Combating adverse selection and moral hazard:

• Collateral

• Net Worth (=$Assets - $Liabilities)

Net Worth – The Foundation of Credit

Factors Causing Financial CrisesAsset Values Drop: Net Worth Down

Stock market decline Decreases net worth of corporations.Unanticipated deflation Debt burdens up/net worth downUnanticipated depreciation $ debts up/net worth downAsset write-downs (bad debts) Net worth down

• Deterioration in Financial Institutions’ Balance SheetsDecline in lending.

Interest Rates Rise Worsens adverse selection (who would pay the high rates?)Increases business needs for external funds

worsens adverse selection and moral hazard problems.

Government Fiscal ImbalancesFears of default on government debt Capital flight

Banking CrisesLoss of information production / disintermediation.

• Increases in Uncertainty Decline in lending.

Crises (and Threatened Crises) We Have Known

• The Great Depression, 1929 – 1939• Mexican Default, 1982• Continental Illinois, 1984…Oil patch loans…TBTG

• Third World Debt Crisis, 1980s Lost Decade• Savings & Loan Debacle, 1986 – 1990• Black Monday, October 19, 1987

• Tequila Crisis, 1994 – 1995• East Asia Financial Crisis, 1997 - 1998• Long Term Capital Management, 1998• dot.com bust, 2000• 911, 2001

• Subprime-triggered crisis The Great Recession, 2007 –

The Great Depression: Mother of all Crises

Stock Market Crash Spending cutback

Bank Panic Monetary Contraction

Bank Failures Reduced Lending

Price Deflation/Deflationary Expectations Debt Deflation

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1929

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djia, left scale $/pound, right scaleproducer price index, right scale mfg employment, right scale

Producer Price Index

Onset of the Depression: Persistent Deflation…Persistent Job Loss

$/pound

DJIA

Manufacturing Employment

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djia, left scale $/pound, right scaleproducer price index, right scale mfg employment, right scale

New Deal Reflation

DJIA

Manufacturing Employment

$/pound

Producer Price Index

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1929

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1929

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real m1 balances (ppi deflator) demand deposit to currency ratio real m2 balances (ppi deflator)

Ratio of Demand Deposits To Currency

Real Money Holdings

New Deal Reflation

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djia, left scale $/pound, right scaleproducer price index, right scale mfg employment, right scale

DJIA

Manufacturing Employment

Producer Price Index

$/pound

Stimulus and Retrenchment: Recession in Depression

Dynamics of Financial Crises in Emerging Market Economies

• Stage one: Initiation of Financial Crisis.• Path one: mismanagement of financial liberalization

• Weak supervision and lack of expertise lending boom.• Domestic banks borrow from foreign banks. • Fixed exchange rates give a sense of lower risk.• Securities markets not well-developed Banks important

• Path two: severe fiscal imbalances:• Governments force banks to buy government debt. • When government debt loses value, bank net worth down .

Additional factors:• Increase in interest rates (from abroad)• Asset price decrease

• Uncertainty linked to unstable political systems

Dynamics of Financial Crises in Emerging Market Economies

• Stage two: currency crisisBank losses currency crises:

• Government cannot raise interest rates (doing so forces banks into insolvency)…

• … and speculators expect a devaluation. • Foreign and domestic investors sell the domestic currency.

• Stage three: Full-Fledged Financial Crisis:• The debt burden in terms of domestic currency up • Banks more likely to fail:

– Individuals are less able to pay off their debts (value of assets fall).

– Debt denominated in foreign currency increases (value of liabilities increase).

Financial Crises: Mexico 1994-1995 ...Tequila

• Financial liberalization in the early 1990s: – Lending boom/weak supervision/lack of expertise.– Banks accumulated losses/net worth declined.

• Rise in interest rates abroad.• Increased uncertainty (political instability).• Domestic currency devaluated Dec. 20, 1994.

– Tesobono burden • Rise in actual and expected inflation.

Financial Crises: East Asia 1997-1998

• Financial liberalization in the early 1990s: – Lending boom/weak supervision/lack of expertise.– Banks accumulated losses/net worth declined.

• Uncertainty increased – stock market declines and failure of prominent firms

• Domestic currencies devaluated (1997). • Rise in actual and expected inflation.

