Lecture 2

Financial Crises and the Subprime Meltdown

Reading: Mishkin, Chapters 12 & 13, special attention to slides

16-, because some material is not in the textbook

Lecture 2: Banking and Money

Questions and problems:
• Mishkin, Chapters 12 & 13, problems 5, 7, 9, 10, 15, 17, 20
(see next slide)

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 Lecture 2

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Factors Causing Financial Crises

• Asset Markets Effects on Balance Sheets

• Stock market decline
• Decreases net worth of corporations

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• Unanticipated decline in the price level
• Liabilities increase in real terms and net worth decreases

• Unanticipated decline in the value of domestic currency

• Increases debt denominated in foreign currencies and decreases net
worth

• Asset write-downs 3
Factors Causing Financial Crises

• Deterioration in Financial Institutions’ Balance Sheets

• Decline in lending (credit crunch)

• Banking Crisis

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• Loss of information production and disintermediation

• Increases in Uncertainty
• Decrease in lending

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Factors Causing Financial Crises

• Increases in Interest Rates

• Increases adverse selection problem

• Increases need for external funds and therefore adverse selection

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and moral hazard

• Government Fiscal Imbalances

• Create fears of default on government debt

• Investors might pull their money out of the country

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Dynamics of past financial Crises in
developed countries
• Stage one: Initiation of Financial Crisis
• Mismanagement of financial deregulation / liberalization /
innovation

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• Asset price boom & bust

• Spikes in interest rates

• Increase in uncertainty

• Stage two: Banking Crisis

• Stage three: Debt Deflation

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Sequence of Events in Developed Countries’ Crises

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Dynamics of Financial Crises in Emerging
Market Economies
• Stage 1: Initiation of Financial Crisis
• Path 1: mismanagement of financial liberalization/globalization
• Weak supervision and lack of expertise leads to a lending boom
• Domestic banks borrow from foreign banks
• Fixed exchange rates give a sense of lower risk

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• Banks play a more important role in emerging market economies, since
securities markets are not well developed yet
• Path 2: severe fiscal imbalances
• Governments in need of funds sometimes force banks to buy
government debt
• When government debt loses value, banks incur bond losses and their
net worth decreases
• Additional factors
• Increase in interest rates (from abroad) 8
• Asset price decrease
• Uncertainty linked to unstable political systems
Dynamics of Financial Crises in Emerging
Market Economies
• Stage 2: Currency Crisis
• Deterioration of bank balance sheets triggers currency crises:
• Government cannot raise interest rates (doing so forces banks into insolvency)…
• … and speculators expect a currency devaluation
• How severe fiscal imbalances triggers currency crises:
• Foreign and domestic investors sell the domestic currency

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• Stage 3: Full-Fledged Financial Crisis
• The debt burden in terms of domestic currency increases (net worth
decreases)
• Increase in expected and actual inflation reduces firms’ cash flow

• Banks are more likely to fail:

• Individuals are less able to pay off their debts (value of assets falls)
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• Debt denominated in foreign currency increases (value of liabilities increases)
Financial Crises: Mexico 1994-1995

• Financial liberalization in the early 1990s:

• Lending boom, coupled with weak supervision and lack of expertise

• Banks accumulated losses and their net worth declined

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• Rise in interest rates abroad

• Uncertainty increased (political instability)

• Domestic currency devaluated on December 20, 1994

• Rise in actual and expected inflation

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Financial Crises: East Asia 1997-1998

• Financial liberalization in the early 1990s:

• Lending boom, coupled with weak supervision and lack of expertise

• Banks accumulated losses and their net worth declined

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• Uncertainty increased (stock market declines and failure of
prominent firms)

• Domestic currencies devaluated by 1997

• Rise in actual and expected inflation

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Financial Crises: Argentina 2001-2002

• Government coerced banks to absorb large amounts of debt due

to fiscal imbalances

• Rise in interest rates abroad

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• Uncertainty increased (ongoing recession)

• Domestic currency devaluated on January 6, 2002

• Rise in actual and expected inflation

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Sequence of Events in Emerging Market Financial Crises

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The 1980s S&L Banking Crisis (US)
• Financial innovation and new financial instruments increased
risk taking
• Increased deposit insurance led to increased moral hazard

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• Deregulation
• Depository Institutions Deregulation and Monetary Control Act of
1980 (abolition of regulation Q on maximum depositi interest
rates)
• Depository Institutions Act of 1982 (deregulation of S&L)

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The Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 (US)

• Financial Institutions Reform, Regulatory and Enforcement Act

of 1989 (FIRREA)

• Federal Deposit Insurance Corporation (FDIC) and

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Improvement Act of 1991

• Cost of the S&L bailout = approximately $150 billion, or 3% of

US GDP

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The Subprime Financial Crisis
of 2007 – 2008
• Financial innovations emerge in the mortgage markets:
• Subprime and Alt-A mortgages: Subprime lending is the
lending by financial intermediaries to individuals that show a
limited ability to repay (“NINJA” loans: No income, no job, no
assets)

