FINANCIAL MARKETS AND

INSTITUTIONS
Spring 2023
Chapter 3. Financial crisis
Lecturer: Pierre-Xavier Maguès
TABLE OF CONTENTS
I. Introduction – definition of financial crisis
II. Dynamics of Financial Crisis (three stages)
III. The Great Depression
IV. The Global Financial Crisis of 2007-2009.
REFERENCES
Mishkin, F., Eakings, S.G., Financial Markets and Institutions, 9th edition,
Pearson, 2018.

Financial Service Authority, Turner Review – A regulatory Response to the

global banking crisis, 2009.
King, M., The end of Alchemy, W. W. Norton & Company, 2016.
 FINANCIAL CRISES ARE MAJOR DISRUPTIONS IN
FINANCIAL MARKETS CHARACTERIZED BY SHARP
DECLINES IN ASSET PRICES AND FIRM FAILURES.
Source: https://economictimes.indiatimes.com/news/international/business/ten-years-of-the-us-financial-crisis-the-days-that-
roiled-the-world-markets/articleshow/64990945.cms
 Initiation of a Financial Crisis
Stage • Credit Boom and Bust
one • Asset-price Boom and Bust
• Increase in Uncertainty

DYNAMICS OF
Stage
FINANCIAL two
Banking Crisis

CRISIS
Stage Debt Deflation
three
 1. Credit Boom and Bust

The cause of financial crises are often related to:

• financial innovation - introduction of new type of

STAGE ONE: loans or other financial products
• financial liberalization – elimination of restrictions on
INITIATION OF A financial markets and institutions (deregulation). It can
stimulate financial institutions to increase lending,
leading to credit boom.
CRISIS • government safety nets – for ex. deposit insurance
can increase moral hazard incentive for banks to take
on greater risk

Steps in deterioration in financial institutions’ balance sheets

Fewer funds
Value of loans Lending cut, Lenders-savers
Losses on Capital => fewer
fails relative deleveraging pulling out
loans mount decreases loans =>
to liabilities funds
credit freeze
 2. Asset-Price Boom and Bust

Price of assets such as stocks and real estate are mostly driven by
investors expectations of the assets’ future income streams.

• The asset-price bubble is the rise of asset prices well above their

STAGE ONE: fundamental economic value (.com bubble, housing price bubble).

• When the bubble burst, stock and real estate prices drop, companies’
INITIATION OF A capital decline, value of collateral they can pledge drops and they
have tendency to make riskier investments (increasing moral hazard).

CRISIS • The asset price bust also causes a decline in the value of financial
institutions’ assets, leading to less capital and a deterioration in their
balance sheets.

3. Increase in Uncertainty

Financial crises usually start in periods of high uncertainty, stock market

crash, failure of major financial institution.
 Decline in financial institutions’ asset value and tougher business conditions
lead into insolvency (net worth is negative) and potentially bankruptcy

Bank panic
STAGE TWO: Depositors fearing for their deposits and not knowing the quality of banks’
loans, withdraw their deposits. In severe cases, this can lead to bank runs,
BANKING on both good and bad banks, to the point that some of them fail.

CRISIS Fire sale of assets

Banks sell assets quickly to raise necessary funds, pushing the asset prices
further down, which can result in insolvency for some banks. Fewer banks,
increased information asymmetry, lack of funds for productive investment
opportunities.
 Debt-deflation is the process by which, in a
period of falling prices, interest on debt takes
an increasing share of declining income and
so reduces the firms’ net worth (capital).
STAGE THREE:
• Most of the debt contracts have a contract
DEBT DEFLATION value specified as a fixed money quantity.
• Borrowers can struggle both with paying their
debt and a decreasing value of the collateral
used to secure their debt in a mortgage loan.
 Institutions try to reduce interest
charges by repaying some debt,
which implies thy fire-sell collateral
Collateral Debt with a discount, which at the end of
the day will incur a global assets
price decline

Loss of collateral value means it is

STAGE THREE: Debt
required to repay some debt to
match both amounts. It requires
again to fire-sell some collateral,

DEBT DEFLATION Collateral which will accelerate the loss of

asset value, and so on.
This phenomenon leads to “debt
deflation”
Sequence of
Events in
Financial
Crises in
Advanced
Economies

