Understanding Financial Crises

Financial Crisis Defined

• A financial crisis involves significant disruption to information flow in financial markets
• This leads to increased financial frictions and market dysfunction
• Asymmetric information, including moral hazard and adverse selection, contributes to this
• Financial market dysfunction can cause broad economic activity to collapse

Dynamics of Financial Crises: Initial Phase

• Financial crises often begin with mismanagement of financial liberalization or innovation
• Credit booms and busts can occur if lenders lack expertise or incentives to manage risk
• Financial institution balance sheets can deteriorate as loan losses mount
• Declining net worth causes financial institutions to deleverage by cutting back on lending

Asset-Price Boom and Bust

• Prices of assets like shares or real estate increase above their fundamental values
• Asset-price bubbles burst, causing companies’ net worth to decline
• The incentive to make risky investments grows and uncertainty increases
• Information scarcity increases financial frictions, leading to decreased lending and economic activity

Banking Crisis

• Deteriorating balance sheets can cause financial institutions to become insolvent
• Depositor panic leads to withdrawals
• Banks may sell assets to raise funds and spark fire sales
• Insolvent firms are liquidated, and recovery starts as uncertainty decreases and balance sheets improve

Debt Deflation Stage

• Sharp declines in price level coupled with economic downturns can hinder recovery
• Debt deflation occurs when debt, fixed in nominal terms, becomes more burdensome as prices decline
• Net worth deteriorates, and the real value of debt increases

The Great Depression

• The Great Depression as triggered by a stock market crash and bank panics
• This lead to continuing declines in stock prices and debt deflation.

Global Financial Crisis of 2007-2009: Causes

• Financial innovations in mortgage markets
• Agency problems
• Subprime and Alt-A mortgages
• Mortgage-backed securities
• Collateralized debt obligations (CDOs)
• Asymmetric information and failures of credit-rating agencies

Global Financial Crisis of 2007-2009: Effects

• Residential housing boom and bust driven by subprime mortgage market
• Housing prices declined sharply
• Fannie Mae and Freddie Mac purchased trillions in mortgage-backed securities
• The originate-to-distribute model was subject to principal-agent problems
• Borrowers lacked incentives to disclose information about their ability to pay

Financial Institutions’ Balance Sheets

• Rising defaults from falling housing prices caused balance sheets to deteriorate
• Lower net worth led to deleveraging
• Asset prices declined substantially
• A run on the shadow banking system occurred, affecting hedge funds, investment banks, and nondepository firms
• Short-term borrowing via repurchase agreements (repos) financed these entities

Global Financial Crisis: Global Impact

• High-profile firms Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund and Washington Mutual failed in September 2008
• The crisis peaked in September 2008
• US House of Representatives rejected, then approved a $700 billion bailout package

Government Intervention and Recovery

• Federal Reserve, US Treasury, and TARP intervened
• Economic Stimulus Act of 2008 and American Recovery and Reinvestment Act of 2009 were implemented
• Recession was less severe than the Great Depression due to government intervention

Canada and the 2007-2009 Financial Crisis

• August 2007: freezing of the asset-backed commercial paper (ABCP) market
• High-risk, long-term, zero-down subprime mortgages grew in 2007 and 2008
• Subprime mortgages were banned in summer 2008
• June 2012: new regulations capped amortization and refinancing

Canada Spared the Worst

• Canadian banks faced issues, but the government did not bail them out
• Shares fell almost 50%, and some experienced huge losses
• Tighter banking regulations, conservative practices, higher capital requirements, greater leverage restrictions, and fewer securitized mortgages contributed

Financial Regulation Response

• Microprudential supervision focused on individual institutions pre-crisis, but was insufficient
• Post-crisis, macroprudential supervision was implemented to address the entire system
• Counter cyclical capital requirements and tighter credit standards were established

Dodd-Frank Act of 2010

• Included consumer protection measures
• Established Resolution Authority
• Introduced systemic risk regulation for SIFIs
• Implemented Volcker Rule
• Derivatives regulations were put in place

The nominal anchor

• Price stability is defined by central bankers as keeping inflation low and stable
• Central bankers are are aware of the social and economic costs of inflation
• The nominal anchor ties down the price level to achieve price stability

Nominal Anchor & Time-Inconsistency Problem

• Nominal anchor limits the time-inconsistency problem
• Policymakers often pursue discretionary monetary policy which can lead to expectations about inflation, driving wages/prices up
• Rising wages and prices will lead to higher inflation without higher output

Goals of Monetary Policy

• High employment, output stability, and the natural rate of unemployment
• Economic growth
• Stability of financial markets and interest rates
• Stability in foreign exchange markets

Price Stability Goal of Monetary Policy

• Hierarchical mandates prioritize price stability
• Dual mandates aim for price stability and maximum employment
• Either mandate is acceptable if price stability remains the primary long-run goal

Inflation Targeting Methodology

• A medium-term numerical target goal needs to be announced publicly
• Institutional commitment to price stability needs to be in place as the main long-run goal
• Variables need to used inclusively to achieve optimal decisions
• Create an increased transparency of strategy
• Increased accountability of the central bank

Inflation Targeting Advantages

• Reduces the potential for falling in a time-inconsistency trap
• Stresses a need for transparency and accountability
• Consistency with democratic principles
• Should improve performance

Inflation Targeting Disadvantages

• Delayed signaling can occur
• Can create too much rigidity
• Has potential for increased output fluctuations
• Has potential for low economic growth during disinflation