Financial Crises: Argentina 2001-2002• Currency board: 1 Peso = $1• Fiscal imbalance

– banks coerced to absorb government debt• Appreciation of $ Argentine recession• Rise in interest rates abroad.• Uncertainty increased (ongoing recession).• Domestic currency devaluated, Jan. 6, 2002• Rise in actual and expected inflation.

Sequence of Events in Emerging Market Financial Crises

U.S. Financial CrisesStage One• Mismanagement of

financial liberalization and innovations

• Asset price boom & bust• Spikes in interest rates• Increase in uncertainty

Stage two: Banking Crisis

Stage three: Debt Deflation

Financial Crisis of 2007 - 2009• Financial innovations in mortgage markets:

– Subprime and Alt-A mortgages– Mortgage-backed securities– Collateralized debt obligations (CDOs)

• Housing price bubble forms– World savings glut

Increase in liquidity from cash flows surging to the US – Subprime mortgage market housing demand and prices up.

• Agency problems arise– “Originate to distribute”

principal (investor) agent (mortgage broker) problem.

– Commercial and investment banks/rating agencies …weak incentives to assess quality of securities

• Information problems surface…A “Minsky Moment”Housing price bubble bursts/Crisis spreads globallyhttp://www.nytimes.com/interactive/2009/04/29/business/2009-wide-housing-graphic.html

Easy Money

Policy

Capital Inflows

Eager Home Buyers

InnovativeBanks

Rating Agencies

AmbitiousMortgage Brokers

SecuritizationMBSs

EscalatingHouse Prices

Gov’t SponsoredEnterprises

Developer Clout

Bank Regulators

The best of times

A “Global Saving Glut”

Easy MoneyPolicy

Capital Inflows

Eager Home Buyers

InnovativeBanks

Rating Agencies

AmbitiousMortgage Brokers

SecuritizationMBSs

EscalatingHouse Prices

Gov’t SponsoredEnterprises

Developer Clout

Bank Regulators

The best of times

House Price – Foreclo

sureSpiral

Demand –Jobs –

Wages – Income –

SpiralDeleveraging – Debt DeflationSpiral

GovernmentRevenue – CutbackSpiral

Global Repercussion Spiral Macroecono

mic Linkages

and Feedbacks

Vicious Spirals Unleashed

Financial Crisis of 2007 - 2009 (cont’d)• Banks’ balance sheets deteriorate

– Write downs– Sale of assets and credit restriction

• High-profile firms fail– Bear Stearns (March 2008)– Fannie Mae and Freddie Mac (July 2008)– Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund

(MMMF) and Washington Mutual (September 2008).• Fed pumps up bank reserves: TARP/TALF,etc.

– Lend and lend freely • Bailout package enacted

– House votes down the $700 billion bailout package (9/29/08) Stock market slumps Bailout passes on October 3. – Congress approves a $787 billion economic stimulus plan on

February 13, 2009.

• Recession deepens

ResponsesLender of Last Resort / Spender of Last Resort

• Tax Rebate $124 bil.• Fed Fund Rate Cuts• Fannie/Freddie $200 bil.• Bear-Stearns $29 bil.• AIG $174 bil.Fed “Facilities”• Primary Dealer Credit Facility (PDCF) $58 bil.• Treasury Security Loan Facility (TSLF) $133 bil.• Term Auction Facility (TAF) $416 bil.• Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.• Money Market Investor Funding Facility (MMIFF) $540 bil.• More Fed Fund Rate Cuts … Hold At ~0%• Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.• Term Asset-Backed Securities Loan Facility (TALF) $200 bil.• Emergency Economic Stabilization Act/TARP $700 bil.

Government LoansGovernment Equity

• Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act

• TARP II

• Stress Tests

House Price – Foreclo

sureSpiral

Demand –Jobs –

Wages – Income –

SpiralDeleveraging – Debt Deflation

Spiral

GovernmentRevenue – CutbackSpiral

Global Repercussion Spiral Macroecono

mic Linkages

and Feedbacks

Vicious Spirals Reversed? Tackle them all together!

StimulusProgram• Infrastructure Spending• Tax Cuts

Federal AidTo States

RefinanceMortgages

Revive dual banking systemCash for Trash• Recapitalize banks• Revive securitization

G – 20• Coordinated Stimulus

Macroeconomic Linkages and

Feedbacks

Vicious Spirals Unleashed

FIGURE 2 Treasury Bill–to–Eurodollar Rate (TED) Spread

Source: www.federalreserve.gov/releases/h15/data.htm