Economic Crisis: Financial Crises

Economic Crisis

Financial Crises

Lecture Preview
  • The lecture will develop a framework to understand the dynamics of financial crises.
  • Topics include:
    • The Great Depression
    • The 2007–2009 Financial Crisis

Case: The Great Depression

  • In 1928 and 1929, stock prices doubled in the U.S.
  • The Fed tried to curb this period of excessive speculation with a tight monetary policy, which led to a collapse of more than 60% in October 1929.
  • Between 1930 and 1933, one-third of U.S. banks went out of business as agricultural shocks led to bank failures.
  • Stock prices crashed in 1929, falling by more than 60%, and continued to fall to only 10% of their peak value by 1932.

Stock Market Prices During The Great Depression

  • Stock prices crashed in 1929, falling by more than 60%, and then continued to fall to only 10% of their peak value by 1932.

Adverse Selection and Moral Hazard

  • Adverse selection and moral hazard in credit markets became severe during the Great Depression.
  • Firms with productive uses of funds were unable to get financing.
  • Credit spreads increased from 2% to nearly 8% during the height of the Depression.

Credit Spreads During The Great Depression

  • Credit spreads (the difference between rates on Baa corporate bonds and U.S. Treasury bonds) rose sharply during the Great Depression.

The Great Depression: Deflation and Unemployment

  • The deflation during the period led to a 25% decline in price levels.
  • The prolonged economic contraction led to an unemployment rate of around 25%.
  • The Depression was the worst financial crisis ever in the U.S., explaining why the economic contraction was also the most severe ever experienced by the nation.

Case: The 2007–2009 Financial Crisis

  • Three central factors:
    • Financial innovation in mortgage markets
    • Agency problems in mortgage markets
    • The role of asymmetric information in the credit rating process

Financial Innovation in Mortgage Markets

  • Less-than-credit worthy borrowers found the ability to purchase homes through subprime lending, a practice almost nonexistent until the 2000s.
  • Financial engineering developed new financial products to further enhance and distribute risk from mortgage lending.

Agency Problems in Mortgage Markets

  • Mortgage originators did not hold the actual mortgage but sold the note in the secondary market.
  • Mortgage originators earned fees from the volume of the loans produced, not the quality.

Rating Agencies' Role

  • Agencies consulted with firms on structuring products to achieve the highest rating, creating a clear conflict.
  • The rating system was hardly designed to address the complex nature of the structured debt designs.
  • The result was meaningless ratings that investors had relied on to assess the quality of their investments.

Housing Boom and Underwriting Standards

  • Initially, the housing boom was lauded by economists and politicians and helped stimulate growth in the subprime market.
  • However, underwriting standards fell, and people were clearly buying houses they could not afford, except for the ability to sell the house for a higher price.

Housing Prices: 2002-2010

  • By 2009, housing prices had fallen by over 30%.

Fed's Role in the Housing Price Bubble

  • Some argue that low interest rates from 2003 to 2006 fueled the housing bubble.
  • In early 2009, Mr. Bernanke rebutted this argument and argued rates were appropriate.
  • He also pointed to new mortgage products, relaxed lending standards, and capital inflows as more likely causes.

Impact of Mortgage Defaults

  • As mortgage defaults rose, banks and other FIs saw the value of their assets fall.
  • This was further complicated by the complexity of mortgages, CDOs, defaults swaps, and other difficult-to-value assets.
  • Banks began the deleveraging process, selling assets and restricting credit, further depressing the struggling economy.

Shadow Banking System

  • The shadow banking system also experienced a run, including hedge funds, investment banks, and other liquidity providers.
  • When the short-term debt markets seized, so did the availability of credit to this system.
  • This led to further “fire” sales of assets to meet higher credit standards.

Stock Prices: 2002-2010

  • Stock prices fell by 50% from October 2007 to March of 2009.

Credit Spreads: 2002-2010

  • Credit spreads (the difference between rates on Baa corporate bonds and U.S. Treasury bonds) rose by more than 400 basis points (4 percentage points) during the crisis.

Key Events in 2008

  • March 2008: Bear Sterns fails and is sold to JP Morgan for 5% of its value only 1 year ago
  • September 2008: both Freddie and Fannie put into conservatorship after heaving subprime losses.
  • September 2008: Lehman Brothers files for bankruptcy. Merrill Lynch sold to Bank of America at “fire” sale prices.
  • AIG also experiences a liquidity crisis.

European Involvement

  • Europe was actually first to raise the alarm in the crisis.
  • With the downgrade of $10 billion in mortgage-related products, short-term money markets froze.
  • In August 2007, a French investment house suspended redemption of some of its money market funds.
  • Banks and firms began to horde cash.

Bank Failures

  • The end of credit led to several bank failures.
  • Northern Rock was one of the first, relying on short–term credit markets for funding. Others soon followed.
  • By most standards, Europe experienced a more severe downturn than the U.S.