Source: Mishkin, F., Eakings, S.G., Financial Markets and Institutions, 9th edition, Pearson, 2018, p. 208.
THE GREAT DEPRESSION
 1. Stock Market Crash (October 1929)

• During 1928-1929 stock market boom in U.S. (prices

doubled)
• FED viewed this as a result of excessive speculation
The Great and pursued tightening of monetary policy => increase
in interest rates to limit rise in stock prices
Depression • On October 24, 1929, “Black Thursday” – market
crash, a record 12.9 million shares were traded that
day
• On October 29, 1929, “Black Tuesday” – 16 million
shares were traded and millions of shares ended
worthless
• Result - prices fall by 40% by the end of 1929.
 Droughts = sécheresse
2. Bank Panics
• Severe droughts in Midwest led to sharp decline
in agricultural production => farmers could not
pay back their bank loans
• Defaults on farm mortgages led to large loan
The Great losses on bank balance sheet in these regions.
• Weak economy and fear of bank failure led to
Depression bank panics interchanging for two years. More
than 1/3 of U.S. commercial banks failed.
• In 1933. U.S. president Franklin Delano Roosvelt
declared a “bank holiday” – temporary closing of
all banks

The Great
Depression
“Credit Spread” is the difference
in the interest rate of a risky
bond (e.g. issued by a firm) with
the interest rate of a same
maturity “risk-free” bond
(Government bond). The higher
the spread, the higher the risk.
3. Continuing decline in stock
prices Dow-Jones Industrial Average (DJIA) (1929-1939
• By mid 1932., stocks has
declined to 10% of their
value at the 1929. peak
• Investment spending
collapsed by 90% from its
1929. level
• Rise in credit spread –
lenders started charging
much higher interest rates to
protect themselves from
credit losses Source: Mishkin, F., Eakings, S.G., Financial Markets and
Institutions, 9th edition, Pearson, 2018, p 212.
 Huge decline
in prices

Debt
deflation
The Great
Depression Prolonged • Unemployment
economic rose to 25% of
the labor force
contraction

Decrease in
demand for • Impact on
economies
foreign worldwide
goods
The global financial crisis of
2007-2009
 The main causes of the crisis were:

1. Macro-imbalances - large current account surpluses

for China, Japan and some other east Asian emerging
economies vs. large current account deficit for U.S.,
UK, Ireland, Spain and some other developed
The global countries

financial crisis 2. Financial market innovation – structured credit

of 2007-2009 products

3. Growth of financial sector accompanied by an

increase in total system leverage
“financial leverage” is the result from using credit or
borrowed money as funding source to invest in assets.
Problems arise when the value of assets decline and 4. Asymmetric information and credit-rating services
that asset value < loan value

Source: Financial Service Authority, Turner Review – A regulatory Response to the global banking crisis, 2009.
High Savings

• China, Japan and other east Asian emerging economies followed

an export-led growth strategy and ran large trade surpluses.

• They were producing more than they were spending and saving
more than they were investing at home.

• These high savings that exceed domestic investment, China and

•
other surplus countries placed into world capital markets.

For ex. foreign exchange reserves of China’s central bank were

Macro-
almost exclusively invested in risk-free or close to risk-free U.S.
government bonds.
imbalances
• Although U.S., UK and some other western countries were
running large trade deficits, consumption was not high enough
to offset high savings of emerging countries.

• The consequence - a reduction in mid-term and long-term risk-

free interest rates to historically low level!
Source: Financial Service Authority, Turner Review – A regulatory Response to the global banking crisis, 2009.

Macro-imbalances
• Having persistent trade deficit, thanks to growth in
import, U.S. and UK relied on central banks and
their monetary policy to help them achieve steady
growth.

• Their central banks responded by cutting short-

term interest rates to boost the growth of money,
credit and domestic demand. Macro-
• As a consequence, low interest rates : imbalances
➢ Helped drive rapid growth of credit in developed
countries (for ex. residential mortgages)

➢ Have driven among investors a “search for yield”.

