financial crises and the subprime meltdown

Well-working financial system solves asymmetric information problems Financial crises occurs when increases in asymmetric information causes severe adverse selection and moral hazard problems. Results in financial markets inability to channel funds efficiently

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Copyright  2011 Pearson Canada Inc 9 - 1

Chapter 9

Financial Crises and the

Subprime Meltdown

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Factors Causing Financial Crises

• Well-working financial system solves

asymmetric information problems

• Financial crises occurs when increases in

asymmetric information causes severe

adverse selection and moral hazard problems.

• Results in financial markets inability to

channel funds efficiently

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Asset Market Effects on Balance Sheets I

• Stock market Decline

– Leads to lower net worth and lenders are more unwilling

to lend funds.

– Leads to a decline in investment and aggregate demand

• Unanticipated Decline in the Price Level

– Debt contracts have fixed (nominal) interest rates with

long maturity.

– Unanticipated decline in price level leads to high real

liabilities which decreases net worth and increases problems of adverse selection and moral hazard – Lead to lower lending, lower investment and lower

aggregate demand

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Asset Market Effects on Balance Sheets II

• Unanticipated Decline in the Value of Domestic

Currency

– Debt contracts denominated in foreign currency

– When foreign currency’s value decreases, the domestic

debt burden increases – Deterioration of balance sheet and decline in net worth

– Increase adverse selection and moral hazard

– Leads to a decline in investment and aggregate demand

• Asset Write-Downs

– Decline in asset prices lead to write-owns on value of

assets which also impacts lending.

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Deterioration in Financial Institutions’

Balance Sheets

• Banking Crisis

• Increases in Uncertainty

• Increases in Interest Rates

• Government Fiscal Imbalances

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Dynamics of Past Canadian Financial Crises:

Stage I

Stage One: Initiation of Financial Crisis

• Mismanagement of Financial Liberalization

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Dynamics of Past Canadian Financial Crises:

Stage 2

• Worsening business conditions and

uncertainty leads depositors to withdraw their funds

• Decreases the number of banks and worsens both adverse selection and moral hazard

problems in the credit markets.

• Further spiralling down of the economy

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Dynamics of Past Canadian Financial

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Sequence of Events in the Canadian Financial

Crises

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The Subprime Financial Crisis of

– Called mortgage-backed securities

• Financial engineering led to structured credit

products

• Collateralized debt obligations (CDOs) paid out cash flows from subprime mortgage-backed securities in different tranches

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Housing Price Bubble Forms

• Liquidity from China and India lead to huge increase subprime mortgage market ($1 trillion by 2007)

• Increased U.S home ownership

• Lead to asset price boom in housing

• Higher housing prices allowed refinancing for larger loans

• Subprime borrowers unlikely to default since they

could sell their house to pay loan

• Growth in subprime mortgage market increased

demand for houses increasing further housing prices

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Agency Problems Arise

• Subprime mortgage market based on

originate-to-distribute business model

• Subject to principal-agent problem

• Mortgage brokers earn fee through volume

not from ensuring credit worthiness

• Lax regulation was also a factor

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Subprime Mortgage Crisis Problems

Continue I

• Information Problems Surface

• Housing Price Bubble Bursts

• Crisis Spreads Globally

• Banks Balance Sheets Deteriorate

• High Profile Firms Fail

bank in the U.S was sold for 5% of its worth one year earlier

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Subprime Mortgage Crisis Problems

Continue II

• Bail-out package debated

• Recovery in sight?

• Subprime mortgages in Canada

– Federal government opened mortgage market to U.S firms

– Following U.S meltdown, Canadian government

banned subprime mortgages in 2008

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Canada’s Banking System: Envy of the

World I

• Canadian banks shares declined by 50% and

announced huge losses

– CIBC lost $2.1 billion in derivative trading in 2008

• U.S and Europe have provided bailouts to

their banking sector

• Canadian government did not provide bailout funds or rescue package

• Why?

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Canada’s Banking System: Envy of the

World II

• Canadian banks held mortgages on balance

sheets

– Ensured that borrowers were credit worthy

• Canadian banking regulation more

conservative than U.S.

– Higher capital requirements protected against

losses

• Canadian banks more diversified

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Dynamics of Financial Crises in Emerging

• There are key differences in how financial

crises evolve in emerging markets

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Sequence of Events in Emerging-Market

Crises

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Stages of Financial Crises in Emerging

Markets I

Stage One:

• Path One: Mismanagement of Financial

Liberalization and Globalization

• Path Two: Severe Fiscal Imbalances

• Additional Factors

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Markets II

Stage Two: Currency Crisis

• Currency crisis triggered by deterioration of bank

balance sheets

– Defend currency through increase in interest rates, banks must pay more to obtain funds

– Increasing costs could lead to insolvency

• Could also be the result of severe fiscal imbalances

– Government debt repayment questionable, investors pull funds from country and sell domestic currency

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Markets III

Stage Three: Full Fledged Financial Crisis

• Emerging markets have debts typically

denominated in US dollars.

• Unanticipated depreciation or devaluation

increases the debt burden of domestic firms

– Net worth declines

– Leads to adverse selection and moral hazard

problems– Reduces investment and aggregate demand

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Twin Crises

• Collapse of currency leads to higher inflation

• Sharp depreciation leads to upward pressure on

import prices

• Lead to a rise in both actual and expected inflation

• Increased interest payments for firms lead to cash

flow reductions and decline in net worth increases

asymmetric information problems reducing

investment and economic activity

• Further economic decline occurs through

deterioration of banks balance sheets

Tiêu đề	Financial Crises and the Subprime Meltdown
Chuyên ngành	Economics
Thể loại	Chapter
Năm xuất bản	2011

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Số trang	22
Dung lượng	241,5 KB