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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
Copyright 2011 Pearson Canada Inc. 9 - 1 Chapter 9 Financial Crises and the Subprime Meltdown Copyright 2011 Pearson Canada Inc. 9 - 2 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 Copyright 2011 Pearson Canada Inc. 9 - 3 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 Copyright 2011 Pearson Canada Inc. 9 - 4 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. Copyright 2011 Pearson Canada Inc. 9 - 5 Deterioration in Financial Institutions’ Balance Sheets • Banking Crisis • Increases in Uncertainty • Increases in Interest Rates • Government Fiscal Imbalances Copyright 2011 Pearson Canada Inc. 9 - 6 Dynamics of Past Canadian Financial Crises: Stage I Stage One: Initiation of Financial Crisis • Mismanagement of Financial Liberalization and Innovation – Credit boom – Deleveraging • Asset Price Boom and Bust – Asset-price bubble • Spikes in Interest Rates • Increase in Uncertainty Copyright 2011 Pearson Canada Inc. 9 - 7 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. Copyright 2011 Pearson Canada Inc. 9 - 8 Dynamics of Past Canadian Financial Crises: Stage 3 • Economic downturn lead to sharp decline in prices – Debt deflation • Substantial unanticipated decline in the prices level lead to further deterioration in firms net worth • This increases adverse selection and moral hazard problems. • Investment spending and aggregate demand activity are depressed. Copyright 2011 Pearson Canada Inc. 9 - 9 Sequence of Events in the Canadian Financial Crises Copyright 2011 Pearson Canada Inc. 9 - 10 The Subprime Financial Crisis of 2007- 2008 • Subprime mortgages for less creditworthy counterparties • Alt-A mortgages for borrowers with higher expected default rates • Bundling of loans into debt securities is called securitization – 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. [...]... Dynamics of Financial Crises in Emerging Market Economies • Developing countries are increasingly opening economies to trade in goods, services and financial flows • Emerging economies have experienced financial crises • There are key differences in how financial crises evolve in emerging markets Copyright 2011 9- Sequence of Events in Emerging-Market Crises Copyright 2011 9- Stages of Financial Crises. .. 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... bank in the U.S was sold for 5% of its worth one year earlier Copyright 2011 9- 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 Copyright 2011 9- Canada’s Banking System: Envy of the World... Could also be the result of severe fiscal imbalances – Government debt repayment questionable, investors pull funds from country and sell domestic currency Copyright 2011 9- Stages of Financial Crises in Emerging 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... declines – Leads to adverse selection and moral hazard problems – Reduces investment and aggregate demand Copyright 2011 9- 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... 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? Copyright 2011 9- Canada’s Banking System: Envy of the World II • Canadian banks held mortgages on balance sheets... Emerging-Market Crises Copyright 2011 9- 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 Copyright 2011 9- Stages of Financial Crises in Emerging Markets II Stage Two: Currency Crisis • Currency crisis triggered by deterioration of bank balance sheets – Defend... increasing further housing prices Copyright 2011 9- 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 Copyright 2011 9- Subprime Mortgage Crisis Problems Continue I • • • • • Information Problems Surface... 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 Copyright 2011 9-