Demand for yield, stimulated by macro-

imbalances paved the way financial innovation!
 ▪ Before 2000, only the most credit-worthy
(prime) borrowers could obtain residential
mortgages.
▪ Deregulation (Gramm-Leach-Bliley Act,
1999), recession end in 2001. and rising
housing prices and securitization, push banks
to engage in subprime mortgage lending -
Financial giving loans to borrowers with low credit
ratings.
innovation
▪ Securitization is the financial practice of
pooling various types of contractual debt
(residential mortgages, commercial
mortgages, …) and converting them into
securities.
 • Securitization allowed loans to be packaged up and
sold to a diversified set of end investors – originate-
Securitization to-distribute model.
• Loans were removed from balance sheet and credit
risk passed to end investors.
• The securitization was mostly preformed by:
• Special purpose vehicle (SPV) created by banks (CDOs,
CMOs, CLOs)
• Government sponsored enterprises (GSE) – Fannie
Mae, Freddie Mac (created by government to increase
mortgage lending by facilitating securitization of MBS)
 • The creation of a collateralized debt
Collateralized obligation involves a corporate entity called a

Debt special purpose vehicle (SPV) that buys a

collection of cash-flow generating assets
Obligations (such as corporate bonds and loans,
commercial real estate bonds and mortgage-
(CDOs) backed securities).

• SPVs are usually created by the parent banks

just for the purposes of buying and
repackaging assets.
Credit rating terminology (source : Investopedia)

Investment Grade
The better the rating, the lower the risk,
hence the lower the « credit spread », AAA
being (almost) « risk-free »

Non Investment Grade

Collateralized Debt Obligations (CDOs)
The SPV separates the payment streams (cash
flows) from the assets into buckets that are
referred to as tranches:
▪ super senior tranche – the highest rated
tranches, the ones that are paid off first,
least risky
▪ senior tranche – paid out next, bit riskier,
pay higher interest rates
▪ mezzanine tranche – paid out next, more
risk and higher interest rates
▪ equity tranche - this is the first set of cash
flows that are not paid out if the
underlying assets go into default and stop
making payments, has the highest risk.
 As the housing boom began to slow in mid-
2006, investors became skittish about the riskier
parts of those investments. So the banks
created -- and ultimately provided most of the
money for -- new CDOs. Those new CDOs
bought the hard-to-sell pieces of the original
CDOs. Each new CDO had its own risky pieces.
Banks created yet other CDOs to buy those.

CDO chain

Source: https://www.propublica.org/article/the-cdo-daisy-chain
 The size of
securitization
activity

Source: https://www.economy.com/mark-zandi/documents/FCIC-Zandi-011310.pdf
 ▪ By securitizing risky assets, bank remove these assets from
balance sheet and pass credit risk to an end investor, thus
lowering capital requirements
• Reduces refinancing risk - Mortgages are financing using
short-term debt which must be refinanced.

Banks’ Main • Reduces illiquidity risk - Mortgages are illiquid and will
likely need to be sold at a large discount.
Benefit of
• But when the crisis - most of the holdings of the
Securitization securitized credit, and the vast majority of the losses
which arose, were not in the books of end investors
intending to hold the assets to maturity, but on the books
of highly leveraged banks and bank-like institutions!
 • Credit default swaps are derivative contracts that allows
investor to exchange (swap) his credit risk with that of
Credit default swaps another investor.

• In a CDS, the buyer of the swap makes payments to the

swap’s seller until the maturity date of a contract.

• In return, the seller agrees that in the event that the debt
issuer defaults – the seller will pay the buyer the
security's value as well as all interest payments that
would have been paid between that time and the
security’s maturity date.

• Credit risk isn't eliminated – it has been shifted to the CDS

seller.

• The risk is that the CDS seller defaults at the same time
the borrower defaults.