Monetary Policy Lessons From the Global Financial Crisis

• Financial sector developments greatly impact economic activity
• The zero-lower-bound on interest rates is a serious problem
• Cleanup costs after a financial crisis are very high
• Price and output stability do not ensure overall financial stability

Inflation Targeting Implications

• Inflation targets need to be seriously considered at the central bank (typically around 2%)
• The zero-lower-bound problem needs to be raised if target level is too low
• Flexibility needs to exist if inflation targeting

Central Banks Restraining Asset-Price Bubbles

• In order to restrain asset-price bubbles, the government can:
• Implement macro prudential policies
• Implement monetary policies
• Central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed without any reaction

Policy Instruments

• Policy instruments like reserve aggregates include:
• Total reserves, nonborrowed reserves, monetary base, and the nonborrowed base
• Interest rates like the overnight interest rate

Policy Instrument Criteria

• Instruments need to be easily observable and measurable
• Quick, accurate measurements are necessary
• Instruments need to be easily controllable
• Instruments need to have predictable effects on goals

Foreign Exchange

• Exchange rates affect the relative price of domestic and foreign goods which is why they are important
• Exchange rates: price of one currency in terms of another in a foreign exchange market
• Currencies are traded over-the-counter (OTC) rather than exchanges such as the Toronto Stock Exchange
• Appreciation: a currency rises in value relative to another; depreciation: a currency falls in value relative to another

Exchange Rate Factors

• Factors that affect the exchange rate in the long run:
• Law of one price and purchasing power parity
• Relative price levels
• Trade barriers
• Preferences for domestic versus foreign goods
• Productivity

Mortgage Defined

• Mortgage: A long-term loan secured by real estate that is amortized with payments going toward the principal and interest each month
• Market rates, loan terms and loan amortization are characteristics of mortgages

Mortgage History

• Mortgage defaults during the agricultural recession of 1890, made long-term mortgages inaccessible
• Mortgages following the WWII, were originally short-term balloon loans that often had a five year maturity or less

Mortgage Characteristics

• Collateral: The real estate being financed
• Down payments: A portion of the purchase price made at time of purchase by the purchaser
• Qualifications for loans, are made following review of credit history

Mortgage Scores

• A credit score reported at loan application is called a FICO score
• FICO (equifax) range is 300-850 and the average range is 660-720

Mortgage Types

• A payment that is fixed and pays the interest plus principal
• Balance will be zero when the last payment is made
• Mortgages insured if down payment is <20%, conventional mortgages otherwise
• Adjustable-rate mortgages allow interest rate fluctuation

Global Mortgages

• Thrift institutions were the primary originator of mortgages in the U.S.
• Loans are often sold to other parties, freeing cash to originate another loan

Mortgage Banking Elements

• The originator packages the loan for an investor
• The investor holds the loan
• The servicing agent handles the paperwork

Mortgage Risks

• Securitization of mortgages allows for diversification, reducing default risks
• A mortgage-backed security (MBS) is often created by rights to cash flows are sold as separate securities
• GNMA and FHLMC are types of mortgage pass-through

Types of Mortgages

• In 2000, only 2% of mortgages were subprime, climbing to 17% by 2006
• CDO (collateralized debt obligation) creation helped create deal flow to continue lending in subprime markets
• New legislation may require mortgage originators to hold a part of the mortgages they create

IPO Financing

• Financing often comes from:
• Founder’s resources (love money)
• Angels
• Venture capital funds
• Capital is provided by institutional companies
• Managers are venture capitalists that sit on boards

Trading Markets

• Private and public transactions are classified into primary and secondary markets
• An IPO (initial public offering) occurs when stocks are offered for the first time
• A secondary market, allows investors to trade outstanding shares between each other

Primary Markets

• Stock market types by location:
• Physical location exchanges, where traders meet/trade on the market floor
• Computer/telephone market, where traders do not see one another
• The NYSE and AMEX are the two largest auction markets for stocks

Market Trading Methods

• Dealer markets keep an inventory and place bids and asks, and have computerization
• Examples include: Nasdaq National Market, Nasdaq SmallCap Market, London SEAQ, German Neuer Markt
• The OTC market is the equivalent to a computer bulletin board

Listed Canadian Exchanges

• The Toronto Stock Exchange (TSX) and TSX Venture Exchange are the main exchanges in Canada
• TMX, group Inc, owns the TSX and Montreal Exchange which hosts derivatives

The NYSE

• The New York Stock Exchange, NYSE-Euronext, is the largest stock market in the world, with a market capitalization of US$15 trillion on December 31, 2008
• 2,447 companies were listed with over 2.3 billion shares traded per day

NASDAQ

• NASDAQ: computerized network for securities dealers
• Second largest global market in the US based on market capitalization with 5,000 companies listed.

IPO: decision to go public

• Selling firms stock to outside investors in public markets turn the company from privately to public

IPO Advantages

• Current stockholders can diversify
• Liquidity is increased
• Easier to raise capital in future
• Special deals to insiders will be harder
• Firm value is established

The IPO Process

• Select an investment bank
• Choose a price range for preliminary (or red herring) prospectus
• File the prospectus for reviews from the commission and make corrections
• Final offering price is set in the prospectus
• Oral commitments are obtained

IPO Investment Banking

• Reputation and experience in the industry is an important consideration for choosing an investment banker
• Support in the IPO market
• If very small, investment banker may insist of a 'best efforts' basis
• Prices are assessed until until pricing

IPO Underwriting

• In IPO Underwriting, companies:
• Typically overprice to increase the likelihood of oversubscription to reduce risk to the underwriter
• Increase ease with investment banks to reward preferential customers
• Often give away less due to the fact firms are underpriced