Money and Banking Chapter 12 The Financial Crisis of 2007-2008

Chapter 12 The Financial Crisis of CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Define financial crisis and differentiate between systemic and crises . Describe a generic asset bubble . Define leverage and explain its role in asset bubble formation . Explain why bubbles burst , causing financial panics . Define and explain the importance of lender of last resort . Define and explain the importance of bailouts . Narrate the causes and consequences of the financial crisis that began in 2007 . URL books 268

Financial Crises LEARNING OBJECTIVE . What is a financial crisis ?

A financial crisis occurs when one or more markets or intermediaries cease functioning or function only erratically and . A crisis involves only one or a few markets or sectors , like the Savings and Loan Crisis described in Chapter 11 The Economics of Financial Regulation . A systemic crisis involves all , or almost all , of the system to some extent , as during the Great Depression . Financial crises are neither new nor unusual . Thousands of crises , including the infamous Tulip Mania and South Sea Company episodes , have rocked systems throughout the world in the past hundred years . Two such crises , in and 1773 , helped lead to the American Revolution . After its independence , the United States suffered systemic crises in 1792 , 1857 , 1873 , 1884 , 1907 , and 2008 . crises have been even more numerous and include the credit crunch of 1966 , stock market crashes in ( when the Dow dropped from a close on January 12 , 1973 , to a 788 close on December , 1973 , to a 578 close on December , 1974 ) and 1987 , the failure of Capital Management in 1998 , the troubles of 2000 , the dramatic events following the terrorist attacks in 2001 , and the subprime mortgage debacle of 2007 . Sometimes , crises burn out or are brought under control before they spread to other parts of the system . Other times , as in 1929 and 2007 , crises spread like a wildfire until they threaten to burn the entire system . Stop and Think Box While we ridicule ancient superstition we have an implicit faith in the bubbles of banking , and yet it is to discover a greater absurdity , in ascribing omnipotence to bulls , cats and onions , than for a man to carry about a thousand acres of land . in his pocket book . This gross bubble is practiced every day , even upon the of avarice itself . So we see wise and honest Americans , of the nineteenth century , embracing phantoms for realities , and running mad in schemes of , tastes , pleasures , URL books 259

wealth and power , by the soul sic aid of this hocus of , and , Hard Times . When were these words penned ?

How do you know ?

This was undoubtedly penned during one of the nineteenth century financial crises mentioned above . Note the negative tone , the allusion to Americans , and the reference to the nineteenth century . In fact , the pamphlet appeared in 1818 . For a kick , it to blogs bemoaning the crisis that began in 2007 200 09 archives individual 2008 03 ' 2008 10 Both systemic and crises damage the real economy by preventing the normal of credit from savers to entrepreneurs and other businesses and by making it more or expensive to spread risks . Given the damage financial crises can cause , scholars and are keenly interested in their causes and consequences . You should be , too . KEY TAKEAWAYS Throughout history , systemic ( widespread ) and ( confined to a few industries ) financial crises have damaged the real economy by disrupting the normal flow of credit and insurance . Understanding the causes and consequences of financial crises is therefore important . Tim Arango , The and the American Revolution , New York Times ( 29 November 2008 ) ref books URL books 270

Asset Bubbles LEARNING OBJECTIVE . What are asset bubbles and what role does leverage play in their creation ?

Asset bubbles are rapid increases in the value ofsome asset , like bonds , commodities ( cotton , gold , oil , tulips ) equities , or real estate . Some combination of low interest rates , new technology , unprecedented increases in demand for the asset , and leverage typically create bubbles . Low interest rates can cause bubbles by lowering the total cost ownership . Recall from Chapter Interest Rates that interest rates and bond prices are inversely related . Algebraically , the i term is in the denominator of the ( i ) as it gets smaller , must get larger ( holding constant , of course ) Stop and Think Box In colonial New York in the and , interest rates on mortgages were generally percent . In the late and early , they fell to about percent , and expected revenues from land ownership increased by about 50 percent . What happened to real estate prices ?

Why ?