• The volume of CDS outstanding increased 100-fold from

1998 to 2008, estimates of the debt covered by CDS
Source: https://en.limitmarkets.com/blog/credit-default-swap-cds/
contracts, as of November 2008, ranging from US$33 to
$47 trillion
 Borrower
Brokers packed up mortgages loans into
Mortgage Backed Securities (MBS) and
sell them to investors
Coupons, interests, and nominal amount at maturity
I am an investor in MBS
shares
I assume the borrowers will not meet
their loan obligation
I buy a CDS and transfer the “credit
default risk” to a counterpart by paying
premiums
Premiums
Protection seller “A”
The seller of the CDS
agrees to pay me the full amount of the
MBS share in case of a borrower’s
In case of borrower’s default,
default
“A” pay the coupon, nominal
amount to the CDS’s buyer
 Growth in outstanding credit default swaps (2004-2008)

Explosion of
credit derivatives

Source: Financial Service Authority, Turner Review – A regulatory Response to the global banking crisis, 2009.
1. Mortgage brokers that originated the loans did not have a
strong incentive to evaluate the borrower’s ability to repay the
loan, since they would quickly sell the loan to investors via
MBS.

2. Adverse selection became a problem – risky investors lined up

to obtain housing loans, knowing that they can profit if prices
of houses goes up, but also knowing that they can default if
prices go down.
Agency
3. Commercial and investment banks which were earning large problems in
fees by underwriting MBS and CDOs and had weak incentives
to assess the quality of securities. the
4. Large fees from issuing financial derivatives such as credit
default swaps drove insurance companies (ex. AIG) to mortgage
excessively issue these securities – in 2008. there were about
$60 trillion of CDS outstanding. markets
5. The conflict of interest of rating agencies – they were earning
large fees for advising clients on how to structure complex
financial instruments like CDOs and at the same time they were
supposed to rate these instruments.
 As a Borket, I don’t pay attention to borrowers credit
Borrower quality, as I earn structuring fees, and can sell the loans
Brokers packed up mortgages loans into
Mortgage Backed Securities (MBS) and
sell them to investors
As an “insurer”
I get nice fees

I am an investor in MBS
shares Protection seller “A”
I assume the borrowers will not meet The seller of the CDS
their loan obligation agrees to pay me the full amount of the
I buy a CDS and transfer the “credit MBS share in case of a borrower’s
default risk” to a counterpart by paying default
premiums

I’m protected by the CDS against credit If « A » does not have the adequate
default
equity base, this does not work anymore
 Growth of the financial
sector

▪ The evolution of the securitized credit

model was accompanied by a
remarkable growth in the relative size
of financial services within the overall
economy.

Source: Financial Service Authority, Turner Review – A regulatory Response to the global banking crisis, 2009.
Effects of the
2007-2009
financial crisis
 Effects of the 2007-2009 financial crisis

Residential houses boom and bust

Deterioration of financial institutions’ balance sheets

Run on the shadow banking system

Crisis spread to global financial markets

Failure of major financial institutions

 Residential houses boom and bust
SUBPRIME LOAN:
Loan made to low credit ratings
borrowers, i.e. to people having a high ▪ Housing prices boomed from 2002-2006, fueling the
probability of defaulting on the interst
or loan repayment market for subprime mortgages and forming an asset-
price bubble.

▪ Lending standards decline and the loan-to–value ratio

rose.

▪ After a sustained boom, housing prices began a long

decline beginning in 2006.
▪ The subprime borrowers found that the value of their
houses fell well below the mortgage amount.
▪ Default on mortgages shot up sharply.
▪ As more borrowers defaulted, the supply of homes for
sale increased. This placed downward pressure on
LOAN-TO-VALUE RATIO
=
housing prices.
Mortgage loan amount
Appraised property value
 Decline in U.S. • Global investor demand for
housing prices lead mortgage-related securities
to rising default of evaporated.
mortgages
Deterioration of
financial • Leaving banks and other
institutions’ Value of MBS and
CDOs collapsed
financial institutions with
lower value of assets and
balance sheets thus lower capital

Banks and other FI

start to deleverage,
selling of assets and
restricting lending
 Shadow banking system
• The shadow banking system is a term for non-bank financial intermediaries that
provide services similar to traditional commercial banks but are not subject to the
same regulations as depository banking.

• It involves hedge funds, investment banks, credit insurance provider, money market
funds, …

• Vulnerable because they borrowed short-term in liquid markets to purchase long-

term, illiquid and risky assets.

• Most of their funding was through repurchase agreements (repos) – short-term

borrowing with MBS used as a collateral.

