C. 9 Financial Crises

Question 1

Financial frictions

Answer 1

Asymmetric information problems which act as a barrier to efficient allocation of capital

Question 2

Financial crisis

Answer 2

When information flow in financial markets experience a particularly large disruption, which the result that financial frictions increase sharply and financial markets stop functioning. Then, the economy collapses

Question 3

Financial liberization

Answer 3

The elimination of restrictions on financial markets and institutions

Question 4

Credit boom

Answer 4

When financial institutions go on a lending spree

Question 5

Stages of financial cresis

Answer 5

1) Initial Phase
2)
3) (sometimes)

Question 6

Deleveraging

Answer 6

When financial institutions with reducing capital cut back on their lending to borrower-spenders

Question 7

Stages of financial cresis

Answer 7

1) Initial Phase
2) Banking Crisis
3) (sometimes) Debt Deflation

Question 8

Consequences of the initial phase

Answer 8

• Adverse Selection
• Moral hazard problems worsen
• Lending contracts
  Loans become scarce, so borrower-spenders aren’t able to fund productive investments and decrease spending which causes the economy to contract

Question 9

Fundamental economic value

Answer 9

Value based on realistic expectatons of the assets’ future income streams

Question 10

Initial phase

Answer 10

Increase in uncertainty, asset-price decline, and deterioration in FI’s balance sheets lead to:

• Adverse Selection
• Moral hazard problems worsen
• Lending contracts
  Loans become scarce, so borrower-spenders aren’t able to fund productive investments and decrease spending which causes the economy to contract

Question 11

Banking Crisis

Answer 11

Economic activity declines

• > Banking crisis
• > Adverse selection, moral hazard problems worsen, and lending contracts
• > Economic activity declines

Question 12

Debt Deflation

Answer 12

Unanticipated decline in price level

• > Adverse selection, moral hazard problems worsen, and lending contracts
• > Economic activity declines

Question 13

Insolvency

Answer 13

Net worth becomes negative

Question 14

Fire sales

Answer 14

Banks sell of assets quickly to raise the necessary funds

Question 15

Bank panic

Answer 15

Multiple banks fail simultaneously

Question 16

Debt deflation

Answer 16

A substantial, unanticipated decline in the price level sets in, leading to a further deterioration in firms’ net worth because of the increased burden of indebtedness

Question 17

Credit spread

Answer 17

The difference between the interest rate on loans and households and businesses and the interest rate on completely safe assets that are sure to be paid bank

Question 18

Causes of 2007-2009 financial crisis

Answer 18

1) Financial innovation in mortgage markets
2) Agency problems in mortgage markets
3) Asymmetric information in credit-rating process

Question 19

Financial engineering

Answer 19

The development of new, sophisticated financial instruments

Question 20

Structured credit products

Answer 20

Paid out income streams from a collection of underlying assets, designed to have particular characteristics that appealed to investors with differing preferences

Question 21

Principal-agent problem in mortgage markets

Answer 21

Principal-agent problem: Mortgage brokers didn’t evaluate thoroughly if borrowers could pay their loans back because they were quick to sell the loans to investors in the form of mortgage-backed securities. The mortgage brokers acted as agents for the investors (principals) but didn’t have the investors’ best interests at heart.

Question 22

Adverse selection problem in mortgage markets

Answer 22

Risk-loving real-estate investors lined up to obtain loans to acquire houses that would be very profitable if housing prices went up, knowing they could “walk away” if housing prices went down

Question 23

Financial derivatives

Answer 23

Financial instruments whose payoffs are derived from previously issued securities

Question 24

Credit default swap

Answer 24

A financial derivative that provides payments to holders of bonds if they default

Question 25

Asymmetric information and credit-rating agencies

Answer 25

Rating agencies were subject to conflicts of interest because the large fees they earned from advising clients on how to structure products that they rated, meant they didn't have enough incentive to make accurate ratings (like a soul)

Question 26

The impact of the 2007-2009 crisis was most evident in five key areas

Answer 26

1) US residential housing market 2) FIs' balance sheets 3) The shadow banking system 4) Global financial markets 5) The headline grabbing failures of major firms in the financial industry

Question 27

Shadow banking system

Answer 27

Composed of hedge funds, investment banks, and other nondepository financial firms which are not as tightly regulated as banks are

Question 28

Repurchase agreements (repos)

Answer 28

Short-term borrowing that, in effect, uses assets like mortgage-backed securities as collateral

Question 29

Haircuts

Answer 29

A larger amount of collateral on a repo. E.g. $100M loan taken out in a repo, and borrower has to post $105M of collateral. -> 5% haircut

Question 30

The early symptom of the US subprime crisis in Canada

Answer 30

The freezing of the asset-backed commercial paper market (ABCP) in August 2007 causing a sharp decrease in liquidity in short-term Canadian credit markets.

Question 31

The Canadian version of subprime mortgages

Answer 31

High-risk, zero down, long term (40 years) mortgages in 2007 and 2008 when the conservative govt opened up the mortgage market to big US players.

Question 32

Why was Canada spared the worst of the financial crisis?

Answer 32

1) More tightly regulated 2) Bank regulations revised every five years 3) Financial institutions work in harmony together 4) Traditionally more conservative in their lending 5) Well diversified and are not limited to traditional retail banking (e.g. can hire investment brokers) but these extra arms are still tightly regulated 6) Canadian banks hold a large portion of their mortgages and these mortgages are not as securitized (1/3) as the U.S. banks' ones (2/3). This gives banks incentives to make sure their mortgage loans are good loans

Question 33

Why was Canada spared the worst of the financial crisis?

Answer 33

1) More tightly regulated 2) Bank regulations revised every five years 3) Financial institutions work in harmony together 4) Traditionally more conservative in their lending 5) Well diversified and are not limited to traditional retail banking (e.g. can hire investment brokers) but these extra arms are still tightly regulated 6) Canadian banks hold a large portion of their mortgages and these mortgages are not as securitized (1/3) as the U.S. banks' ones (2/3). This gives banks incentives to make sure their mortgage loans are good loans 7) Canadian laws allow banks to go after other assets when a borrower walks away from a mortgage, making them less likely to do so