Transcript Chapter 21

Money and Banking
Robert E. Wright
Vincenzo Quadrini
Chapter 12 The Financial Crisis of 2007-8
Chapter Objectives
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Define financial crisis and differentiate
between systemic and non-systemic
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.
1. Financial Crises
Chapter Objectives
• Define financial crisis and differentiate between systemic and nonsystemic crises.
What is a financial crisis?
1. Financial Crises
One or more financial markets or
intermediaries:
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cease functioning
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function inefficiently
1. Financial Crises
Non-systemic:
• One or a few markets
Example:
Savings and loan crisis
1. Financial Crises
Systemic:
• Entire financial system
Example:
The Great Depression
1. Financial Crises
Systemic crises in U.S.:
1792
1818-19
1837-39
1857
1873
1884
1893-95
1907
1929-33
2008
1. Financial Crises
Non-systemic crises in U.S.:
1966
Credit markets
1973-74
Stock markets
1987
Stock markets
1998
Hedge funds
2000
Tech stocks
2001
Post-911
2007
Mortgage market
1. Financial Crises
Non-systemic
Not contained
Contained
Become systemic
Burn out
1. Financial Crises
Both systemic and non-systemic crises damage the real
economy by:
• preventing the normal flow of credit
from savers to entrepreneurs/businesses
• making it more difficult or expensive to spread risks.
1. Financial Crises
Chapter Objectives
• Define financial crisis and differentiate between systemic and nonsystemic crises.
Key Takeaways
 Throughout history, systemic (widespread) and non-systemic (contained
within a few industries); financial crises have damaged the real economy
by disrupting the normal flow of credit and insurance.
 Understanding their causes and consequences is therefore important.
2. Asset Bubbles
Chapter Objectives
• Describe a generic asset bubble.
• Define leverage and explain its role in asset bubble formation.
What are asset bubbles and what role does
leverage play in their creation?
2. Asset Bubbles
Asset bubbles are rapid increases in the value of
some asset, like bonds, commodities (cotton,
gold, oil, tulips), equities, or real estate.
Causes:
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low interest rates,
new technology,
unprecedented increases in demand, and
leverage
2. Asset Bubbles
The big ten financial bubbles:
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• 1636, the Dutch Tulip Bulb Bubble
• 1720, the South Sea Bubble
• 1720, the Mississippi Bubble
• 1927-29, the Stock Price Bubble
1970s, bank loans to developing countries
1985-89, real estate and stocks (Japan)
1992-1997, real estate and stocks (Asia)
1990-1993, foreign investment (Mexico)
• 1995-2000, OTC stocks (U.S.)
2003-2007, Real estate and credit (U.S.)?
from Charles P. Kindleberger and Robert Aliber, Manias, Panics, and Crashes.
New York: John Wiley & Sons, Inc. (2005)
2. Asset Bubbles
Causes:
• low interest rates
PV = FV/(1+i)n
As i decreases,
PV increases.
2. Asset Bubbles
Causes:
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low interest rates
Example
Land as a perpetuity and FV as its expected revenues:
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PV = FV/i
PV = £100/.08 = £1,250
PV = £100/.04 = £2,500
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PV = £150/.04 = £3,750
effect of interest rate decrease
effect of interest rate decrease +
effect of expected asset value increase
2. Asset Bubbles
Causes:
• new technology
The effect of new technology can be thought of as
increasing FV,
leading to a higher PV.
2. Asset Bubbles
Causes:
• new technology
Example: Equities
In the Gordon Growth Model: P = E x (1+g)/(k– g)
• low interest rates decrease k (required return)
• new inventions increase g (constant growth rate)
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Price increases
2. Asset Bubbles
Causes:
• unprecedented increases in demand
Demand can be increased merely by investors’
expectations of higher prices in the future:
In the One Period Valuation Model:
P = E/(1+k) + P1/(1+k).
As P1 increases, P increases.
2. Asset Bubbles
Causes:
• unprecedented increases in demand
Some scholars verify the existence of an asset
bubble when news about the price of an asset
affects the economy, rather than the economy
affecting the price of the asset.
