Chapter 0 Financial Crises Financial Crisis most financial crises involve asset price crashes and failures insolvency of financial institutions Asset price crashes are sudden large drops in asset prices such as stock or real estate Great Depression 1929 1933 Subprime crisis that began in mid 2007 The Mechanics of Financial crises Asset Price Crash Crashes may follow a bubble The response of the central bank is the key to controlling the economic damage from a crisis Bubble Asset price that has risen above the level justified by economic fundamentals Sentiment shifts and assest prices fall often causing a vicious cycle of selling and panic Insolvency A financial institution is insolvent when the value of its assets is less than its liabilities making net worth negative Regulators will close insolvent banks Insolvency can spread between institutions because they are connected for example banks have deposits in and make loans to other banks If one bank becomes insolvent it may not be able to pay back loans that other banks have given it Liquidity Crises Commercial banks may lack enough liquid assets to meet depositors demands Bank run Banks are forced to sell assets at fire sale prices and this results in losses than can cause insolvency Investment banks such as Lehman Brothers that raise funds by borrowing experience liquidity crises when creditors lose confidence and stop lending forcing asset sales Bank run Crises can spread to other financial institutions as depositors and creditors lose confidence spreading a crisis throughout the economy Direct Cost of Financial Crises Asset holders suffer losses when asset prices fall Homeowners Owners of common stock Owners of financial institutions lose their equity Creditors of financial institutions lose the funds they have lent When banks fail uninsured depositors and the FDIC incur losses Losses on assets reduce aggregate expenditure Lending and Spending in a Financial Crisis The indirect effects of a crisis can cause a recession Loss of wealth lower consumer and business confidence reduce consumption A crisis causes a credit crunch decline in borrowers collateral and net worth worsen adverse selection and moral hazard reducing lending Bank failures reduce lending because failed banks don t lend Remaining banks become fearful and reduce lending to increase liquid assets repair balance sheets Lower lending reduces aggregate expenditure by firms and individuals who rely on banks loans for funds The direct and indirect effects cause a fall in aggregate expenditures that reduces output causing a recession A Vicious Cycle The recession may further reduce asset prices The recession can worsen banking problems Both of these feedbacks can trigger a vicious cycle of falling output and worsening financial problems A crisis may sustain itself for a long time Policy Responses to Financial Crises All of these are used by regulators to fight crises Monetary policy interest rate and or money supply not very effective Lower interest rates to stimulate aggregate expenditure to offset the effects of asset price crashes and reduced bank lending this has not worked Provide liquidity Fed s focus in 2008 2009 was saving the system Stimulate the economy once banking system is stabilized The Fed provides liquidity lends to banks through traditional discount loans New credit facilities created in 2008 and 2009 Most of the new credit facilities have expired The Federal Reserve was created in 1913 to be a Lender of Last Resort Bailouts Some economists believe that central banks should raise interest rates to dampen asset price bubbles that lead to crashes but this idea is controversial How do you know it s a bubble The Sub Prime Market and Fed Policy Actions Types of Mortgages Prime conforming loan Fannie Mae Borrower has a good credit score 680 or higher Borrower fully documents their income and assets Low debt to income ratio does not exceed 35 Borrower injects at least 20 equity down payment Sub Prime no problem mortgage NINJA Loans Can t make a down payment No problem Don t earn enough to meet the monthly tab No problem No doc loans we don t care if you have no income Option ARMs don t have enough to make monthly payment send what you can Traditional Model Financial Institutions originator carry all risks Modern Model Financial Institutions shift risk to other institutions The Fed s Monetary Policy Toolbox Prior to the sub prime crisis the Federal Reserve used three monetary policy tools the old toolbox Open Market Operations and the target federal funds rate Purchase and sale of government securities Discount Rate Discount loan the interest rate the Fed charges on loans it makes to commercial banks Reserve Requirement the level reserves banks are required to hold either as vault cash on deposit or at a Federal Reserve bank 10 of demand deposits The Fed has lowered the Federal funds rate from 5 25 in 2007 to a range of 0 0 25 August 9 BNP Paribas France s largest bank halts redemptions on three investment funds August 16 Fitch ratings downgrades Countrywide Financial Corporation to BBB August 17 The Federal Reserve Board votes to set the Discount Rate 50 basis points above the FOMC s federal funds rate target which at that time was 5 75 Discount Rate Federal Funds Rate 100 basis points 1 percentage point So basically they lowered the discount rate so banks would borrow more because they sensed that banks needed liquidity The Fed also increased the maximum primary credit borrowing term to 30 days renewable by the borrower Originally this was an overnight loan So now banks had much more time to pay back the discount loans September 18 the FOMC votes to reduce its target for the federal funds rate 50 basis points to 4 75 October 31 The FOMC votes to reduce its target for the federal funds rate 25 basis points to 4 50 percent December 12 Finding banks reluctant to borrow the Fed creates the Term Auction Facility TAF in which reserves are auctioned to depository institutions against a wide variety of collateral The TAF also allowed any commercial bank to borrow from the Fed By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress January 2008 federal funds rate reduced 2 times 75 bp and 50 bp to 3 25 March 11 The Federal Reserve