(BBA)CH9 Financial Crisis

8/2/2019 (BBA)CH9 Financial Crisis

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Chapter Nine

Financial Crisesandthe Subprime Meltdown


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Factors Causing Financial Crises (p. 199) A financial crisis:

It occurs when an increase in asymmetric informationfrom a disruption in the financial system causes agencyproblem that renders financial market incapable ofchanneling fund from savers to borrowers with productiveinvestment opportunities.


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Factors Causing Financial Crises (p. 200-202) The six factors play an important role in financial crises.

1. Asset market effects on the balance sheets.2. Deterioration in balance sheets of financial institutions.3. Banking crisis.4. Increases in uncertainty.5. Increases in interest rates.6. Government Fiscal Imbalances.


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Asset Market Effects on Balance Sheets (p.200-201) The state of balance sheets of borrower shows the severityof asymmetric information problem in financial market. The following things happened in asset market may

weaken the state of balance sheets of borrower.1. Stock Market Decline;2. Unanticipated Decline in Aggregate Price Level;3. Unanticipated Decline in Value of Domestic Currency;4. Asset Write-Downs.


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Asset Market Effects on Balance SheetsBalance Sheet of Borrowers

Assets Liabilities & Equities Investment LiabilitiesFixed assets Equities

1. Stock prices fall

1. Stock prices fall2. Price level falls

3. FX falls


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Asset Market Effects on Balance SheetsBalance Sheet of banks

Assets Liabilities & Equities Loans LiabilitiesInvestment Equities

4. Bad lending


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Asset Market Effects on Balance Sheets (p.200) A. Stock Market Decline:

1. That a decline in stock market means net worth of acorporation will fall makes lenders less willing to lend.

2. As value of collateral declines, it provides lessprotection for lenders. Lenders are less protectionagainst adverse selection.


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Asset Market Effects on Balance Sheets (p.200) B. Unanticipated Decline in Aggregate Price Level:

1. A decrease in net worth of firms due to a decline inprice level led to raise value of liabilities of firm in realterm. (Fisher effect)

2. An unanticipated decline in price level thus leads to adrop in lending and economic activities.


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Asset Market Effects on Balance Sheets (p.200) C. Unanticipated Decline in Value of Domestic Currency:

1. With debt contracts denominated in foreign currency,the debt burden of domestic firms increases as anunanticipated depreciation of domestic currency.Thus, there is a deterioration in firm's balance sheetand decline in net worth.

2. The increase in agency problems leads to a decline ininvestment and economic activities.


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Asset Market Effects on Balance Sheets (p.200) D. Asset Write-Downs

1. Asset price declines lead to a write-down of the valueasset side of balance sheet of financial institutions andalso lead to a contraction of lending.


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Deterioration in Balance Sheets of FinancialInstitutions (p.201) Given that financial institutions suffer a deterioration in

their balance sheets and have a contraction in capital. Thus, they will have fewer resources to lend, and lending

will decline.


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Banking Crisis (p.201) As bank panic occurred when multiple banks fail

simultaneously, depositors will withdraw their moneyfrom bank due to not knowing quality of bank loanportfolio.

A decrease in bank lending during a bank crisis decreasesupply of funds available to borrowers, which leads tohigher interest rates.


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Increases in Uncertainty (p.201) Due to failure of a prominent financial or non-financial

institutions, a recession, or stock market crash, it is hardfor lenders to screen good credit risks from bad creditrisks.

Hence, inability of lender to solve adverse selectionmakes them unwilling to lend and leads to a decline inlending, investment, and aggregate economic activity.


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Increases in Interest Rates (p.201-202) Interest rate rises up because of increased demand for

credit or a decline of money supply.(supply and demand model for money)

Although bad credit risks are willing to borrow at highinterest rates, lender have fear of default on the borrowers.That leads to a decline in making loans.

High interest rates lead to a decline in cash flow of firms.If lenders do not know borrowers, they may choose not tolend.


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Government Fiscal Imbalances (p.202) Government fiscal imbalances may create fears of defaulton government debt.

(fiscal deficit: taxation revenuesgovernment expenditure) It may lead to a destruction of balance sheet of banks asgovernment may enforce banks to purchase governmentbonds. It may lead to decrease in value of domestic currency as

investors pull money out of country, which will weakenthe balance sheets of firms with large amounts of debtdenominated in foreign currency.