• According to Paul Krugman repo and other forms of shadow banking accounted for
an estimated 60% of the "overall US banking system“.
 “Repo” = repurchase agreement

A a BANK, I am lending cash to “A” A a non-Bank, being

and gets a collateral, a Tbill (or counterpart “A”, I’m
cash
MBS…) for example, borrowing cash from the
from Jan. 24th 2023 to Jan. 31st 2023 Bank providing a collateral (a
(1 week) Tbill or MBS Tbill or MBS)
It is like “borrowing” the Tbill during 1 (collateral)
week
 Run on the shadow banking system

• To raise funds, these institutions engaged in

fire sales of assets => rapid sales of assets
lowered asset prices => further decline in
financial institutions’ asset values => lowered
value of collateral => increased haircut =>
liquidity struggle.

• The current panic involved financial firms

"running" on other financial firms by not
renewing sale and repurchase agreements
(repo) or increasing the repo margin, forcing Source: Mishkin, F., Eakings, S.G., Financial Markets and
massive deleveraging, and resulting in the Institutions, 9th edition, Pearson, 2018, p 219.
banking system being insolvent (Gorton, Gary
"Securitized Bank and the Run on Repo”,
2009.)
• Due to globalization, the financial crisis quickly spread to Europe

• In 2007., after Fitch and Standard & Poor’s announced ratings

downgrades on MBS and CDOs totaling more than $10 billion

• BNP Paribas announced that it was halting redemptions on three

investment funds due to subprime problems

• In the United Kingdom: Northern Rock (September 2008) and

Royal Bank of Scotland failed (October 2008)
Global
• The crisis in Europe generally progressed from banking system financial
crises to sovereign debt crises.
markets
• The increase in budget deficits that followed the financial crash of
2007–2009 led to fears of government defaults and a surge in
interest rates.

• The sovereign debt, which began in Greece, moved on to Ireland,

Portugal, Spain, and Italy.
 AIG, which had written of 400
Bear Stearns, the fifth billions of CDS, did not have the
largest investment bank in Merrill Lynch, the third largest capital to honor its
U.S., was forced to sell itself investment bank was commitments; U.S. taxpayers
to J.P. Morgan for less than purchased by Bank of America covered its obligations instead in
5% of its value the year for a price below 60% of its a bailout that exceeded $100
earlier value the year earlier billion.

Mar. 2008 July 2008 Sep. 2008 Sep. 2008 Sep. 2008

Fannie Mae and Freddie Mac, Lehman Brothers,

privately owned, government- the fourth largest
sponsored enterprises (they investment bank in
together insured over $5 trillion of U.S., filed for
mortgages and MBS) were taken bankruptcy
over by FED and U.S. Treasury

Failure of financial institutions

 • In October 2008., The Emergency Economic
Stabilization Act, also called the Troubled Asset Relief
Program (TARP), the most important provision of the
Bush administration, was signed into law.

Government • This act authorized the Treasury to spend $700 billion

Intervention purchasing subprime mortgage assets from troubled
financial institutions or to inject capital into these
institutions.

• In the United Kingdom, the government announced a

£500 billion bank rescue package in October, 2008.
 Height of the 2007–2009
Financial Crisis

▪ The stock market crash in the fall of

2008, with the week beginning October
6, 2008, showing the worst weekly
decline in U.S. history (Dow Jones
dropped around 7%)
▪ Surging interest rates faced by borrowers
led to sharp declines in consumer
spending and investment.
▪ The unemployment rate shot up, going
over the 10% level
 • Macroprudential versus microprudential supervision, shift form focus
on the safety and soundness of individual financial institutions to
safety and soundness of the financial system

• Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

➢ Consumer protection - Bureau of Consumer Financial Protection

regulates consumer financial products and services in compliance

Response of with federal law

➢ Annual stress tests of the largest banks to ensure that they have
Financial enough capital to withstand bad macroeconomic outcomes
Regulation ➢ Systemic risk regulation – formed Financial Stability Oversight
Council to regulate systematically important financial institutions

➢ Volcker Rule - prohibits depository banks from proprietary

trading, it limits banking entities to owning no more than 3
percent in a hedge fund or private equity fund