Chapter 12: Financial Crises and the Subprime Meltdown Flashcards
financial crisis occurs …
when there is a particularly large disruption to information flows in financial markets, with the result that financial friction increase sharply and financial markets stop functioning.
investment bubbles
A bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. Occur when prices for a particular item rise far above the item’s real value.
factors causing financial crises (in order-> is a loop!)
- Asset market effects on balance sheets
- Deterioration in Financial Institutions Balance sheet
- Banking crisis
- increases in uncertainty
- increases in interest rates
- government fiscal imbalances
asset market effects on balance sheets
- Stock market decline
- unanticipated decline in the price level
- unanticipated decline in the value of domestic currency
- asset write downs
- Stock Market Decline
• Net worth of the corporation falls
• Lenders are less willing to lend
• Investment and aggregate output will decline
• Firms make more risky investments, which will make lending
less attractive
- Unanticipated Decline in the Price Level
• Many debt contracts with fixed rates have long maturities
• Unanticipated declines in the price level decreases the net
worth of firms
• Raise value of borrowing firms’ liabilities in real terms
• Leads to a drop in lending and economic activity
- Unanticipated Decline in the Value of the Domestic Currency
• Because of uncertainty of value of domestic currency, it is often
easier to issue debt denominated in foreign currencies.
• Unanticipated decline in the value of the domestic currency, the
debt burden of domestic firms increases.
- Asset write-downs
• Asset prices declines lead to a write-down of the asset side of
the balance sheet of a financial institution.
• This leads to a contraction of lending.
Deterioration in Financial Institutions’ Balance Sheet
FI: deterioration in balance sheet
- > substantial contraction and their capital
- > banks lending declines
- > decline in spending
- > slowing economic activity
Bank Panic
when multiple banks fall simultaneously.
• Leads to decrease in bank lending and decrease in supply of
funds available to borrowers, and to higher interest rates.
Increases in Uncertainty
Increase in uncertainty in Financial Markets
- > Increases difficultyto screen credit risk
- > Decline in lending, investment and economic activity
Increases in Interest Rates
- High interest rates
- More bad credit risk
- Decline in lending
Government Fiscal Imbalances
• Fear of default on government debt
e.g. Eurozone sovereign debt crisis GIIPS (-> in Greece, Irland, Italy, Portugal and Spain)
• Demand from individual investors for government bonds may
fall, causing governments to force banks to buy it
• Debt falls in price and weaken balance sheet of banks, that will
have to contract lending
Stages of Dynamics of Financial Crises
Stage 1: Initiation of a Financial Crisis
Stage 2: Banking Crisis
Stage 3: Debt Deflation
Stage One: Initiation of a Financial Crisis
- Credit Boom and Bust: Mismanagement of financial liberalization/innovation leading to asset price boom and bust
- Asset-price Boom and Bust
- Spikes in Interest Rates
- Increase in Uncertainty
Stage two: Banking Crisis
• Fire sales of assets may cause their prices to decline so much that more banks become insolvent and the resulting contagion can then lead to multiple bank failures and full fledged bank panic
Stage three: Debt Deflation
• Substantial unanticipated decline in the price level sets in
leading to a further deterioration in firm’s net worth
because of the increased burden of indebtedness
• Financial innovations emerge in the mortgage markets:
structured credit products that paid out income streams
from a collection of underlying assets, designed to have a
particular risk characteristics that appealed to investors
with differing preferences.
FYI Collateralized Debt Obligations (CDOs)
• The creation of a collateralized debt obligation involves a corporate
entity called a special purpose vehicle (SPV) that buys a collection of
assets such as corporate bonds and loans, commercial real estate
bonds, and mortgage-backed securities.
• The SPV separates the payment streams (cash flows) from these assets
into buckets that are referred to as tranches.
different qualities tranches
• The highest rated tranches, referred to as super senior tranches are
the ones that are paid off first and so have the least risk.
• The lowest tranche of the CDO is the equity tranche and this is the first
set of cash flows that are not paid out if the underlying assets go into
default and stop making payments. This tranche has the highest risk
and is often not traded.
Housing price bubble forms
• Increase in liquidity from cash flows surging to the United States
• Development of subprime mortgage market fueled housing demand and
housing prices
Agency problems arise
• “Originate-to-distribute” model is subject to principal-(investor) agent
(mortgage broker) problem
• Borrowers had little incentive to disclose information about their ability to
pay
• Commercial and investment banks (as well as rating agencies) had weak
incentives to assess the quality of securities
Housing price bubble bursts
• After a sustained boom, housing prices began a long decline
beginning in 2006.
• The decline in housing prices contributed to a rise in defaults on
mortgages and a deterioration in the balance sheet of financial
institutions.
• This development in turn caused a run on the shadow banking
system.