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• This involves a higher lending rate
• One category of these loans are the ARMs (Adjustable Rate
Mortgages), and bad ARMs increased by 3 times in the
period 2007-2009
• Mortgage-backed securities (MBS)

• Collateralized debt obligations (CDOs)

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• Credit Default Swaps (CDS) – like buying a fire insurance
policy on your… neighbour house
Housing price bubble forms
• House ownership in the US increased from 64% in 1994 to a record
high of 69.2% in 2004

• Increase in liquidity from cash flows surging to the United States

• Development of subprime mortgage market fuelled housing

demand and housing prices.

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• Higher demand was one of the factors causing prices to explode

• Many switched to ARMs with lower initial rates to refinance their

purchases

• This was backed up by US government policies (especially

following the attack on the Twin Towers on 9/11/2001 – George W.
Bush) to boost demand and growth
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Agency problems form
• Agency problems arise
• “Originate to distribute” model is subject to principal (investor)
agent (mortgage broker) problem
• Borrowers had little incentive to disclose information about their

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ability to pay
• Commercial and investment banks (as well as rating agencies) had
weak incentives to assess the quality of securities
• The loans were getting securitized from monoline insurance
companies and they were given an AAA rating by credit rating
agencies

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Economic and Political Objectives

• Regulators did not act prudentially and Central banks

and governments only acted after the crisis

• The very low interest rates over a prolonged period of

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time gave banks more incentives to take on extra risk
(risk-taking channel of monetary policy)

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Bubble forms and bursts
• Supply of new houses exceeds demand by a lot

• Information problems surface

• Bad loans rise considerably and banks fail

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• The crisis spreads through securitized assets, CDS (e.g.
AIG and monoline insurers), interbank lending and
information sharing

• Major financial institutions fail in the Summer and Fall of 20

2008
The Subprime Financial Crisis of
2007 - 2008 (cont’d)
• Banks’ balance sheets deteriorate
• Write downs
• Sell of assets and credit restriction

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• High-profile firms fail
• Bear Stearns (March 2008)
• Fannie Mae and Freddie Mac (July 2008)
• Lehman Brothers, Merrill Lynch, AIG, Reserve
Primary Fund (mutual fund: “breaking the buck”)
and Washington Mutual (September 2008).
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The Subprime Financial Crisis of
2007 - 2008 (cont’d)

• Crisis spreads globally

• Sign of the globalization of financial markets

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• TED spread (3 months interest rate on
Eurodollar minus 3 months Treasury bills
interest rate) increased from 40 basis points to
450 b.p. in mid-October 2008

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Mindmap of the Subprime financial crisis
of 2007-2008

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 Treasury Bill–to–Eurodollar Rate
(TED) Spread

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Source: www.federalreserve.gov/releases/h15/data.htm
Why did the crisis spread?
• Subprime Debt Obligations “made in USA” held around
the world caused global financial shock
• Housing bubbles burst in UK , Ireland, Spain as well as
US
• Failure of Lehman Bros in September 2008 caused
massive panic over counterparty risk. AIG required

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$180 billion bailout to cover Credit Default Swaps (CDS),
insurance against bond defaults underwritten without
reserves
• Stress on banks around the world led to shrinking credit
availability. “Shadow” off-balance-sheet banking sector
collapsed as short-term funding vanished
• Falling demand spread from US to all countries: as US
imports dropped, other countries’ exports fell
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The Subprime Financial Crisis of
2007 - 2008 (cont’d)
• Bailout package debated
• US House of Representatives voted down the
$700 billion bailout package on September
29, 2008.

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• It passed on October 3.

• Recovery
• US Congress approved a $787 billion
economic stimulus plan on February 13, 2009
• But crisis becomes a euro-area crisis
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European crisis
• US housing prices peaked in late 2006

• European housing prices peaked a year later

• Financial Crisis struck Europe & US at same time,

August 2007, after Bear, Stearns, Fannie Mae &

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Freddie Mac taken over with US Government
assistance in April and July of 2007

• International credit markets froze up on 9 August

2007 (ECB injected €90bn of liquidity vs. €60bn on
9/11/2001) when subprime based hedge funds
collapsed in Europe and US. No longer able to
borrow short-term funds, banks faced much higher 27
risk premia
 Quarterly real GDP growth rates

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Source: International Financial Statistics, IMF.
European financial institutions under stress
• BNP-Paribas, AXA and Oddo forced to close funds in
August 2007

• UK bank Northern Rock taken over by government

• German state banks IKB, WestLB, BayernLB and

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SachsenLB bailed out by government

• Irish banks given government deposit guarantees

• Switzerland injects funds into UBS [Credit Suisse 2023 ]