2. Asset Bubbles
Causes:
• Leverage
To increase their returns, investors often employ
leverage, or borrowing:
R = (Pt1 – Pt0)/Pt0
decreasing Pt0
increasing R
2. Asset Bubbles
“Irrational Exuberance”
Robert J. Schiller (2000, revised 2005)
• Economic factors
• Cultural components
• Psychological factors
amplified by feedback loops
2. Asset Bubbles
“Irrational Exuberance”
Robert J. Schiller (2000, revised 2005)
Economic factors
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The capitalist explosion and the ownership society
Cultural and political changes favoring business success
New information technology
Supportive monetary policy and the Greenspan Put
The baby boom and bust and their perceived effects on the markets
An expansion of media reporting of business news
Analysts’ optimistic forecasts
The expansion of defined contribution pension plans
The growth of mutual funds
The decline of inflation and the effects of money illusion
Expansion of the volume of trade: discount brokers, day traders, and 24-hour
trading
The rise of gambling opportunities
2. Asset Bubbles
“Irrational Exuberance”
Robert J. Schiller (2000, revised 2005)
Cultural factors
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The news media
New era economic thinking
Psychological Factors
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Psychological anchors for the markets
Herd behavior and epidemics
Rationalizing exuberance: efficient markets and random walks
2. Asset Bubbles
Chapter Objectives
• Describe a generic asset bubble.
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 selffulfilling, 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.
3. Financial Panics
Chapter Objectives
• Explain why bubbles burst, causing financial panics.
What are financial panics and what cause them?
3. Financial Panics
A financial panic occurs when leveraged financial
intermediaries and other investors must sell
assets quickly in order to meet lenders’ calls.
3. Financial Panics
Bubble becomes a negative bubble
Shock
• Interest rates rise
• Asset values fall
Credit tightens
Sell off/defaults
Asset values fall
• Interest rates rise
• Lending volume falls
More sell
off/defaults
3. Financial Panics
Negative bubble becomes credit crisis
Credit freezes
Asset values fall
• Interest rates rise
• Lending stops
• Asset value expectations fall
3. Financial Panics
Credit crisis becomes contraction
Credit freezes
Asset values fall
•Interest rates rise
•Lending stops
•Asset value expectations fall
Growth stops
Employment falls
Contraction
•Confidence falls
•Consumption falls
3. Financial Panics
During de-leveraging, the forces that drove asset prices up now
conspire to drag them lower.
Asset bubble
Negative asset bubble
Interest rates = low
Interest rates = high
Value expectations = high
Value expectations = low
3. Financial Panics
Causes:
• higher interest rates
Example
Land as a perpetuity and FV as its expected revenues:
• PV = FV/i
• PV = £100/.06 = £1,666.66
• PV = £100/.12 = £833.33
• PV = £75/.12 = £625
effect of interest rate increase
effect of interest rate increase +
effect of expected asset value decrease
3. Financial Panics
Chapter Objectives
• Explain why bubbles burst, causing financial panics.
Key takeaways
 The bursting of an asset bubble, or the rapidly declining prices of
an asset class, can lead to a financial panic, reductions in the
quantity of available credit, and the de-leveraging of the financial
system.
 The most highly leveraged investors suffer most.
4. Lender of Last Resort
Chapter Objectives
• Define and explain the importance of lender of last resort.
What is a lender of last resort and what does it
do?
4. Lender of Last Resort
Purpose:
Stop panics and de-leveraging by:
• adding liquidity to the financial system and/or
• attempting to restore investor confidence.
4. Lender of Last Resort
Methods:
• Increase money supply
• Reduce interest rates
• Loan to open credit markets
• Restore confidence
4. Lender of Last Resort
Role of:
Central Bank
IMF
Wealthy individuals
The most common form of lender of last resort
today is the government central bank, like the
ECB or the Federal Reserve.
4. Lender of Last Resort
Restore confidence and currency
“This is preeminently the time to speak the truth, the whole truth, frankly
and boldly. Nor need we shrink from honestly facing conditions in our
country today. This great Nation will endure as it has endured, will revive
and will prosper. So, first of all, let me assert my firm belief that the only
thing we have to fear is fear itself—nameless, unreasoning, unjustified
terror which paralyzes needed efforts to convert retreat into advance. In
every dark hour of our national life a leadership of frankness and vigor has
met with that understanding and support of the people themselves which
is essential to victory. I am convinced that you will again give that support
to leadership in these critical days…
…there must be provision for an adequate but sound currency…
We do not distrust the future of essential democracy. The people of the
United States have not failed.”