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Dynamics of Past US Financial Crisis (p.202) Financial crises in US have two or three stages as follows:

1. Stage 1: Initiation of financial Crisis2. Stage 2: Banking Crisis3. Stage 3: Debt Deflation


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Figure 1Sequence of Events in US Financial Crisis (p.203)


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Stage One: Initiation of Financial Crisis (p.202-205) There are several ways cause financial crises to beginwhen there are failure of major financial institutions.

1. Mismanagement of financial liberalization / innovation.2. Asset price boom and bust.3. Spike in interest rates.4. Increase in uncertainty.


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Mismanagement of Financial Liberalization /Innovation (p.204) With financial liberalization and innovation, banks createmany new financial products. In the long run, it promotes financial development and

encourage a well-run financial system. In the dark side,it prompts financial institutions to go on a lending spree,often called a credit boom. But, they do not have enough expertise to manage risks of

those products. Also, regulators have not expertise oradditional resources to monitor new activities.


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Mismanagement of Financial Liberalization /Innovation (p.204) During bad time, government safety net tries to preventbank panics and encourage banks to keep lending. This may weaken the discipline for the banks. Depositors know that they will not loss their deposits ifthe banks fail.


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Amounts of Subprime Mortgage Lending in 2001-2006

Source: Inside Mortgage Finance

120

185

310

530

625600

0

100

200

300

400

500

600

700

Y 2001 Y 2002 Y 2003 Y 2004 Y 2005 Y 2006

USDB

illion


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Securitization & Financial InnovationInvestment banks engage in securitization of sub-primemortgages and further innovate structured notes.I. Securitization II. Financial Innovation

MBS: Mortgage-Backed SecuritiesCDO: Collateralized Debt ObligationCDS: Credit Default Swap

SubprimeLoansMBSBased onSubprime

CDOBased onMBSCDSBased onCDO


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Mismanagement of Financial Liberalization /Innovation (p.204) Losses on loans begin to mount and the drop in the valueof loans falls resulting in a decrease in net worth of banks. Then, banks cut back on the amounts of their lending,

which is called de-leveraging. With less capitals, banks become riskier, causingdepositors to pull out their money from banks.


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Asset Price Boom and Bust (p.205) Asset-price bubble:Asset prices, in the stock market and real estate market,can be driven above their fundamental economic values

by investor psychology. Asset-price bubbles are often driven by credit booms, inwhich a large increase in credit to fund purchase of assets,thereby driving up their prices. Asset price bust can lead to a deterioration in balancesheet of financial institutions, which results in a decline innet worth.


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FHFA Seasonally Adjusted House Price Index forUSA, 2001Q1 - 2010Q2

Source: Federal Housing Finance Agency (2010/09/06)

-10.00%

-8.00%

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%6.00%

8.00%

10.00%

2001Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 2009Q1 2010Q1

House Price Appreciation From Same Quarter from One Year Earlier (%)


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Spike in Interest Rates (p.205) Many financial crises were precipitated by increases ininterest rates. High interest rates lead to a decrease in cash flow for

firms. Thus, good firms are not willing to borrow at highinterest rates, and in contract, bad are willing to borrow athigh interest rates,


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Increase in Uncertainty (p.205) US financial crises had started in the periods of highuncertainty, such as after a recession has begun, a crash inthe stock market, or a failure of a major financial

institution. With information harder to come by, agency problemsincrease and lead to a decline in lending and economicactivity.


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Stage Two: Banking Crisis (p.205-206) Due to the worsening business conditions and uncertainty

about bank health, depositors start to withdrew their fundsfrom banks and bank crisis or bank panic often happens.

Then, for the typical US financial crisis, there are asorting out solvent firms from healthy firm by bankruptcyproceeding. (we called filing Chapter 11)


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Stage Three: Debt Deflation (p.206) If economic downturn leads to a decrease in price level,

debt deflation occurred, in which an unanticipated declinein price level, leading to a further deterioration in networth of firms because of increased burden ofindebtedness. (Fisher Equation: )e

rii


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Sub-prime Financial Crisis of 2007-2008


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Subprime Financial Crisis of 2007-2008 (p.207) Mismanagement of financial innovation in the subprime

residential mortgage market and a bursting of a bubble inhousing prices were the underlying forces behind thefinancial crisis of 2007-2008


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Subprime Financial Crisis of 2007-2008 (p.207) The framework for analyzing financial crisis is as follows:

1. Financial innovations emerge in the mortgage markets;2. Housing price bubble forms;3. Agency problems arise;4. Information problems surface;5. Housing price bubble bursts;6. Crisis spread globally;7. Balance sheet of bank deteriorates;8. High-profile firms fail;9. Bailout package debated.