They rose because it was cheaper to borrow money , thus lowering the total cost of real estate ownership , and because the land was expected to create higher revenues . Thinking of the land as a perpetuity and as the expected revenues arising from it And that is just the real estate effect . Increasing by leads to the following , or a tripling . In 1762 , Benjamin Franklin reported that the Rent of old Houses , and Value of Lands , are trebled in the last Six URL books 271

The of new technology can be thought of as increasing , leading , of course , to a higher . Or , in the case of equities , low interest rates decrease ( required return ) and new inventions increase ( constant growth rate ) in the Gordon growth ( of which lead to a higher price . Large increases in the demand for an asset occur for a variety of reasons . Demand can be increased merely by investors expectations of higher prices in the future , as in the one period valuation ( If many investors believe that , must be greater than a year ( or any other period ) hence , demand for the asset will increase and the expectation of a higher , will be vindicated . That sometimes leads investors to believe that be higher than , leading to a cycle that repeats through to At some point , the value of the asset becomes detached from fundamental reality , driven solely by expectations of yet higher future prices . In fact , some scholars verify the existence of an asset bubble when news about the price of an asset the economy , rather than the economy the price of the asset . To increase their returns , investors often employ leverage , or borrowing . Compare three investors , one who buys asset entirely with his own money , one who borrows half of the price of asset , and one who borrows 90 percent of the price of asset . Their returns ( not including the cost of borrowing , which as noted above is usually low during bubbles ) will be equal to those calculated The effects of leverage on returns in a rising market . Figure The on returns in a rising market The were calculated using the rate of return formula ( Pu ) discussed in Chapter Interest Rates . Here , coupons are zero and hence drop out so that ( Pu ) URL books

In this example , returns for the investor are great 110 ( rendered as 10 in the ) 120 130 But the returns are not as high as the investor who borrowed half the cash , in essence paying only 50 of his own money for the 100 asset at the outset 110 120 130 But even he looks like a chump compared to the investor who borrowed most of the money to the original purchase , putting up only 10 of his own money 110 120 130 If you are thinking the most highly leveraged investor is the smart one , go back and reread the section of Chapter The Financial System that discusses the between risk and return before continuing . KEY TAKEAWAYS Asset bubbles occur when the prices of some asset , like stocks or real estate , increase rapidly due to some combination of low interest rates , high leverage , new technology , and large , often shifts in demand . The expectation of higher prices in the future , combined with high levels of borrowing , allow asset prices to detach from their underlying economic fundamentals . For more on the crisis , see Tim Arango , The Revolution , New York Times ( 30 November 2008 ) ref URL books 273

Financial Panics LEARNING OBJECTIVE . What are financial panics and what causes them ?

A financial panic occurs when intermediaries and other investors must sell assets quickly in order to meet lenders calls . Lenders call loans , or ask for repayment , when interest rates increase when the value of collateral pledged to repay the loan sinks below the amount the borrower owes . Calls are a normal part of everyday business , but during a panic , they all come en masse due to some shock , often the bursting of an asset bubble . Bubbles , like people , are bound to die but nobody knows in advance when they will do so . A burst is sometimes triggered by an obvious shock , like a natural catastrophe or the failure of an important company , but sometimes something as seemingly innocuous as a large sell order can touch them off . During a panic , almost everybody must sell and few can or want to buy , so prices plummet , triggering additional calls , and yet more selling . Invariably , some investors , usually the most highly leveraged ones , can not sell assets quickly enough , or for a high enough price , to meet the call and repay their loans . Banks and other lenders begin to suffer defaults . Their lenders ( other banks , depositors , holders of commercial paper ) in turn , begin to wonder if they are still . Asymmetric information and uncertainty , as described in Chapter 11 The Economics of Financial Regulation , reign supreme , inducing lenders to restrict credit . At some point , investors emotions take over , and they literally go into , one that makes Tony Soprano attacks seem like a stroll in the park . Panics often cause the rapid of the system , a period when interest rates for riskier types and securities increase when a credit crunch , or a large decrease in the volume of lending , takes place . Such conditions often usher in a negative bubble , a period when high interest rates , tight credit , and expectations of lower asset prices in the future cause asset values to trend downward , sometimes well below the values indicated by underlying economic fundamentals . During , the forces that drove asset prices up now conspire to drag them lower . URL books 5019 ) 274

Stop and Think Box In New York in 1764 , interest rates spiked from to 12 percent and expected revenues from land plummeted by about 25 percent . What happened to real estate prices and why ?

