able to fund productive investments and decrease spending which causes the economy to contract
Fundamental economic value
Value based on realistic expectatons of the assets’ future income streams
Initial phase
Increase in uncertainty, asset-price decline, and deterioration in FI’s balance sheets lead to:
- Adverse Selection
- Moral hazard problems worsen
- Lending contracts
Loans become scarce, so borrower-spenders aren’t able to fund productive investments and decrease spending which causes the economy to contract
Banking Crisis
Economic activity declines
- > Banking crisis
- > Adverse selection, moral hazard problems worsen, and lending contracts
- > Economic activity declines
Debt Deflation
Unanticipated decline in price level
- > Adverse selection, moral hazard problems worsen, and lending contracts
- > Economic activity declines
Insolvency
Net worth becomes negative
Fire sales
Banks sell of assets quickly to raise the necessary funds
Bank panic
Multiple banks fail simultaneously
Debt deflation
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
Credit spread
The difference between the interest rate on loans and households and businesses and the interest rate on completely safe assets that are sure to be paid bank
Causes of 2007-2009 financial crisis
1) Financial innovation in mortgage markets
2) Agency problems in mortgage markets
3) Asymmetric information in credit-rating process
Financial engineering
The development of new, sophisticated financial instruments
Structured credit products
Paid out income streams from a collection of underlying assets, designed to have particular characteristics that appealed to investors with differing preferences
Principal-agent problem in mortgage markets
Principal-agent problem: Mortgage brokers didn’t evaluate thoroughly if borrowers could pay their loans back because they were quick to sell the loans to investors in the form of mortgage-backed securities. The mortgage brokers acted as agents for the investors (principals) but didn’t have the investors’ best interests at heart.
Adverse selection problem in mortgage markets
Risk-loving real-estate 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
Financial derivatives
Financial instruments whose payoffs are derived from previously issued securities
Credit default swap
A financial derivative that provides payments to holders of bonds if they default
Asymmetric information and credit-rating agencies
Rating agencies were subject to conflicts of interest because the large fees they earned from advising clients on how to structure products that they rated, meant they didn’t have enough incentive to make accurate ratings (like a soul)
The impact of the 2007-2009 crisis was most evident in five key areas
1) US residential housing market
2) FIs’ balance sheets
3) The shadow banking system
4) Global financial markets
5) The headline grabbing failures of major firms in the financial industry
Shadow banking system
Composed of hedge funds, investment banks, and other nondepository financial firms which are not as tightly regulated as banks are
Repurchase agreements (repos)
Short-term borrowing that, in effect, uses assets like mortgage-backed securities as collateral
Haircuts
A larger amount of collateral on a repo. E.g. $100M loan taken out in a repo, and borrower has to post $105M of collateral. -> 5% haircut
The early symptom of the US subprime crisis in Canada
The freezing of the asset-backed commercial paper market (ABCP) in August 2007 causing a sharp decrease in liquidity in short-term Canadian credit markets.
The Canadian version of subprime mortgages
High-risk, zero down, long term (40 years) mortgages in 2007 and 2008 when the conservative govt opened up the mortgage market to big US players.
Why was Canada spared the worst of the financial crisis?
1) More tightly regulated
2) Bank regulations revised every five years
3) Financial institutions work in harmony together
4) Traditionally more conservative in their lending
5) Well diversified and are not limited to traditional retail banking (e.g. can hire investment brokers) but these extra arms are still tightly regulated
6) Canadian banks hold a large portion of their mortgages and these mortgages are not as securitized (1/3) as the U.S. banks’ ones (2/3). This gives banks incentives to make sure their mortgage loans are good loans
Why was Canada spared the worst of the financial crisis?
1) More tightly regulated
2) Bank regulations revised every five years
3) Financial institutions work in harmony together
4) Traditionally more conservative in their lending
5) Well diversified and are not limited to traditional retail banking (e.g. can hire investment brokers) but these extra arms are still tightly regulated
6) Canadian banks hold a large portion of their mortgages and these mortgages are not as securitized (1/3) as the U.S. banks’ ones (2/3). This gives banks incentives to make sure their mortgage loans are good loans
7) Canadian laws allow banks to go after other assets when a borrower walks away from a mortgage, making them less likely to do so