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Financial Innovations Emerge in the MortgageMarkets (p.207) Before 2000, only most credit worthy (prime) couldobtain residential mortgage loans. Sub-prime Mortgage: Mortgages for borrowers with less-

than-stellar credit records. Alt-A Mortgage: Mortgages for borrowers with higher

expected default rates than prime, but with better creditrecords than subprime borrowers.


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National Distribution of FICO Scores% ofpopulation

FICO Scores Range

SourceFair Isaac Credit Corporation

25

812

15 18

27

13

05

1015202530

up to499

500-549

550-599

600-649

650-699

700-749

750-799

800+


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Mortgage LoansComparison among of Prime, Alt-A and Subprime (new approval case in 2006)

SourceInside Mortgage Finance

Type Scores Lendingratio Debt toincome ratio Ave. amount ofper lendingprime 741 75% 37% USD 0.162 millionAlt-A 709 81% 38% USD 0.316 millionsubprime 630 87% 42% USD 0.588 million


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Financial Innovations Emerge in the MortgageMarkets (p.207) Securitization:

A process that bundling of smaller loans ( like mortgage,vehicle loans, and so on) into standard debt securities bylowering transaction costs and computer technology.

Financial engineering, the development of new andsophisticated financial instruments products.


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Mortgages-Backed (pass-through) SecuritiesSelling

Purchasing Mortgage-backMortgages Securities

Fannie MaeGinnie MaeFreddie Mac

Purchase mortgage loansform banks, S & Ls,mutual saving banks Institutional investors

Funds


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Financial Innovations Emerge in the MortgageMarkets (p.207) Mortgage-backed Securities: A standard debt security is tobundle and quantify the default risk of the underlyinghigh-risk mortgages. Structured Credit Products: financial products are derivedfrom cash flows of underlying assets and can be tailoredto have particular risk characteristics that appeal toinvestors with different preferences. Collateralized Debt Obligations: CDOs are paid out thecash flow from subprime mortgage-backed securities in

different tranches. (AAA, Mezzanine, BBB, )


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The Structure of Asset-Backed Securities (ABS)Asset-BackedSecurities

MBSRMBS CMBS

CDOCLO/CBO

Alt-A/Subprime

Prime Arbitrage BalanceSheet

Traditional ABSConsumer

/Car LoanLeasing/

Student

Loans

Trade &

A/R

others Hybrid


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Rating and Tranche of CDO

Source: CitiBank

CDO

AAA/AaaAA/Aa2

BBB/Baa2BB/Ba2B/B2

No Rating

A/Aa Mezzanine

Junior/

subordinated

Tranche

EquityTranche

SeniorTranche

MBS


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Housing Price Bubble Forms (p.208) Subprime borrowers could refinance their houses withlarger loans when their homes appreciated in values. Subprime borrowers could reduce their default risk since

they could sell their houses by higher prices to pay offtheir loans. At the same time, investors were happy to purchasesubprime mortgage-backed securities with high returns.


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Agency Problems Arise (p.208) Originate-to-distribute is that mortgage was originated bya separate party (a mortgage broker), and then distributeto an investor as an underlying assets in a security. Commercial and investment banks earned large fees byunderwriting mortgaged-backed securities (MBS) andstructured credit products (like CDOs). Credit rating agencies evaluated these securities subject to

conflicts of interest. They earned fees from rating themand from advising customers on how to structure thesesecurities to get the highest rating.


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Information Problems Surface (p.209) The structured products like CDOs, CDOs, CDOs, andso on are so complicated that it is hard to value the cashflow of the underlying assets for a security or determine

who actually own these assets.


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Housing price Bubble Bursts (p.209) As housing price rose and profits for originators andlenders was high, standards of banks for subprimemortgage became lower and lower. Riskier subprime borrowers were easy to obtain mortgageloans and even the 2nd and the 3rd mortgages on 80% ofloan-to-value ratio. With housing prices falling under the value of house after

the peak in 2006, homeowners walked away from theirhomes and sent them back to lenders.


