financial crises and the subprime meltdown

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Chapter 9
Financial Crises and the
Subprime Meltdown
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Factors Causing Financial Crises
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Well-working financial system solves
asymmetric information problems
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Financial crises occurs when increases in
asymmetric information causes severe adverse
selection and moral hazard problems.
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Results in financial markets inability to channel
funds efficiently
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Asset Market Effects on Balance Sheets I
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Stock market Decline
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Leads to lower net worth and lenders are more unwilling
to lend funds.
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Leads to a decline in investment and aggregate demand

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Unanticipated Decline in the Price Level
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Debt contracts have fixed (nominal) interest rates with
long maturity.
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Unanticipated decline in price level leads to high real
liabilities which decreases net worth and increases
problems of adverse selection and moral hazard
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Lead to lower lending, lower investment and lower
aggregate demand
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Asset Market Effects on Balance Sheets II
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Unanticipated Decline in the Value of Domestic
Currency
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Debt contracts denominated in foreign currency
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When foreign currency’s value decreases, the domestic
debt burden increases
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Deterioration of balance sheet and decline in net worth
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Increase adverse selection and moral hazard
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Leads to a decline in investment and aggregate demand

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Asset Write-Downs
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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
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Banking Crisis
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Increases in Uncertainty
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Increases in Interest Rates
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Government Fiscal Imbalances
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Dynamics of Past Canadian Financial Crises:
Stage I
Stage One: Initiation of Financial Crisis
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Mismanagement of Financial Liberalization and
Innovation
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Credit boom
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Deleveraging
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Asset Price Boom and Bust
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Asset-price bubble
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Spikes in Interest Rates
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Increase in Uncertainty
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Dynamics of Past Canadian Financial Crises:
Stage 2
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Worsening business conditions and uncertainty
leads depositors to withdraw their funds.
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Decreases the number of banks and worsens
both adverse selection and moral hazard
problems in the credit markets.
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Further spiralling down of the economy.
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Dynamics of Past Canadian Financial
Crises: Stage 3
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Economic downturn lead to sharp decline in prices

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Debt deflation
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Substantial unanticipated decline in the prices level
lead to further deterioration in firms net worth
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This increases adverse selection and moral hazard
problems.
•
Investment spending and aggregate demand activity
are depressed.
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Sequence of Events in the Canadian Financial
Crises
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The Subprime Financial Crisis of 2007-
2008
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Subprime mortgages for less creditworthy
counterparties
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Alt-A mortgages for borrowers with higher expected
default rates
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Bundling of loans into debt securities is called

securitization
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Called mortgage-backed securities
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Financial engineering led to structured credit products
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Collateralized debt obligations (CDOs) paid out cash
flows from subprime mortgage-backed securities in
different tranches.
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Housing Price Bubble Forms
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Liquidity from China and India lead to huge increase
subprime mortgage market ($1 trillion by 2007)
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Increased U.S. home ownership
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Lead to asset price boom in housing
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Higher housing prices allowed refinancing for larger
loans
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Subprime borrowers unlikely to default since they
could sell their house to pay loan
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Growth in subprime mortgage market increased
demand for houses increasing further housing prices

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Agency Problems Arise
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Subprime mortgage market based on
originate-to-distribute business model
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Subject to principal-agent problem
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Mortgage brokers earn fee through volume not
from ensuring credit worthiness
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Lax regulation was also a factor
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Subprime Mortgage Crisis Problems
Continue I
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Information Problems Surface
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Housing Price Bubble Bursts
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Crisis Spreads Globally
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Banks Balance Sheets Deteriorate
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High Profile Firms Fail
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March 2008, Bears Stear 5
th
largest investment 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
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Bail-out package debated
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Recovery in sight?
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Subprime mortgages in Canada
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Federal government opened mortgage market to
U.S. firms
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Following U.S. meltdown, Canadian government
banned subprime mortgages in 2008
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Canada’s Banking System: Envy of the

World I
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Canadian banks shares declined by 50% and
announced huge losses
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CIBC lost $2.1 billion in derivative trading in 2008
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U.S. and Europe have provided bailouts to their
banking sector
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Canadian government did not provide bailout
funds or rescue package
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Why?
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Canada’s Banking System: Envy of the
World II
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Canadian banks held mortgages on balance
sheets
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Ensured that borrowers were credit worthy
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Canadian banking regulation more
conservative than U.S.
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Higher capital requirements protected against

losses
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Canadian banks more diversified
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Dynamics of Financial Crises in Emerging
Market Economies
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Developing countries are increasingly opening
economies to trade in goods, services and
financial flows.
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Emerging economies have experienced
financial crises
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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:
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Path One: Mismanagement of Financial
Liberalization and Globalization
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Path Two: Severe Fiscal Imbalances
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Additional Factors
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Stages of Financial Crises in Emerging
Markets II
Stage Two: Currency Crisis
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Currency crisis triggered by deterioration of bank
balance sheets
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Defend currency through increase in interest rates, banks
must pay more to obtain funds
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Increasing costs could lead to insolvency
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Could also be the result of severe fiscal imbalances
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Government debt repayment questionable, investors pull
funds from country and sell domestic currency
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Stages of Financial Crises in Emerging
Markets III
Stage Three: Full Fledged Financial Crisis
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Emerging markets have debts typically
denominated in US dollars.
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Unanticipated depreciation or devaluation
increases the debt burden of domestic firms
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Net worth declines
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Leads to adverse selection and moral hazard
problems
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Reduces investment and aggregate demand
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Twin Crises
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Collapse of currency leads to higher inflation
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Sharp depreciation leads to upward pressure on
import prices
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Lead to a rise in both actual and expected inflation
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Increased interest payments for firms lead to cash
flow reductions and decline in net worth increases
asymmetric information problems reducing
investment and economic activity
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Further economic decline occurs through
deterioration of banks balance sheets