They dropped because it was more expensive to borrow money , thus increasing the total cost of real estate ownership , and because the land was expected to yield lower revenues . Thinking of the land as a perpetuity and as the expected revenues arising from it And that is just the real estate effect . Decreasing by leads to the following , or a decrease of about . I know of sundry Estates farms and other landed property that has been taken by Execution foreclosed upon , a New York merchant reported late in 1766 , and sold for not more than one third of their value owing to the scarcity of As shown in Figure The effects of leverage on returns in a falling market , the most highly leveraged investor suffers most of all . Figure The on returns in market Again , I used the rate of return formula , but coupons are zero so that ( Pu ) As the price of the asset falls , the investor suffers negative returns URL books

90 80 70 The leveraged investors lose the same percentage and must now pay a high interest rate for their loans , or put up the equity themselves , at a time when the opportunity cost of doing so is substantial ( 90 i 50 50 ) interest on 50 ( 80 50 50 ) interest on 50 ( 70 50 50 ) interest on 50 The higher the leverage , the larger the sum that must be borrowed at high rates . on 90 ( on 90 ( 70 ) 00 on 90 Also , the higher the leverage , the smaller the price change needs to be to trigger a call . At 50 percent leverage , a 100 asset could drop to 50 before the lender must call . At 90 percent leverage , a 100 asset need lose only 10 to induce a call . KEY TAKEAWAYS The bursting ofan asset bubble , or the rapidly declining prices of an asset class , usually leads to a financial panic , reductions in the quantity of available credit , and the of the financial system . The most highly leveraged investors suffer most . site category URL books 276

Lender of Last Resort LEARNING OBJECTIVE . What is a lender of last resort and what does it do ?

As noted above , panics and the that often occur after them can wreak havoc on the real economy by decreasing the volume of loans , insurance contracts , and other beneficial products . That , in turn , can cause firms to reduce output and employment . Lenders of last resort try to stop panics and by adding liquidity to system attempting to restore investor . They add liquidity by increasing the money supply , reducing interest rates , and making loans to worthy borrowers who themselves shut off from their normal sources of external . They try to restore investor confidence by making upbeat statements about the overall health of the economy or system and by implementing policies that investors are likely to beneficial . During the darkest days of 1933 , for example , the US . federal government restored confidence in the banking system through strong executive leadership and by creating the Federal Deposit Insurance Corporation . Stop and Think Box In a single day , October 19 , 1987 , the fell by 20 percent . What caused such a rapid decline ?

Why did the panic not result in or recession ?

According to a short history of the event by Mark ( A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response ) During the years prior to the crash , equity markets had been posting strong gains . There had been an of new investors . Equities were also boosted by some favorable tax treatments given to the of corporate buyouts . The outlook during the months leading up to the crash had become somewhat less certain . Interest rates were rising globally . A growing trade and decline in the value of the dollar were leading to concerns about and the need for higher interest rates in the as On the day of the crash , investors learned that deficits were higher than expected and that the favorable tax rules might change . As prices dropped , record margin calls were made , fueling further selling . The panic did not proceed further because Federal Reserve Chairman Alan restored in the stock URL books 0792 . 277

market by promising to make large loans to banks exposed to brokers hurt by the steep decline in stock prices . the Fed made it known that The Federal Reserve , consistent with its responsibilities as the Nation central bank , affirmed today its readiness to serve as a source of liquidity to support the economic and The most common form of lender of last resort today is the government central bank , like the European Central Bank ( or the Federal Reserve . The International Monetary Fund ( IMF ) sometimes tries to act as a sort of international lender of last resort , but it has been largely unsuccessful in that role . In the past , wealthy individuals like Morgan and private entities like bank tried to act as lenders of last resort , with mixed success . Most individuals did not have enough wealth or to thwart a panic , and bank were at most regional in nature . KEY TAKEAWAY A lender of last resort is an individual , a private institution , or , more commonly , a government central bank that attempts to stop a financial panic by increasing the money supply , decreasing interest rates , making loans , restoring investor confidence . URL books 278

Bailouts LEARNING OBJECTIVE . What is a bailout and how does it differ from the actions of a lender of last resort ?