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Crisis Spreads Globally (p.209) BNP Paribas suspended redemption of shares held insome of itsmoney market funds on August 7, 2008after Fitch and S&P's announced downgrades on

mortgage-backed securities and CDOs totaling over $10billion. Although ECB and FED injected money into financialsystems, banks began to hold cash and were willing to

lend. Thus, Treasury-bills-to-Eurodollar rate spread roseto 240 basis points on August 20, 2007 from 40 basispoints during first quarter of 2007.


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Crisis Spreads Globally (p.209) North Rock Bank, a well-known UK bank, is that hadrelied on wholesale short-term borrowing rather thandeposits and collapsed in September, 2008.


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Bank's Balance Sheets Deteriorate (p.210) The decline in US housing prices led to rising defaults onmortgages. As a result, the value of mortgage-backedsecurities and CDOs collapsed. Because of holding these securities, structured investmentvehicles (SIV), sponsored by banks, suffered losses. With weaker balance sheet, banks began to deleverage,sell off assets, and restricted lending to borrowers.


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High-Profile Firms Fail (p.210) In march of 2008, Bear Sterns, the 5th largest I-bank, hada large amount of subprime-related securities and wasforced to sell to JP Morgan. In September of 2008, Merrill Lynch, the 3th largest I-bank, suffered large losses on subprime-related securitiesand was sold to Bank of America. In September of 2008, Lehman Brothers, the 4th largest I-

bank, heavily suffered subprime-related securities andfiled for bankruptcy.


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High-Profile Firms Fail (p.210) In September of 2008, Washington Mutual Bank, the 6thlargest bank, was sold to JP Morgan. Is was the largestbank failure in US history. In September of 2008, American International Group(AIG), an insurance giant, was downgraded and hadwritten over $400 billion of insurance contracts calledcredit default swap which had to pat out on possible

losses from subprime mortgages.


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High-Profile Firms Fail (p.210-211) FDIC has two ways to address the failure banks:

1. Conservatorship:The right of board of directors and management of afirm is transferred to conservators.For example:Federal Housing Finance Agency (FHFA) acted as aconservator to take over Fannie Mae and Freddie Mac.


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High-Profile Firms Fail (p.210-211) FDIC has two ways to address the failure banks:

2. Receivership:A firm is held by a receiver placed in custodialresponsibility for the property of others.


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Bailout Package Debated (p.211) On October 3, 2008, the Emergency Economic

Stabilization Act was passed to a $700 billion of bailoutpackage, proposed by the Bush Administration, to addressfinancial problems.


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Troubled Asset Relief Program (TARP)

Source: Kiel, Paul, (2009/02/09 ), ProPublica, http://Propublic.org/special/show-me-the-tarp-money.

0

1000020000

3000040000

50000

60000

Citig

roup

BOA

AIG

JPMorg

anCh

ase

WellsF

argo

GM

Goldm

anSachs

Morga

nStanley

PNCFin

ancialSe

rvice

Group

USBancor

p

GMAC

Financial

Servi

ce

Chrysler

Capital

OneF

inance

Regio

nalFin

ancial

Corp

America

nExp

ress

BankofN

YMe

lon

StateS

treetCo

rp

DiscoverFina

ncial


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Recovery in Insight ? (p.211) The increase in uncertainty from bank failure and decline

in stock market resulted in a decline in lending led tounemployment rate rising to over 7% by the end of 2008.

The financial crisis led to a slowing of economic growthand massive government bailouts of financial institutions.


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Dynamics of Financial Crises in Emerging MarketEconomies (p.212-217) Financial crises in emerging market have two or threestages as follows:

1. Stage 1: Initiation of financial Crisis2. Stage 2: Currency Crisis3. Stage 3: Full-Fledged Financial Crisis


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Figure 3 Sequence of Events in Emerging MarketFinancial Crisis (p.213)


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Stage One: Initiation of financial Crisis (p.212-213) In contrast to US crisis, financial crises in emergingmarket countries developed two basic paths:

1. Mismanagement of financial liberalization /globalization.2. Severe fiscal imbalance.


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Path One: Mismanagement of FinancialLiberalization / Globalization (p.213-214) Liberalization occurs by eliminating restrictions and

on financial institutions and markets domestically openingup their markets to flows of capitals and financial firmsfrom other countries.

