Factors Causing Financial Crises Asset Markets Effects on Balance Sheets – Stock market decline Decreases net worth of corporations. – Unanticipated deflation Debt burdens up/net worth down – Unanticipated depreciation $ debts up/net worth down – Asset write-downs (bad debts) Net worth down • Deterioration in Financial Institutions’ Balance Sheets Decline in lending. Increases in Interest Rates – Worsens adverse selection (who would pay the high rates?) – Increases need for external funds worsens adverse selection and moral hazard problems. Government Fiscal Imbalances – Fears of default on government debtCapital flight Banking Crises – Loss of information production / disintermediation. • Increases in Uncertainty Decline in lending.
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Factors Causing Financial Crises Asset Markets Effects on Balance Sheets –Stock market decline Decreases net worth of corporations. –Unanticipated deflation.
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Factors Causing Financial CrisesAsset Markets Effects on Balance Sheets
– Stock market decline Decreases net worth of corporations.– Unanticipated deflation Debt burdens up/net worth down– Unanticipated depreciation $ debts up/net worth down– Asset write-downs (bad debts) Net worth down
• Deterioration in Financial Institutions’ Balance SheetsDecline in lending.
Increases in Interest Rates– Worsens adverse selection (who would pay the high rates?)– Increases need for external funds
worsens adverse selection and moral hazard problems.
Government Fiscal Imbalances– Fears of default on government debt Capital flight
Banking Crises– Loss of information production / disintermediation.
• Increases in Uncertainty Decline in lending.
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:
– 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
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 .