1、Copyright 2012 Pearson Education.All rights reserved.CHAPTER 8Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?2012 Pearson Education.All rights reserved.8-1 Chapter PreviewFinancial crises are major disruptions in financial markets characterized by sharp declines in asset p
2、rices and firm failures.Beginning in August 2007,the U.S.entered into a crisis that was described as a“once-in-a-century credit tsunami.”2012 Pearson Education.All rights reserved.8-2 Chapter PreviewWhy did this financial crisis occur?Why have financial crises been so prevalent throughout U.S.histor
3、y,as well as in so many other countries,and what insights do they provide on the current crisis?Why are financial crises almost always followed by severe contractions in economic activity?We will examine these questions in this chapter.2012 Pearson Education.All rights reserved.8-3 Chapter PreviewIn
4、 this chapter,we develop a framework to understand the dynamics of financial crises.Topics include:Asymmetric Information and Financial Crises Dynamics of Financial Crises in Advanced Economies Dynamics of Financial Crises in Emerging Market Economies 2012 Pearson Education.All rights reserved.8-4 A
5、symmetric Information and Financial Crises In chapter 7,we discussed how a functioning financial system is critical to a robust economy.However,both moral hazard and adverse selection are still present.The study of these problems(agency theory)is the basis for understanding and defining a financial
6、crisis.2012 Pearson Education.All rights reserved.8-5 Dynamics of Financial Crises in Advanced Economies The dynamics of financial crises in emerging market economies have many of the same elements as those found in advanced countries like United States However,there are some important differences.T
7、he next slide outlines the key stages.2012 Pearson Education.All rights reserved.8-6 Sequence of Events in U.S.Financial Crises(a)2012 Pearson Education.All rights reserved.8-7 Sequence of Events in U.S.Financial Crises(b)2012 Pearson Education.All rights reserved.8-8 Stage One:InitiationFinancial c
8、risis can begin in several ways:mismanagement of financial liberalization or innovation asset price booms and busts a general increase in uncertainty caused by failures of major financial institutions 2012 Pearson Education.All rights reserved.8-9 Stage One:Initiation The seeds of a financial crisis
9、 can begin with mismanagement of financial liberalization or innovation:elimination of restrictions introduction of new types of loans or other financial products Either can lead to a credit boom,where risk management is lacking.2012 Pearson Education.All rights reserved.8-10 Stage One:Initiation Go
10、vernment safety nets weaken incentives for risk management.Depositors ignore bank risk-taking.Eventually,loan losses accrue,and asset values fall,leading to a reduction in capital.Financial institutions cut back in lending,a process called deleveraging.Banking funding falls as well.2012 Pearson Educ
11、ation.All rights reserved.8-11 Stage One:Initiation As FIs cut back on lending,no one is left to evaluate firms.The financial system losses its primary institution to address adverse selection and moral hazard.Economic spending contracts as loans become scarce.2012 Pearson Education.All rights reser
12、ved.8-12 Stage One:InitiationA financial crisis can also begin with an asset pricing boom and bust:A pricing bubble starts,where asset values exceed their fundamental prices.When the bubble bursts and prices fall,corporate net worth falls as well.Moral hazard increases as firms have little to lose.F
13、Is also see a fall in their assets,leading again to deleveraging.2012 Pearson Education.All rights reserved.8-13 Stage One:InitiationFinally,a financial crisis can begin with a spike in interest rates or an increase in uncertainty:Many 19th century crises initiated with a spike in rates,due to a liq
14、uidity problems or panics Moral hazard also increases as loan repayment becomes more uncertain Other periods of high uncertainty can lead to crises,such as stock market crashes or the failure of a major financial institution 2012 Pearson Education.All rights reserved.8-14 Stage Two:Banking CrisisDet
15、eriorating balance sheets lead financial institutions into insolvency.If severe enough,these factors can lead to a bank panic.Panics occur when depositors are unsure which banks are insolvent,causing all depositors to withdraw all funds immediately As cash balances fall,FIs must sell assets quickly,
16、further deteriorating their balance sheet Adverse selection and moral hazard become severe it takes years for a full recovery 2012 Pearson Education.All rights reserved.8-15 Stage Three:Debt DeflationIf the crisis also leads to a sharp decline in prices,debt deflation can occur,where asset prices fa
17、ll,but debt levels do not adjust,increases debt burdens.Debt levels are typically fixed,not indexed to asset values Price level drops lead to an increase in adverse selection and moral hazard,which is followed by decreased lending Economic activity remains depressed for a long time.2012 Pearson Educ
