THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 228

CHAPTER 9

Financial Crises and
the Subprime Meltdown

LE A RNI NG OB J ECTI VES
After studying this chapter you should be able to
1. discuss the factors that lead to financial crises
2. explain how increases in adverse selection and moral hazard cause financial
crises
3. discuss the most recent financial crisis, the subprime financial crisis of
2007 2008, which led to a number of banking crises around the world and a
decline in global economic activity

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Financial crises are major disruptions in financial markets characterized by sharp
declines in asset prices and firm failures. Beginning in August of 2007, defaults in
the subprime mortgage market in the United States (for borrowers with weak
credit records) sent a shudder through the financial markets, leading to the worst
financial crisis since the Great Depression and to a number of banking crises
throughout the world. In Congressional testimony, Alan Greenspan, former
Chairman of the U.S. Federal Reserve, described the subprime financial crisis as a
once-in-a-century credit tsunami. Wall Street firms and commercial banks suffered hundreds of billions of dollars of losses. Households and businesses found
they had to pay higher rates on their borrowings and it was much harder to get
credit. Stock markets crashed all over the world, falling by over 40% from their
peak. Many financial firms, including commercial banks, investment banks, and
insurance companies, went belly up.
Why did this financial crisis occur? Why have financial crises been so prevalent

throughout history, 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 by developing a framework to understand the dynamics of financial crises. Building on Chapter 8, we
make use of agency theory, the economic analysis of the effects of asymmetric
information (adverse selection and moral hazard) on financial markets and the
economy, to see why financial crises occur and why they have such devastating
economic effects. We will then apply the analysis to explain the course of events
in a number of past financial crises throughout the world, including the most
recent subprime crisis in the United States.