Chapter 12: Financial Crises and the Subprime Meltdown

Question 1

financial crisis occurs …

Answer 1

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.

Question 2

investment bubbles

Answer 2

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.

Question 3

factors causing financial crises (in order-> is a loop!)

Answer 3

1. Asset market effects on balance sheets
2. Deterioration in Financial Institutions Balance sheet
3. Banking crisis
4. increases in uncertainty
5. increases in interest rates
6. government fiscal imbalances

Question 4

asset market effects on balance sheets

Answer 4

1. Stock market decline
2. unanticipated decline in the price level
3. unanticipated decline in the value of domestic currency
4. asset write downs

Question 5

1. Stock Market Decline

Answer 5

• 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

Question 6

2. Unanticipated Decline in the Price Level

Answer 6

• 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

Question 7

3. Unanticipated Decline in the Value of the Domestic Currency

Answer 7

• 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.

Question 8

4. Asset write-downs

Answer 8

• 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.

Question 9

Deterioration in Financial Institutions’ Balance Sheet

Answer 9

FI: deterioration in balance sheet

• > substantial contraction and their capital
• > banks lending declines
• > decline in spending
• > slowing economic activity

Question 10

Bank Panic

Answer 10

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.

Question 11

Increases in Uncertainty

Answer 11

Increase in uncertainty in Financial Markets

• > Increases difficultyto screen credit risk
• > Decline in lending, investment and economic activity

Question 12

Increases in Interest Rates

Answer 12

1. High interest rates
2. More bad credit risk
3. Decline in lending

Question 13

Government Fiscal Imbalances

Answer 13

• 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

Question 14

Stages of Dynamics of Financial Crises

Answer 14

Stage 1: Initiation of a Financial Crisis
Stage 2: Banking Crisis
Stage 3: Debt Deflation

Question 15

Stage One: Initiation of a Financial Crisis

Answer 15

• 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

Question 16

Stage two: Banking Crisis

Answer 16

• 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

Question 17

Stage three: Debt Deflation

Answer 17

• 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

Question 18

• Financial innovations emerge in the mortgage markets:

Answer 18

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.

Question 19

FYI Collateralized Debt Obligations (CDOs)

Answer 19

• 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.

Question 20

different qualities tranches

Answer 20

• 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.

Question 21

Housing price bubble forms

Answer 21

• Increase in liquidity from cash flows surging to the United States
• Development of subprime mortgage market fueled housing demand and
housing prices

Question 22

Agency problems arise

Answer 22

• “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

Question 23

Housing price bubble bursts

Answer 23

• 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.