18、ation.All rights reserved.8-16 Case:The Great Depression In 1928 and 1929,stock prices doubled in the U.S.The Fed tried to curb this period of excessive speculation with a tight monetary policy.But this lead to a collapse of more than 60%in October of 1929.Further,between 1930 and 1933,one-third of
19、U.S.banks went out of business as agricultural shocks led to bank failures 2012 Pearson Education.All rights reserved.8-17 Stock Market Prices DuringThe Great Depression 2012 Pearson Education.All rights reserved.8-18 Case:The Great DepressionAdverse selection and moral hazard in credit markets beca
20、me severe.Firms with productive uses of funds were unable to get financing.As seen in the next slide,credit spreads increased from 2%to nearly 8%during the height of the Depression.2012 Pearson Education.All rights reserved.8-19 Credit Spreads DuringThe Great Depression 2012 Pearson Education.All ri
21、ghts reserved.8-20 Case:The Great Depression The deflation during the period lead to a 25%decline in price levels.The prolonged economic contraction lead to an unemployment rate around 25%.The Depression was the worst financial crisis ever in the U.S.It explains why the economic contraction was also
22、 the most severe ever experienced by the nation.2012 Pearson Education.All rights reserved.8-21 Case:The 20072009Financial CrisisWe begin our look at the 20072009 financial crisis by examining three central factors:financial innovation in mortgage markets agency problems in mortgage markets the role
23、 of asymmetric information in the credit rating process 2012 Pearson Education.All rights reserved.8-22 Case:The 20072009 Financial CrisisFinancial innovation in mortgage markets developed along a few lines:Less-than-credit worthy borrowers found the ability to purchase homes through subprime lendin
24、g,a practice almost nonexistent until the 2000s Financial engineering developed new financial products to further enhance and distribute risk from mortgage lending 2012 Pearson Education.All rights reserved.8-23 Case:The 20072009 Financial CrisisAgency problems in mortgage markets also reached new l
25、evels:Mortgage originators did not hold the actual mortgage,but sold the note in the secondary market Mortgage originators earned fees from the volume of the loans produced,not the quality In the extreme,unqualified borrowers bought houses they could not afford through either creative mortgage produ
26、cts or outright fraud(such as inflated income)2012 Pearson Education.All rights reserved.8-24 Case:The 20072009 Financial CrisisFinally,the rating agencies didnt help:Agencies consulted with firms on structuring products to achieve the highest rating,creating a clear conflict Further,the rating syst
27、em was hardly designed to address the complex nature of the structured debt designs The result was meaningless ratings that investors had relied on to assess the quality of their investments 2012 Pearson Education.All rights reserved.8-25 Case:The 20072009 Financial CrisisMany suffered as a result o
28、f the 20072009 financial crisis.We will look at five areas:U.S.residential housing FIs balance sheets The“shadow”banking system Global financial markets The failure of major financial firms 2012 Pearson Education.All rights reserved.8-26 Case:The 20072009 Financial Crisis Initially,the housing boom
29、was lauded by economics and politicians.The housing boom helped stimulate growth in the subprime market as well.However,underwriting standard fell.People were clearly buying houses they could not afford,except for the ability to sell the house for a higher price.2012 Pearson Education.All rights res
30、erved.8-27 Case:The 20072009 Financial Crisis Lending standards also allowed for near 100%financing,so owners had little to lose by defaulting when the housing bubble burst.The next slide shows the rise and fall of housing prices in the U.S.The number of defaults continues to plague the U.S.banking
31、system 2012 Pearson Education.All rights reserved.8-28 Housing Prices:20022010 2012 Pearson Education.All rights reserved.8-29 Was the Fed to Blame for the Housing Price Bubble?Some argue that low interest rates from 2003 to 2006 fueled the housing bubble.In early 2009,Mr.Bernanke rebutted this argu
32、ment.He argued rates were appropriate.He also pointed to new mortgage products,relaxed lending standards,and capital inflows as more likely causes.2012 Pearson Education.All rights reserved.8-30 Case:The 20072009 Financial Crisis As mortgage defaults rose,banks and other FIs saw the value of their a
33、ssets fall.This was further complicated by the complexity of mortgages,CDOs,defaults swaps,and other difficult-to-value assets.Banks began the deleveraging process,selling assets and restricting credit,further depressing the struggling economy 2012 Pearson Education.All rights reserved.8-31 Case:The
