Financial Crises: Causes

Question 1

Timeline of the GFC

Answer 1

○ Summer 2007 – Rising defaults in subprime mortgages ○ Autumn 2007 – Failure of 2 large hedge funds and the Northern Rock Bank (NRB) Run
○ Summer 2008 – Fannie Mae and Freddie Mac nationalized
○ September 2008 – Bankruptcy of Lehman Brothers
○ October 2008 – Bank bailout program
○ Autumn 2008 – Spring 2009 – Crisis transmitted to the real economy. There was a global credit crunch and banks stopped lending to firms and consumers, leading to the worst downturn since the Great Depression

Question 2

2 Popular Misconceptions of causes of the GFC

Answer 2

1. Subprime mortgages caused the crisis – in reality, the causes of the crisis were far more fundamental and structural
2. reckless greed and risk-taking

Question 3

Laeven and Valencia (IMF, 2013):

Answer 3

Financial crises have led affected economies into deep recessions. They have often been preceded by excessive credit booms. Most of the recessions studied were preceded by credit booms. The credit boom eventually led to a financial crisis, or at least there is a correlation between credit booms and financial crises

Question 4

Claessens, Kose, and Terrones (IMF, 2008)

Answer 4

• In countries that simultaneously experienced a house-price bubble and a credit boom, the credit boom was much more pronounced

Question 5

A speculative asset price bubble occurs when

Answer 5

Asset prices depart significantly from their fundamental value

Question 6

fundamental value of an asset

Answer 6

the fundamental value of an asset depends on the stream of cashflows generated by that asset in the future. You can think of the fundamental value as the long-run equilibrium value of the asset at the intersection of long-run supply and long-run demand.

Question 7

During 1997 – 2006, US house prices increased by ___%

Answer 7

132

Question 8

How do fundamentals increase?

Answer 8

Fundamentals increase with things like better technology or population growth, or finding new physical assets (oil, coal, etc.)

Question 9

Explain the anatomy of the price-optimism feedback loop

Answer 9

house prices rise > inducing optimism, increased investment through leveraging > investors make capital gains on speculative investments > demand for housing increases, leading to higher prices. Banks also extend more credit, leading to more borrowing and higher prices

Question 10

Explain the “excessive optimism” part of the price-optimism feedback loop

Answer 10

• An asset price bubble occurs through misperception that rising prices are driven by fundamentals, when in reality they are driven by speculation, one of the price-optimism feedback loop components
  
  • Sustained asset price inflation generates excessive optimism that an improvement in fundamentals has occurred
  • This is compounded by “new era” stories – there is always some story that accompanies bubbles that convinces people that fundamentals have improved (when they really have not) – the great moderation

Question 11

What was the Great Moderation and how did it feed into the POFL?

Answer 11

people became convinced due to a period of unprecedented macroeconomic stability that the business cycle was dead and risk had been vanquished.

Question 12

Leveraging

Answer 12

Leveraging is the use of borrowed funds for the purpose of investment in houses or financial assets. You take out a loan and use it to purchase a house in anticipation that prices will increase. Once prices increase, you sell, get your capital gains, repay the loan and are left with the profit. To ensure that borrowers repay their loans, banks require they post collateral, usually their house.

Question 13

The Passive Credit View (Foote et al., 2012)

Answer 13

Under the passive-credit view, credit growth was an effect of the housing bubble and was demand driven. In this point of view, banks were not to blame – they simply responded to the increasing demand for leveraging. They were innocent bystanders, and it was the speculators who were at fault

Question 14

Active Credit Views (Mian and Sufi, 2014)

Answer 14

Under the active-credit view, credit growth was directly driven by the banks and the housing price bubble was a response to this (supply driven)

Question 15

Was the active or passive credit view correct and how do we know?

Answer 15

• Mian and Sufi argue that there is evidence supporting the active credit view –subprime mortgages swelled to 40% of market share from 10% in the period 2002-2006 and Justiniano et al. (2016) found that mortgage interest rates fell sharply during 2002-2005
  
  • Expansion in credit quantity and decline in the interest rate is a classic signal of an outward shift in the credit supply curve. A combination of increased subprime mortgages and falling mortgages interest rates point to the active credit view being correct

Question 16

loan to value ratio

Answer 16

max. loan amount/collateral value

Question 17

Why is it “good” that the crisis was largely supply driven?

Answer 17

policymakers can restrain bank credit expansion through macroprudential regulation, but its hard to restrain speculative investment

Question 18

Informational Casade

Answer 18

• An information cascade, also known as herding, occurs when people disregard their own individually collected information because they feel that everyone else simply could not be wrong –they follow the crowd. With prices rising and rising through a process of the informational cascade, this drives optimism and the cycle repeats

Question 19

The Oil Non-Bubble

Answer 19

• Following a debate on the possibility of an ongoing oil price bubble in 2008 with rising oil prices, Paul Krugman claimed in the NYT that there were no speculative bubbles and oil price increases were driven by fundamentals –his argument was based on the fact that oil stockpiles in private inventories had not soared, implying that speculators were not hoarding oil supplies and therefore did not actively affect the demand for oil
  
  • Many economists disagreed – what if the oil producers themselves were engaging in speculation? Sure, the oil stockpiles above ground were not soaring in inventories, but if oil producers cut their drilling back, then basically the oil is being stored in the ground

Question 20

Leaning Against the Wind

Answer 20

Using monetary policy to deal with credit –Increasing interest rates higher than required to meet the inflation target during a boom phase. LATW might require tightening monetary policy during a recession –this is known as the problem of “two targets and one instrument”

Question 21

Mopping up the Mess

Answer 21

Using monetary policy to deal with credit – Do nothing to interest rates during boom phases, but cut interest rates aggressively should the asset price bubble burst

Question 22

Macroprudential Policy

Answer 22

Macroprudential policy is the application of financial regulation to protect the real economy from swings and cycles in the financial system

Question 23

the primary objective on macroprudential policy

Answer 23

• Its primary objective is to restrain credit growth during a boom phase (allowing monetary policy to focus primarily on inflation)

Question 24

The PS-FS Model

Answer 24

The BoE recently developed the PS-FS Model to illustrate the interaction between monetary policy and macroprudential policy

Question 25

The PS Curve

Answer 25

The PS Curve traces out all combinations of R and K for which the economy satisfies the inflation target. It is downward sloping because an increase in R means inflation falls below target, requiring an offsetting easing in K to return to the PS curve

Question 26

The FS Curve

Answer 26

The FS curve traces out all combinations of R and K for which credit growth target is satisfied. It is also downward sloping.

Question 27

Why the FS Curve is Flatter

Answer 27

The FS curve is flatter because a change in the interest rate has little impact on the credit market, while it has massive impact on inflation. Increasing interest rates don’t really affect the borrowing habits, so you only need a small LTV change. Increasing rates have large impacts on inflation, so you’d need a lot more LTV changes to come back to target