Financial Crises and the
Subprime Meltdown
Chapter 9
1
Financial Crisis
A financial crisis happens when there is
sharp declines in asset prices and
widespread bankruptcies.
 Financial crises occur when there is a
sharp increase in adverse selection and
moral hazard.

2
Financial Crises: A sharp
increase in asymmetric
information that cripples the
financial system
3
Causes of Financial Crisis

Increases in interest rates: Riskier investors
remain in the market while safer ones exit.

Increases in uncertainty: A major failure increases
the uncertainty and inability of the lenders to
gauge the creditworthiness of borrowers.

Balance sheet deterioration: Decline in asset
values, rise in liabilities, decline in net worth.

Banking sector problems: Deterioration of bank
balance sheets.

Government deficits: Possibility of default.
4
Balance Sheet Deterioration

Stock market crash lowers the net worth of
corporations.



Adverse selection increases because the potential
losses to lenders are higher.
Moral hazard increases because borrowers have more
incentives to engage in risky behavior.
Unanticipated deflation raises liabilities.




Debt is usually long-term, fixed interest rate.
Falling prices raise the real value of nominal debt.
Assets are usually real, so they do not gain value.
Net worth declines.
5
Balance Sheet Deterioration

Exchange rate risk may deteriorate balance
sheets.
If contracts are denominated in foreign
currency, any unanticipated devaluation or
depreciation of domestic currency increases
real value of debt.
 Assets are usually denominated in domestic
currency.


Rise in interest rates may increase interest
payments by debtors.

Cash flow will fall lowering the liquidity of the
firm.
6
Deterioration of the balance
sheets of the banks impede
intermediation

Financial institutions provide loans for
economic activity. Deterioration makes
loans less available. Recession.
7
Banking Crisis


If financial institutions have severe deterioration of
balance sheet, bank panic may occur when multiple
banks fail simultaneously. In the absence of deposit
insurance asymmetric information about banks loan
portfolio spurs a panic.
When banks fail their accumulated information that
allows them to make loans to firms also evaporates.
There is a loss of information production, loss of financial
intermediation, shrinking of the supply of funds, higher
interest rates, asymmetric information problems, severe
contraction in economic activity.
8
Increases in Uncertainty

Failure of a prominent institution,
recession, stock market crash make it
hard for lenders to screen good from bad
credit risks. Asymmetric information leads
to contraction.
9
Increases in Interest Rates
Higher interest rates eliminates low risk
ventures and keeps the high risk
ones. Adverse selection.
 Increases in interest rates squeezes cash
flow: receipts down, payments up. High
cash flow firms can finance projects
internally, low cash flow requires outside
financing. Adverse selection and moral
hazard increase, less lending, recession.

10
Government Fiscal
Imbalances: sovereign
risk increases
Increase government debt,
especially foreign debt, raises
fears of default
Government can't find
lenders and forces banks to
buy the bonds

If government default fears emerge,
government bonds lose value, their
interest rate rise. Institutions holding
these bonds see their asset value decline

Balance sheets deteriorate
12
Foreign exchange crisis

Banks liabilities in foreign currency expand
13
Mexican Financial Crisis of ‘94-95
Deregulation of financial markets led to a
lending boom.
 Unperforming loans increased causing a
decline in net worth of banks.

Weak supervision of regulators
 Inability to monitor borrowers


Lending slowed (tight credit market).
14
Tequila Crisis of ‘94-95

Interest rate hikes in the US forced Mexico to raise
its interest rates to keep the value of peso.


Higher interest rates increased adverse selection and
moral hazard.
Assassinations and uprisings increased
uncertainty.



Stock market crashed reducing net worth.
Firms had incentives to undertake risky investments
because the value of their collateral fell.
Adverse selection and moral hazard problems rose.
15
Tequila Crisis of ‘94-95

Expected value of Mexican peso dropped
forcing the spot value downward as well.
Due to NAFTA, tariffs and quotas were to be
removed.
 Inflation in 1990-95 period had fallen to 15.5%
from 70.4% during 1980-90 period but it still was
significantly higher than the US to which the
peso was pegged.
 From 1980 to 1995 trade as a percentage of
GDP doubled from 24% to 48%.

Source: The World Bank, World Development Report 1997, pp. 219, 235, 245
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U.S. Financial Crises
17
Third World Financial Crises
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http://timeline.stlouisfed.org/
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ABCP Asset-Backed Commercial Paper
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Amartya Sen: http://www.nybooks.com/articles/22490?
Martin Wolf: http://www.ft.com/cms/s/0/c6c5bd36-0c0c-11de-b87d0000779fd2ac.html?nclick_check=1
Paul Krugman: http://www.nytimes.com/2009/09/06/magazine/06Economict.html?_r=1&pagewanted=all
Brooksley Born:
http://www.pbs.org/wgbh/pages/frontline/warning/view/?utm_campaign=homepa
ge&utm_medium=top5&utm_source=top5
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