As noted above , lenders of last resort provide liquidity , loans , and confidence . They make loans to solvent institutions facing temporary solvency problems due to the crisis , not inevitable bankruptcy . Bailouts , by contrast , restore the losses by one or more economic agents , usually with taxpayer money . The restoration can come in the form of outright grants or the purchase of equity but often takes the form of subsidized or loans . bailouts are often politically controversial because they can appear to be unfair and because they increase moral hazard , or on the part of entities that expect to be bailed out if they encounter . Nevertheless , if the lender of last resort can not stop the formation of a negative bubble or massive , bailouts can be an way declines in economic activity . During the Great Depression , for example , the federal government used 500 million of taxpayer money to capitalize the Reconstruction Finance Corporation ( In its initial phase , the made some billion in loans to troubled banks , railroads , and other businesses . Though at as welfare for the rich , the , most observers now concede , helped the economy to recover by keeping important companies . Also during the depression , the Home Owners Loan Corporation ( seeded with 200 million of taxpayer dollars , bailed out homeowners , many of whom equity in their homes , by mortgages on terms favorable to the borrowers . Similarly , in the aftermath of the Savings and Loan Crisis , the Resolution Trust Corporation ( closed 747 with total assets of almost 400 billion . Both and made the best of bad situations . made a small accounting , and the cost taxpayers a mere 125 billion while staving off a more severe systemic crisis . Stop and Think Box URL books 279

The 1979 bailout of Chrysler , which entailed a government guarantee of its debt , saved the troubled corporation from bankruptcy . It quickly paid off its debt , and the Treasury , and hence taxpayers , were actually the richer for it . Was this bailout successful ?

At the time , many observers thought so . Chrysler creditors , who received 30 cents for every dollar the troubled owed them , did not think so , however , arguing that they had been to protect Chrysler stockholders . Workers who lost their jobs or were forced to accept reductions in pay and were also skeptical . Now that Chrysler and the other carmakers are again in serious trouble , some scholars are suggesting that the bailout was a disaster in the long term because it fooled Detroit execs into thinking they could continue business as usual . In retrospect , it may have been better to allow Chrysler to fail and a new , leaner , meaner company to emerge like a Phoenix from its ashes . KEY TAKEAWAYS Bailouts usually occur after the actions ofa lender of last resort , such as a central bank , have proven inadequate to stop negative effects on the real economy . They usually entail restoring losses to one or more economic agents . Although politically controversial , bailouts can stop negative bubbles from leading to excessive leveraging , debt deflation , and economic depression . Doug , Financial Stability , Economic Growth , and the Role of Law ( New York Cambridge University Press , 2007 ) URL books ( 280

The Crisis of LEARNING OBJECTIVE . What factors led to the present financial crisis ?

The present crisis began in 2007 as a crisis linked to subprime mortgages , or risky loans to homeowners . In 2008 , services companies turned it into the most severe systemic crisis in the United States since the Great Depression . The troubles began with a major housing asset bubble . As shown in Figure Home Price Composite Index , between January 2000 and 2006 , a major index of housing prices in the United States more than doubled . Prices went up more in some areas than in others because real estate is a local asset . Home prices rose rapidly for several reasons . As shown in Figure US . interest rates , mortgage rates were quite low , to a large extent because the Federal Reserve kept the federal funds rate , the rate at which banks lend to each other overnight , very low . Figure ?

1101110 ' itu ( 18 URL books 281 100 ) Index Value ( 2000 a i Zo ?

i i ?

Date Figure US . interest rates , URL books 282 Percentage 90 ?

