Lecture 21 A Primer on the Financial Crisis Flashcards
asset prices: booms and busts
financial crises often follow a period of optimism and an “asset price bubble”
eventually, optimism turns to pessimism and the bubble bursts, causing asset prices to drop
crucial asset in 2008-09 crisis
housing: house prices soared until 2006, then dropped 30% by 2009
mortgage backed securities (MBS)
a security, traded at financial markets, that is a claim to pool a pool of mortgages
diversifies risk and increases supply of capital to finance homeownership
mortgage path
1) borrower works with a broker or directly with a lender to get a home-purchase loan or a refinancing
2) broker finds a lender who can close the loan. they usually have a working arrangement with multiple lenders
3) lender often funds loan via “warehouse” line of credit from investment bank. then sells loan to the investment bank
4) investment bank packages the loans into a mortgage-backed bond deal, often known as securitization– sells the securitization sorted by risk to investors. lower-rated slices take the first defaults when mortgages go bad, but offer higher returns
5) investors choose what to buy based on their appetites for risk and reward (“tranching”)
falling asset prices
cause defaults on bank loans– since banks are highly leveraged, defaults reduce their capital, increasing the risk of bank failures
in 08-09, many banks held MBS. falling house prices sharply increased the perceived risk of mortgage defaults, reducing the price of such securities
insolvencies and confidence
insolvencies at some banks reduce confidence in others– lending drops, causing “a systemic bank run”
to replace their shrinking reserves, banks must sell assets, causes prices to decline “a fire sale”
in 08-09, the collapse of Bear Stearns and Lehman Brothers reduced confidence in other large institutions, many of which were independent
cause of the recession
a credit crunch (made by frequent defaults and insolvencies), investors don’t get loans, even those with good credit and lucrative opportunities
in 08-09, banks sharply reduced lending to consumers (for buying homes)
recession occurs when
output falls and unemployment rises– with less credit available, consumer and business spending declines: a reduction in aggregate demand
in 08-09, unemployment (mostly manufacturing, construction, etc) rose above 10% and remained very high for many months after the financial crises
the financial system/real economy circle
(financial system) a bust of asset prices - insolvencies at some financial institutions - falling confidence in many financial institutions - (real economy) credit crunch: banks reduce lending - falling aggregate demand causes a recession - recession puts more pressure on asset prices and financial institutions - a bust of asset prices…
monetary policy
conventional monetary policy, unconventional monetary policy
conventional monetary policy
reduce interest rates to stabilize demands
unconventional monetary policy
runs on banks can create a liquidity crisis
fed can directly loan to these banks or buy assets from their portfolio
acts as a “lender of last resort”
fiscal policy
conventional fiscal policy, using public funds to prop up the financial system
conventional fiscal policy
the government increases spending/cuts taxes to stabilize demand
fiscal policy during the financial crisis
economic stimulus act of 2008: $170b
american recovery and reinvestment act of 2009: $750b
