The Crisis

Chapter 9
 Chap. Outline

• The start of the crisis, the decline in

housing prices, and its effects on the
financial system
• The macroeconomic effects of the
housing and financial crises, the
evolution of output, and the policy
responses
• Recovery

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 9-1 From a Housing Problem to a
Financial Crisis (Case-Shiller index)
Figure 9-1 U.S. Housing Prices since 2000
• Evolution, by 2008 down by
31%
• The increase in housing prices
(2000-2006) was justified by
low interest rates and
Mortgage lenders became
increasingly willing to make
loans to more risky
borrowers.
• Housing prices decline caused
by lower demand implies that
mortgage exceed house
value, and higher interest
rates made people unable to
pay. Banking crisis

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 9-1 From a Housing Problem to a
Financial Crisis
Figure 9-2 Bank Assets, Capital, and Liabilities
• liabilities may be Capital=A-L
checkable deposits, or
borrowing from
investors and other
banks. The assets may
be reserves (central
bank money), loans to
consumers, loans to If negative Bankruptcy
1)If assets drop, we have
firms, loans to other
solvency
banks, mortgages,
2)Deposit outflow we have
government bonds, or illiquidity (can’t sell assts)
other forms of securities

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 Leverage

• Capital ratio=Capital/Assets
• Leverage = 1/capital ratio
• Bank capital is the cushion that avoids
bankruptcy
• To be profitable (ia*A-il*L)/K=ROE, the
lower K the higher ROE, but this means
higher leverage which also means higher
risk of bankruptcy
• That is what bank managers did during the
crisis (greed) and regulation was not
sufficient.
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 Complexity

• Another important development of the 1990s and the 2000s

was the growth of securitization
• Securitization is the creation of securities based on a bundle
of assets
• Securitization would seem like a good idea, a way of
diversifying risk and getting a larger group of investors
involved in lending to households or firms
• When underlying mortgages went bad, assessing the value of
the underlying bundles (by rating agencies) in the MBSs, or,
even more so, of the underlying MBSs in the CDOs, was
extremely hard to do because of their complexity.
• It led investors to assume the worst and be very reluctant
either to hold them or to continue lending to those institutions
that did hold them

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 Liquidity
• Yet another development of the 1990s and 2000s
was the development of other sources of finance
than checkable deposits by banks (Wholesale
funding )
• Wholesale funding again would seem like a good
idea, giving banks more flexibility in the amount of
funds they can use to make loans or buy assets
• If investors or other banks, worried about the value
of the assets held by the bank, decide to stop
lending to the bank, the bank may find itself short
of funds and be forced to sell some of its assets. If
these assets are complex and hard to sell, it may
have to sell them at very low prices, often referred
to as fire sale prices
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 9-1 From a Housing Problem to a
Financial Crisis
Figure 9-3 The Ted Spread since 2007
• When housing prices declined,
The risk premium
value of assets declined, K
declined which requires sale of
assets which are complex and
risky; so they had to be sold at
lower prices which exacerbated
the situation.
• The complexity of the securities
(MBSs, CDOs) and of the true
balance sheets of banks (banks
and their SIVs) made it very
difficult to assess the solvency
of banks and their risk of
bankruptcy. Thus, investors
became very reluctant to
continue to lend to them and
banks stoped lending to each
other and anyone else.
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 9-2 The Use and Limits of Policy
Figure 9-4 Yields on 10-Year U.S. Government Treasury, AAA, and
BBB Corporate Bonds, since 2007
• Widening gap during
the crisis between
aaa and bbb, and
aaa and 10 year
treasusry
• more difficult to
acquire fundswhen
interest rates rise

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 9-2 The Use and Limits of Policy
Figure 9-5 U.S. Consumer and Business Confidence, since 2007

• Lower business and

consumer confidence
meant a reduction in
consumption or a
leftward shift in the
IS relation

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 9-2 The Use and Limits of Policy
Figure 9-6 The T-Bill Rate, since 2007

Gov’t counter measures:

In order to prevent a run by depositors,
federal deposit insurance was increased
from $100,000 to $250,000 per account
The fed allowed not only banks, but also
other financial institutions to borrow from
the Fed
It increased the set of assets that
financial institutions could use as
collateral when borrowing from the Fed
the government acquiring shares and
thus providing funds to most of the
largest U.S. banks, lowering leverage
and icreasing capital
•Fed bought mortgage-backed securities

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 9-2 The Use and Limits of Policy
Figure 9-7 Money Demand, Money Supply, and the Liquidity Trap

• When interest rate is

zero, people are
indifferent between
holding bonds and
money. Thus
increasing Ms does
not lower the
interest rate and
thus have no effect
on the economy

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 9-2 The Use and Limits of Policy
Figure 9-8 The Derivation of the LM Curve in the Presence of a
Liquidity Trap

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 9-2 The Use and Limits of Policy
Figure 9-9 The IS–LM Model and the Liquidity Trap

• To avoid the liquidity trap

and its implications using
conventional monetary
policy (buying t-bills), the
Fed could buy other bonds;
for example, mortgages—
loans made by banks to
households, or Treasury
bonds— government bonds
which promise payment
over, say, 10 or 20 years.
This is called quantitative
easing.
• Fed did that during and
after the crisis

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 Focus: Japan, the Liquidity Trap, and
Fiscal Policy
Figure 1 The Interest Rate in Japan since 1990. Japan has been in a
liquidity trap since the mid-1990s.

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 Focus: Japan, the Liquidity Trap, and
Fiscal Policy (Limits of fiscal policy)
• Figure 2 Government
Spending and Revenues (as
a percentage of GDP), Japan,
since 1990. Increasing
government spending and
decreasing revenues have
led to steadily larger deficits.
Higher debt means taxes
need to rise or spending
needs to fall to repay debt.
Both contractionary.
• When debt repayment
becomes an issue, interest
rates on gov’t bonds will rise

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 Why has the recovery from the crisis so
slow in the United States?
• Some economists point to the aggregate
supply side, the banking crisis may affect
the efficiency of the banking system for a
long time, leading to lower productivity and
lower Yn.
• Most economists point also to the aggregate
demand side. For the time being, insufficient
aggregate demand, they argue, is the issue:
– Limits to monetary and fiscal policies.
– Adjustment to equilibrium (in the presence of
liquidity trap) in the AS & AD model also fails.

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 9-3 The Slow Recovery
Figure 9-10 The Liquidity Trap and Adjustment Failure
• Adjustment mechanism
with liquidity trap can be
explained by the absence
of the effect M/P on
demand. (higher u means
lower w and thus p).
Lower prices do not alter
the interest rate even if
M/P increases.
• As long as p is lower than
Pe, AS shifts down but has
no effect on output.

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 Focus: Do Banking Crises Affect the
Natural Level of Output?
Figure 1 The Evolution of Output after Four Banking Crises

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