34、 20072009 Financial Crisis The shadow banking system also experienced a run.These are the hedge funds,investment banks,and other liquidity providers in our financial system.When the short-term debt markets seized,so did the availability of credit to this system.This lead to further“fire”sales of ass
35、ets to meet higher credit standards 2012 Pearson Education.All rights reserved.8-32 Case:The 20072009 Financial Crisis As seen on the next two slides,the fall in the stock market and the rise in credit spreads further weakened both firm and household balance sheets.Both consumption and real investme
36、nt fell,causing a sharp contraction in the economy.2012 Pearson Education.All rights reserved.8-33 Stock Prices:20022010 2012 Pearson Education.All rights reserved.8-34 Credit Spreads:20022010 2012 Pearson Education.All rights reserved.8-35 Case:The 20072009 Financial Crisis Europe was actually firs
37、t to raise the alarm in the crisis.With the downgrade of$10 billion in mortgage related products,short term money markets froze,and in August 2007,a French investment house suspended redemption of some of its money market funds.Banks and firms began to horde cash.2012 Pearson Education.All rights re
38、served.8-36 Case:The 20072009 Financial Crisis The end of credit lead to several bank failures.Northern Rock was one of the first,relying on shortterm credit markets for funding.Others soon followed.By most standards,Europe experienced a more severe downturn that the U.S.2012 Pearson Education.All r
39、ights reserved.8-37 Case:The 20072009 Financial CrisisFinally,the collapse of several high-profile U.S.investment firms only further deteriorated confidence in the U.S.March 2008:Bear Sterns fails and is sold to JP Morgan for 5%of its value only 1 year ago September 2008:both Freddie and Fannie put
40、into conservatorship after heaving subprime losses.2012 Pearson Education.All rights reserved.8-38 Case:The 20072009 Financial CrisisFinally,the collapse of several highprofile U.S.investment firms only further deteriorated confidence in the U.S.September 2008:Lehman Brothers files for bankruptcy.Me
41、rrill Lynch sold to Bank of America at“fire”sale prices.AIG also experiences a liquidity crisis.2012 Pearson Education.All rights reserved.8-39 Case:The 20072009 Financial CrisisThe crisis and impaired credit markets have caused the worst economic contraction since World War II.The fall in real GDP
42、and increase in unemployment to over 10%in 2009 impacted almost everyone.2012 Pearson Education.All rights reserved.8-40 Global:Ireland and the 20072009 Financial Crisis From 9507,Ireland had a booming economy,with 6.3%average annual real GDP growth.But,rising real estate prices and a boom in mortga
43、ge lending were laying the groundwork for a recession.Housing prices doubled twice from 1995 to 2007,while construction was 13%of GDP 2012 Pearson Education.All rights reserved.8-41 Global:Ireland and the 20072009 Financial Crisis Houses prices then fell by 20%in 2007 Banks were hit hard,with high e
44、xposure to real estate and reliance on short-term funding from money markets The Irish government nationalized a large bank,and guaranteed all deposits in an effort to control the recession 2012 Pearson Education.All rights reserved.8-42 Global:Ireland and the 20072009 Financial Crisis Unemployment
45、rose from 4.5%to 12.5%GDP fell by more than 10%,and aggregate price levels fell Like the U.S.,budget deficits rose,and tax increases followed to overset the increase in spending 2012 Pearson Education.All rights reserved.8-43 Dynamics of Financial Crises in Emerging Market Economies The dynamics of
46、financial crises in emerging market economies have many of the same elements as those found in advanced countries like United States However,there are some important differences.The next slide outlines the key stages.2012 Pearson Education.All rights reserved.8-44 Emerging Market Financial Crisis:Se
47、quence of Events(a)2012 Pearson Education.All rights reserved.8-45 Emerging Market Financial Crisis:Sequence of Events(b)2012 Pearson Education.All rights reserved.8-46 Stage One:InitiationFinancial crises in emerging market countries develop along two basic paths:the mismanagement of financial libe
48、ralization or globalization severe fiscal imbalances 2012 Pearson Education.All rights reserved.8-47 Stage One:InitiationCrisis initiation involving the mismanagement of financial liberalization or globalization usually proceeds as follows:The country often starts with a solid fiscal policy A weak c
49、redit culture and capital inflows exasperate the credit boom that follows liberalization,leading to risky lending High loan losses eventually materialize 2012 Pearson Education.All rights reserved.8-48 Stage One:InitiationCrisis initiation involving the mismanagement of financial liberalization or g
50、lobalization usually proceeds as follows:As bank balance sheets deteriorate,lending is cut back(more severe here since the rest of the economy is not as developed)A lending crash fully materializes 2012 Pearson Education.All rights reserved.8-49 Stage One:Initiation Why does prudential regulation fa
