Factors Causing Financial Crises
Asset Markets Effects on Balance Sheets
–
–
–
–
Stock market decline  Decreases net worth of corporations.
Unanticipated deflation  Debt burdens up/net worth down
Unanticipated depreciation  $ debts up/net worth down
Asset write-downs (bad debts)  Net worth down
• Deterioration in Financial Institutions’ Balance Sheets
Decline in lending.
Increases in Interest Rates
– Worsens adverse selection (who would pay the high rates?)
– Increases need for external funds
 worsens adverse selection and moral hazard problems.
Government Fiscal Imbalances
– Fears of default on government debt Capital flight
Banking Crises
– Loss of information production / disintermediation.
• Increases in Uncertainty
Decline in lending.
Stage One
•Mismanagement of
financial liberalization and
innovations
•Asset price boom & bust
•Spikes in interest rates
•Increase in uncertainty
Stage two: Banking Crisis
Stage three: Debt Deflation
U.S. Financial Crises
Financial Crisis of 2007 - 2009
• Financial innovations in mortgage markets:
– Subprime and Alt-A mortgages
– Mortgage-backed securities
– Collateralized debt obligations (CDOs)
• Housing price bubble forms
– World savings glut
Increase in liquidity from cash flows surging to the US
– Subprime mortgage market  housing demand and prices up.
• Agency problems arise
– “Originate to distribute”
 principal (investor) agent (mortgage broker) problem.
– Commercial and investment banks/rating agencies
…weak incentives to assess quality of securities
• Information problems surface
Housing price bubble bursts/Crisis spreads globally
http://www.nytimes.com/interactive/2009/04/29/business/2009-wide-housing-graphic.html
A “Global Saving Glut”
The best
of times
Capital
Inflows
Escalating
House Prices
Easy
Money
Policy
Ambitious
Mortgage Brokers
Eager Home
Buyers
Developer Clout
Innovative
Banks
Bank Regulators
Gov’t Sponsored
Securitization
MBSs
Rating
Agencies
The best
of times
Capital Inflows
Escalating
House Prices
Easy Money
Policy
Ambitious
Mortgage Brokers
Eager Home
Buyers
Developer Clout
Innovative
Banks
Bank Regulators
Gov’t Sponsored
Securitization
MBSs
Rating
Agencies
Vicious Spirals Unleashed
House Price –
Foreclosure
Spiral
Deleveraging – Debt Deflation
Spiral
Demand –
Jobs –
Wages –
Income –
Spiral
Government
Revenue –
Cutback
Spiral
Global Repercussion
Spiral
Macroeconomic Linkages
and
Feedbacks
Financial Crisis of 2007 - 2009 (cont’d)
• Banks’ balance sheets deteriorate
– Write downs
– Sale of assets and credit restriction
• High-profile firms fail
– Bear Stearns (March 2008)
– Fannie Mae and Freddie Mac (July 2008)
– Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund
(MMMF) and Washington Mutual (September 2008).
• Fed pumps up bank reserves: TARP/TALF,etc.
– Lend and lend freely
• Bailout package enacted
– House votes down the $700 billion bailout package (9/29/08)
 Stock market slumps  Bailout passes on October 3.
– Congress approves a $787 billion economic stimulus plan on
February 13, 2009.
• Recession deepens
Responses
Lender of Last Resort / Spender of Last Resort
• Tax Rebate $124 bil.
• Fed Fund Rate Cuts
• Fannie/Freddie $200 bil.
• Bear-Stearns $29 bil.
• AIG $174 bil.
Fed “Facilities”
• Primary Dealer Credit Facility (PDCF) $58 bil.
• Treasury Security Loan Facility (TSLF) $133 bil.
• Term Auction Facility (TAF) $416 bil.
• Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.
• Money Market Investor Funding Facility (MMIFF) $540 bil.
• More Fed Fund Rate Cuts … Hold At ~0%
• Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.
• Term Asset-Backed Securities Loan Facility (TALF) $200 bil.
• Emergency Economic Stabilization Act/TARP $700 bil.
Government Loans
Government Equity
• Stimulus Package $787 bil.
aka The American Recovery and Reinvestment Act
• TARP II
• Stress Tests
Vicious Spirals Unleashed
Vicious Spirals Reversed? Tackle them all together!
Refinance
House
Price –
Mortgages
Stimulus
Demand –
Program
Jobs –
•Infrastructure
Spending
Wages –
•Tax Cuts
Foreclosure
Spiral
Deleveraging
Debt Deflation
Revive dual–banking
system
Cash for Trash
Spiral
Income –
Spiral
•Recapitalize banks
•Revive securitization
Federal Aid
Government
To States
Revenue
–
Cutback
Spiral
GGlobal
– 20 Repercussion
•Coordinated
Spiral Stimulus
Macroeconomic
Linkages
Macroeconomic Linkages
and
and
Feedbacks
Feedbacks
Dynamics of Financial Crises in
Emerging Market Economies
• Stage one: Initiation of Financial Crisis.
• Path one: mismanagement of financial liberalization
•
•
•
•
Weak supervision and lack of expertise  lending boom.
Domestic banks borrow from foreign banks.
Fixed exchange rates give a sense of lower risk.
Securities markets not well-developed  Banks important
• Path two: severe fiscal imbalances:
• Governments force banks to buy government debt.
• When government debt loses value, bank net worth down .
– Additional factors:
• Increase in interest rates (from abroad)
• Asset price decrease
• Uncertainty linked to unstable political systems
Dynamics of Financial Crises in
Emerging Market Economies
• Stage two: currency crisis
– Bank losses  currency crises:
• Government cannot raise interest rates (doing so forces
banks into insolvency)…
• … and speculators expect a devaluation.
• Foreign and domestic investors sell the domestic currency.
• Stage three: Full-Fledged Financial Crisis:
– The debt burden in terms of domestic currency increases
– Banks are more likely to fail:
• Individuals are less able to pay off their debts (value of
assets fall).
• Debt denominated in foreign currency increases (value of
liabilities increase).
Financial Crises: Mexico
1994-1995
• Financial liberalization in the early 1990s:
– Lending boom, coupled with weak supervision
and lack of expertise.
– Banks accumulated losses and their net worth
declined.
• Rise in interest rates abroad.
• Uncertainty increased (political instability).
• Domestic currency devaluated on
December 20, 1994.
• Rise in actual and expected inflation.
Financial Crises: East Asia
1997-1998
• Financial liberalization in the early 1990s:
– Lending boom, coupled with weak supervision
and lack of expertise.
– Banks accumulated losses and their net worth
declined.
• Uncertainty increased (stock market
declines and failure of prominent firms).
• Domestic currencies devaluated by 1997.
• Rise in actual and expected inflation.
Financial Crises: Argentina
2001-2002
• Government coerced banks to absorb large
amounts of debt due to fiscal imbalances.
• Rise in interest rates abroad.
• Uncertainty increased (ongoing recession).
• Domestic currency devaluated on January
6, 2002
• Rise in actual and expected inflation.
FIGURE 3 Sequence of Events in
Emerging Market Financial Crises
FIGURE 2 Treasury Bill–to–
Eurodollar Rate (TED) Spread
Source: www.federalreserve.gov/releases/h15/data.htm