- Franklin D. Roosevelt, President of the U.S. 1933-45
First Inaugural Address, March 4, 1933
4. Lender of Last Resort
Benign Neglect: Let the Markets Purge Themselves
“The ‘leave-it-alone-liquidationists’ led by Secretary of the Treasury
(Andrew) Mellon felt that government should keep its hands off and let
the slump liquidate itself. Mr. Mellon had only one formula: ‘liquidiate
labor, liquidate stocks, liquidate the farmers, liquidate real estate.’ He
insisted that when the people get an inflationary brainstorm, the only way
to get it out of their blood is to let it collapse. He held that even panic was
not altogether a bad thing. He said: ‘ It will purge the rottenness out of the
system. High costs of living and high living will come down. People will
work harder, live a moral life. Values will be adjusted, and enterprising
people will pick up the wrecks from less competent people.’”
- Herbert Hoover, President of the U.S. 1929-33
from The Memoirs of Herbert Hoover, 1952
4. Lender of Last Resort
Chapter Objectives
• Define and explain the importance of lender of last resort.
Key Takeaway
 A lender of last resort is an individual, private institution, or, more
commonly, government central bank that attempts to stop a
financial panic and/or post-panic de-leveraging by increasing the
money supply, decreasing interest rates, making loans, and/or
restoring investor confidence.
5. Bailouts
Chapter Objectives
• Define and explain the importance of bailouts.
What is a bailout and how does it differ from the
actions of a lender of last resort?
5. Bailouts
Bailouts restore the losses suffered by one or more
economic agents, usually with taxpayer money.
Politically controversial:
• Moral hazard
• “Welfare for the rich”
5. Bailouts
Chapter Objectives
• Define and explain the importance of bailouts.
Key Takeaways
 Bailouts usually occur after the actions of a lender of last resort,
such as a central bank, have proven inadequate to stop negative
impacts 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 de-leveraging, debt deflation,
and economic depression.
6. The Crisis of 2007-8
Chapter Objectives
• Narrate the causes and consequences of the financial
crisis that began in 2007.
What factors led to the present financial crisis?
6. The Crisis of 2007-8
2007 Nonsystemic
(mortgage
market)
2008 Systemic
6. The Crisis of 2007-8
2000-2006 Housing bubble
• Low interest rates
• Easy credit
o Securitization
o Lack of regulation
6. The Crisis of 2007-8
2007 Negative housing bubble
• Values decrease
• Mortgage defaults increase
• Bankruptcy of leveraged lenders
• Nationalization of bankrupt “securitizers”
• Nationalization of leveraged intermediaries
• Panic
 Bailout
6. The Crisis of 2007-8
Chapter Objectives
•
Narrate the causes and consequences of the financial crisis that began in 2007.
Key Takeaways
 Low interest rates, indifferent regulators, unrealistic credit ratings for
complex mortgage derivatives, and poor incentives for mortgage
originators 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’s efforts as lender of last resort, the non-systemic crisis
became systemic in September 2008 following the failure of Lehman
Brothers and AIG.
 The government responded with huge bailouts of subprime mortgage
holders and major financial institutions.
Chapter 12 The Financial Crisis of 2007-8
Chapter Summary
 Throughout history, systemic
(widespread) and non-systemic
(contained to a few industries) financial
crises have damaged the real economy
by disrupting the normal flow of credit
and insurance.
 Understanding their causes and
consequences is therefore important.
 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 self-fulfilling, 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.
Chapter 12 The Financial Crisis of 2007-8
Chapter Summary
 The bursting of an asset bubble, or the
rapidly declining prices of an asset class,
can lead to a financial panic, reductions
in the quantity of available credit, and
the de-leveraging of the financial system.
 The most highly leveraged investors
suffer most.
 A lender of last resort is an individual,
private institution, or, more commonly,
government central bank that attempts
to stop a financial panic and/or postpanic de-leveraging by increasing the
money supply, decreasing interest rates,
making loans, and/or restoring investor
confidence.
 Bailouts usually occur after the actions of
a lender of last resort, such as a central
bank, have proven inadequate to stop
negative impacts on the real economy.
Chapter 12 The Financial Crisis of 2007-8
Chapter Summary
 They usually entail restoring losses to one
or more economic agents.
 Although politically controversial,
bailouts can stop negative bubbles from
leading to excessive de-leveraging, debt
deflation, and economic depression.
 Low interest rates, indifferent regulators,
unrealistic credit ratings for complex
mortgage derivatives, and poor
incentives for mortgage originators 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.
Chapter 12 The Financial Crisis of 2007-8
Chapter Summary
 Despite the Fed’s efforts as lender of last
resort, the non-systemic crisis became
systemic in September 2008 following
the failure of Lehman Brothers and AIG.
 The government responded with huge
bailouts of subprime mortgage holders
and major financial institutions.