Date Federal Funds Mortgage Mortgages also became much easier to obtain . Traditionally , mortgage lenders held mortgage loans on their own balance sheets . If a homeowner defaulted , the lender , usually a bank or life insurance company , suffered the loss . They were therefore understandably cautious about whom they lent to and on what terms . To shield themselves from loss , lenders insisted that borrowers contribute a substantial percentage of the homes value as a down payment . The down payment ensured that the borrower had some equity at stake , some reason to work hard and not to default . It also provided lenders with a buffer if housing prices declined . Traditionally , lenders also that borrowers were employed or had other means of income from investments or other sources . All that changed with the widespread advent of securitization , the practice of bundling and selling mortgages to institutional investors . Banks also began to engineer those bundles , called ( into more complex derivative instruments like collateralized mortgage obligations ( afforded investors the portfolio diversification URL books , 283

of holding a large number of mortgages allowed investors to pick the they desired . They did so by slicing a group of into derivative securities ( aka tranches ) with credit ratings ranging from A , which would be the last to suffer losses , to , which would suffer from the first defaults . The A tranches , of course , enjoyed a higher price ( lower yield ) than the tranches . The holders of the tranches , those who took on the most risks , suffered most during the subprime maelstrom , Securitization allowed mortgage lenders to specialize in making loans , turning them more into than lenders . Origination was much easier than lending because it required little or no capital . a large number of new mortgage , most mere brokers , appeared on the scene . Paid a commission at closing , had little incentive to screen good borrowers from bad and much more incentive to sign up anyone with a pulse . A race to the bottom occurred as competed for business by reducing screening and other credit standards , At the height of the bubble , loans to no income , no job or assets ( NINJA ) borrowers were common . liars loans for hundreds of thousands of dollars were made to borrowers without documenting their income or assets . Instead of insisting on a substantial down payment , many cajoled homeowners into borrowing 125 percent of the value of the home because it increased their commissions , They also aggressively pushed adjustable rate mortgages ( ARMs ) that offered low initial teaser rates and later were reset at much higher levels . Regulators allowed , and even condoned , such practices in the name housing , even though six earlier mortgage securitization schemes had ended badly . Regulators also allowed Mae and Freddie Mac , two giant mortgage securitization companies whose debt was effectively guaranteed by the federal government , to take on excessive risks and leverage themselves to the hilt , They also allowed agencies to give ratings to complicated securities of dubious quality . For the problem with agencies , see Chapter Financial Structure , Transaction Costs , and Asymmetric Information . Observers , including Yale Robert and Stems , about the impending crisis , but few listened . As long as housing prices kept rising , shoddy underwriting , weak regulatory oversight , and overrated securities were because borrowers who got into URL books ' 284

trouble could easily or sell the house for a . Indeed , many people began to purchase houses with the intention of them a month later for a quick buck . In June 2006 , however , housing prices peaked , and by the end ofthat year it was clear that the bubble had gone . By summer 2007 , prices were falling quickly . Defaults mounted as the option disappeared , and borrowers wondered why they should continue paying a mortgage on a house worth only , especially at a time when a nasty increase in fuel costs and a minor bout of strained personal budgets . Highly leveraged subprime mortgage lenders , like Countrywide and , suffered large enough losses to erode their narrow base of equity capital , necessitating their bankruptcy or sale to stronger entities . By early 2008 , investment bank Bear , which was deeply involved in subprime securitization products , teetered on the edge of bankruptcy before being purchased by Morgan for a mere 10 per share . As the crisis worsened , the Federal Reserve responded as a lender of last resort by cutting its federal funds target from about to less than percent between August 2007 and August 2008 . It also made massive loans directly to distressed institutions . Mortgage rates decreased from a high of percent in July 2007 to percent in January 2008 , but later rebounded to almost percent in August 2008 . Moreover , housing prices continued to slide , from an index score in July 2007 to just 178 a year later . Defaults on subprime mortgages continued to climb , endangering the solvency of other highly institutions , including Mae and Freddie Mac , which the government had to nationalize ( take over and run ) The government also arranged for the purchase of Lynch by Bank of America for 50 billion in stock . But it decided , probably due to criticism that its actions were creating moral hazard , to allow Brothers to go bankrupt , That policy quickly , however , because dragged one of its major , down with it . Once bitten , twice shy , the government stepped in with a massive bailout for to keep it from bankrupting yet other large institutions as it toppled . Figure ) value of Don ' Su ( URL books ' 285

