Financial Crises

1. Financial Crises Chapter 13

2. Chapter 13 Learning Goals Distinguish between systemic and non-systemic crises List 5 shocks that can precipitate a financial crisis Define leverage and explain its in role in asset bubble formation Explain how leverage led to the crisis of 2008

3. Non systemic crisis • only affects a few markets or sectors • e.g. the S&L crisis

4. Systemic crisis • Involves the whole financial system • e.g. the Great Depression, the crisis of 2008

5. Five Shocks • Deterioration in financial institutions’ balance sheets (security price declines) • Banking panics • Increases in uncertainty. • Increases in interest rates. • Government fiscal imbalances.

6. Financial Crisis of 2008 Once in a life time credit tsunami.

7. Financial Crisis of 2008 Leverage of I-banks vs commercial banks

8. Maturity Transformation Borrowing short … issuing money market instruments Lending long … investing in toxic securities

9. Toxic securities? CDO’s created from subprime mortgages.

10. Contributing factors: Advances in computer technology led to lower transactions costs in securitizing mortgages.

11. Innovations, such as CDO and CDS, were not regulated nor well understood. Asymmetric information problem was made worse by the complexity of the instruments.

12. Principal-agent problem in: 1. Originate to distribute business model for mortgage lending. 2. Underwriting and sale of mortgage backed securities.

13. 2009 0 pure-play bulge bracket investment banks. 1. Lehman went under 2. Merrill Lynch merged with Bank of America 3. Goldman Sachs obtained a bank charter 4. Morgan Stanley obtained a bank charter 5. Bear Stearns was bought by JP Morgan Chase

16. I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance. And I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.

17. Resolution versus Bailout