• Iceland’s banks unable to roll over short term borrowing,

default on deposits of foreigners [documentary “Inside
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Job”/Mishkin role ]
 Credit in the Eurozone (% change)

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Source: European Commission (2009)
Monetary policy response by European
Central Bank (ECB)

• The ECB did not react quickly (only lowered interest rates in
October 2008) and only strongly acted in 2012

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• Eventually injected liquidity into European banks unable to
obtain short-term funds in market

• Euro fell against the dollar due to “safe haven” flight to US

Treasury securities

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Interest rates in the Eurozone and the US
(interbank rates)

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Sources: ECB, Federal Reserve Bank of New York
 Public Support to the Financial Sector
(as of 18 February 2009, % of GDP)

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Source: International Monetary Fund (2009).

Fiscal Policy Responses to Recession

• Automatic stabilizers of falling taxes, rising welfare and

unemployment payments kick in as incomes fall and
unemployment rises

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• Discretionary fiscal stimulus enacted in most countries,
depending on their fiscal positions

• European countries limited by “Stability and Growth

Pact” to 3% fiscal deficits, except in time of “exceptional
economic distress”
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Changes in Budget Balances,
October 2008 (% gdp)

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Source: IMF (2009)

The Role of the Euro
• Previous economic crises in Europe have led to large
devaluations of currencies
• Within the Eurozone, the single currency prevents
devaluation , provides automatic financial support through
capital markets

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• Non-euro currencies depreciated sharply in 2008, British
pound sterling, Swedish kronor, Polish zloty, Hungarian
forint
• But the €uro is an “incomplete” currency because it is
NOT backed by a Eurozone budget with an independent
taxation power
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Mindmap of the Subprime financial crisis
of 2007-2008

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Problematic countries and the financial crisis

• The global financial crisis found European countries with

strong fiscal and institutional imbalances

• This was irrespective of the condition of the banking

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sector, which in some countries was strong and in other
countries was weak

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Economic imbalances

• Economic development

• Government debt

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• Youth unemployment

• Poverty lines

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Long term interest rates (10-year) Euro (01/08/2007-31/07/2022)

Source: ECB

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Imbalances in purchasing power – 2021, source: GfK

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Ukraine

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Government debt to GDP ratio in EU– 1Q2023

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Youth unemployment rates (06/2023) – Europe (source: Eurostat/statista)

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People at risk of poverty or social exclusion in European countries

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Institutional imbalances -- the mother of
economic imbalances

1. Bureaucratic quality

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2. Rule of law and function of independent authorities

3. Corruption and shadow economy

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Governance quality -- 2021

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The European Quality of Government Index (EQI) captures average citizens’ perceptions and experiences
with corruption, quality and impartiality of three essential public services – health, education and policing -
in their region of residence.
Perception of corruption – Europe – 2021, source: Statista

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Economic theory and evidence

• Institutions shape economics and the long-term

prospects of countries (as well as their convergence) is
conditional on good institutions (Acemoglu, 2014)

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• Poor institutions work in the same fashion as the poverty
trap

• They hinder even the role of financial markets, which

price the relevant country risk and impose higher
financial costs on domestic firms (Delis et al., 2019)
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Who benefits from institutional improvements?
Source: Beatrice Pierluigi, David Sondermann, 2018. Macroeconomic
imbalances in the euro area: where do we stand? European Central
bank, Occasional Paper Series No 211.

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Who benefits from institutional improvements?
Source: Beatrice Pierluigi, David Sondermann, 2018. Macroeconomic
imbalances in the euro area: where do we stand? European Central
bank, Occasional Paper Series No 211.

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 Conclusions
• Cautious Eurozone response to Financial Crisis

• Interest rate policy reaction delayed: concentration on inflation target, but…*

• Fiscal policy reaction muted: “Stability & Growth Pact”

• Common currency members avoided large devaluations and foreign currency

debt

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• European governments have tried to act together, not always successfully

• Institutional imbalances threaten European cohesion

• The Ukraine-Russia crisis, a game changer? For the better or the worse?

* Through its supports of liquidity to banks and Long Term Repurchase Operations (LTRO) of
government bonds, the European Central Bank’s (ECB) consolidated balance sheet became
bloated (with money creation unleashing inflation in 2022 to a 40-year high):
• from €1,150bn on 31/12/06 (prior to the Great Financial Crisis), equivalent to 13% of the
Eurozone (EZ) 2006 GDP (€8,739bn) 51
• to €4,671bn on 31/12/19 (prior to the pandemic crisis), equivalent to 39% of the EZ 2019 GDP
(€11,984bn)
• and to a record €8,564bn on 31/12/21, equivalent to…70% of the EZ 2021 GDP (€12,269bn)
ECB’s balance sheet in €Bn(1998-05-2023)

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Bottom line: Mindmap of the Subprime
financial crisis of 2007-2008

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