11000 10000 9000 ' 15 ) Date Figure Bond yields , er 2008 URL books 286 I Percent , I ' i ' 99 99 ' Date The damage , however , had been done and panic overtook both the credit and stock markets in September and October 2008 . Figure Daily closing value of the Dow Jones Industrial Average , 2008 and Figure Bond yields , 2008 portray the carnage graphically . Stop and Think Box What is happening in Figure Bond yields , 2008 ?

Investors sold corporate bonds , especially the riskier Baa ones , forcing their prices down and yields up . In a classic to quality , they bought Treasuries , especially ones , the yields of which dropped from percent on September to percent on the September 17 . With an economic recession and major elections looming , politicians worked feverishly to develop a bailout plan . The Bush administration plan , which offered some 700 billion to large institutions , initially met defeat in the House of Representatives . After various amendments , URL books 287

including the addition of a large sum of pork barrel sweeteners , the bill passed the Senate and the House . The plan empowered the Treasury to purchase distressed assets and to inject capital directly into banks . Combined with the 300 billion Hope for Homeowners plan , a bailout for some distressed subprime borrowers , and the direct bailout of , the government bailout effort became the largest , in percentage of terms , since the Great Depression . The Treasury later decided that buying toxic assets , assets of uncertain and possibly no value , was not economically or politically prudent . Government ownership of banks , however , has a shaky history too because many have found the temptation to direct loans to political favorites , instead of the best borrowers , irresistible . Economists and are now busy trying to prevent a repeat performance , or at least mitigate the scale of the next bubble . One approach is to educate people about bubbles in the hope that they will be more cautious investors . Another is to encourage bank regulators to use their powers to keep leverage to a minimum . A third approach is to use monetary interest rates or tighter money supply bubbles before they grow large enough to endanger the entire system . Each approach has its strengths and weaknesses . Education might make investors afraid to take on any risk . Tighter regulation and monetary policy might squelch legitimate , creating industries and sectors . A combination of better education , more watchful regulators , and less accommodative monetary policy may serve us best . KEY TAKEAWAYS Low interest rates , indifferent regulators , unrealistic credit ratings for complex mortgage derivatives , and poor incentives for mortgage led to a housing bubble that burst in 2006 . As housing prices fell , homeowners with dubious credit and negative equity began to default in unexpectedly high numbers . Highly leveraged financial institutions could not absorb the losses and had to shut down or be absorbed by stronger institutions . Despite the Fed efforts as lender of last resort , the crisis became systemic in September 2008 following the failure of Brothers and . URL books 288

The government responded with huge bailouts of subprime mortgage holders and major financial institutions . Kenneth , Mortgage Securitization in the United States Twentieth Century Developments in Historical Perspective , in Michael and Richard , Financial Systems Institutions and Markets in the Twentieth Century ( Burr Ridge , IL Irwin Professional Publishing , 1995 ) a es ' Leaving Las Vegas No Dire Mistakes so Far , but Governments Will Find Exiting Banks Far Harder Than Entering Them , The Economist ( 22 November 2008 ) 22 . URL books 289

Suggested Reading , Danny , Charles Ka Yui Leung , and Eng Ong . Mortgage Markets Worldwide . John Wiley and Sons , 2007 . Charles , and Robert . Manias , Panics , and Crashes A History of Financial Crises , ed . John Wiley and Sons , 2005 . Frederic . How Should We Respond to Asset Price Bubbles ?

in Banque de France , Financial Stability Review . October 2008 , and Brad . Bailouts or Responding to Financial Crises in Emerging Markets . New York Peterson Institute , 2004 . Robert . Irrational . New York , 2006 . The Subprime Solution How Today Global Financial Crisis Happened , and What to Do . Princeton , Princeton University Press , 2008 . Bailout An Insiders Account Failures and Rescues . New York Beard Books , 2000 . URL books