This process is called financial globalization.


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Path One: Mismanagement of FinancialLiberalization / Globalization (p.214) Financial globalization allowed local banks to borrow

abroad. Banks pay high interest rate to attract foreigncapitals and can rapidly increase lending.

Capital inflow is stimulated by government policy ofpegging foreign exchange against dollar.It is important for foreign investors to bear lower risks offoreign exchange.


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Path One: Mismanagement of FinancialLiberalization / Globalization (p.214) In the emerging countries, powerful business ownedbanks would like to prevent supervisors to do their jobs. Powerful businesses who contribute heavily to politician

campaigns can persuade politicians to weaken regulators. Bank regulators have weak supervision and banks havelack of expertise in screening and monitoring ofborrowers.


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Path One: Mismanagement of FinancialLiberalization / Globalization (p.214) Then, the lending booms lead to riskier lending than is inthe advanced countries. Highly riskier lending starts producing loans losses, which

deteriorates the balance sheet in banks and then banksreduce lending. As a result, if banks get in trouble, government is likely tobail it out and taxpayers foots the bill.


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Path Two: Severe Fiscal Imbalances (p.215) Government with budget deficit often forced banks topurchase government bonds with lower rating. But, investors who lose confidence in the ability of

government repay its debt unload the bonds led to adecrease in bond prices. As a result, deterioration in balance sheet of banks causesa decline in lending and can lead to bank panic.


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Stage Two: Currency Crisis (p.215) The deterioration in bank balance sheet and severefiscalimbalance are two keys trigging speculative attacks. A currency pegging to dollar becomes subject to a

speculative attack, in which speculators engage in massivesales of the currency. Emerging counties use limited foreign reserves to sustainvalue of their currencies.


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Stage Two: Currency Crisis (p.215) A. How Deterioration in Bank Balance Sheets Triggers

Currency Crisis: As banks are in trouble, government has to rise interest

rate to defense currency value and encourage capitalinflow. But, banks have to pay more to obtain funds. There is dilemma for government and banks.

1. An increase in interest rate may destroy weaken banks.2. No increase in interest rate will not defense currency

value.


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Stage Two: Currency Crisis (p.215) Speculators can recognize the trouble in a country andrealize when government ability to defend the currency islimited. Once, central bank exhausted its foreign currency reserves,which led to depreciation of domestic currency.


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Stage Two: Currency Crisis (p.216) B. How Severe Fiscal imbalance Triggers Currency Crisis: When government budget deficits spin out of control,foreign and domestic investors begin to suspect that the

country may not be able to pay back its government debtsand will start pulling money out of country and selling thedomestic currency. Fiscal situation is out of control results in a speculative

attack against the currency.


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Stage Three: Full-Fledged Financial Crisis (p.217) As currency value falls, it will lead to an increase in valueof debts relative to assets and a decline in net worth offirms. Collapse of currency value leads to higher inflationresulting in an increase in interest payment causing adecrease cash flows of firms. As a result, many of firms can not pay off their debts

resulting huge losses of banks and even bank crisis. The concurrent currency and financial crisis are called thetwin crises.


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Mexican crisis of 1994andArgentina financial crisis of 1999


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Analysis

1. Increase in Interest Rates. Before Mexican crisis in 1994 and Argentinafinancial crisis in 1999, Fed reserve raised fed fund

rate to head of inflation. That put upward pressure on interest rate in bothMexico and Argentina in order to sustain exchangerate (pegging to dollar).


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Analysis

3. Asset Market Effects on Balance Sheets. Mexico central bank intervened in FX market andraised interest rate. It was unable to stem attack and

was forced to devalue the peso in December 1994. Because of large current account deficit and weaknessin the Thai financial system, Thai central bank wasforced to allow baht to float downward in July 1997. Depreciation resulted in insolvency for firms withsubstantial amounts of debt in denominated of foreigncurrency.


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Analysis

4. Problems in the Banking Sector. In the early 1990, Bank deregulations resulted in alending boom. Because of weak supervision by regulators and lackof screening at banks, losses on loans began to mount.


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Analysis

5. Government Fiscal Imbalances. In 1998, Argentina entered into a recession and had afiscal problem. Argentina coerced banks into absorbing large amountof government debt.

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(BBA)CH9 Financial Crisis