Financial Crisis -- a major disruption in financial markets that is characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms.Financial Crises in Advanced EconomiesStage One: Initiation of Financial Crisis- Mismanagement of financial liberalization/innovationLending expands rapidlyLack of expertise in judging riskLosses on loans results in deleveragingDeterioration in financial institutions balance sheets- Asset-price bubble – a pronounced increased in assetprices that departs from fundamental values.- Increase in uncertaintyAfter recession, stock market crash, failure of a major financial institutionStage Two: Banking CrisisLoss of information production. Stage Three: Debt deflationIncreased burden of indebtedness from unanticipateddecline in the price levelThe Great DepressionStock Market Crash – stock prices decline beginning in 1929 andby 1932 were only 10% of their 1929 peak value. See page 190.Bank panics – beginning in late 1930 and continued until Jan. 1934. More than 1/3 of U.S. commercial banks failed.Uncertainty in financial markets increases the spread between corporate bonds and U.S. Treasury bonds.Debt deflation – price level declined by 25% from 1930-1933.Prolonged contraction with unemployment rates of 25%.The Global Financial Crisis of 2007-2009: Causes- Financial innovations emerge in the mortgage marketsMortgage-backed securities provide a new source of financing for subprime and Alt-A mortgages. Collateralized debt obligations (CDOs) were structured to appeal to varying risk preferences.- Agency problems ariseIn the originate-to-distribute business model the mortgage broker is paid a fee to originate the mortgage. The mortgage is then sold as a security. The broker has little incentive to make sure that the mortgage is a good credit risk.- Conflict of interest of the credit-rating agencies –they rated securities and also advised clients how to structure securities to get the highest rating.The Global Financial Crisis of 2007-2009: Effects- Housing price bubble formsGrowth of the subprime mortgage market increased the demand for houses which led to housing price increases.- Housing price bubble burstsMany subprime borrowers now underwater.Increase in defaults.- Banks’ Balance Sheet DeteriorateLosses from holdings of mortgage-backed securities. Deleveraging.- Run on the Shadow Banking SystemIncreased deleveraging and economic contraction.- Crisis spreads globallyFrench investment house suspends redemption of shares held in money market funds.- High-profile firms failBear Stearns (March 2008) sold for less than5% of what it was worth a year earlierFannie Mae and Freddie Mac (Sept 2008) put into conservatorship (run by government)Lehman Brothers (Sept 2008) filed for bankruptcy- Bailout package debatedCrisis worsened as Congress debated bailout package.- The Economic Recovery Act of 2008Treasury Asset Relief Plan (TARP) authorizedthe Treasury to spend $700 billion purchasing subprime mortgage assets from troubled financial institutions or to inject capital into banking institutions.Raised the FDIC limit to $250,000 temporarily (made permanent with the passage of Dodd-Frank)Financial Crises in Emerging Market EconomiesStage one: Initiation of financial crisisPath One – mismanagement of financial liberalization/globalizationWeak supervision and lack of expertise leads to alending boom.Path Two – severe fiscal imbalancesGovernments in need of funds sometimes force banks to buy government debt.Additional factorsIncrease in interest rates from abroadAsset price decreasesUncertainty linked to unstable political systemsStage Two – currency crisisIf the government raises interest rates to attract capital inflows, it will harm already weakened domestic banks. Speculators expect a devaluation.Stage Three Debt burden increases from the
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