Financial Crises: Causes Flashcards
(27 cards)
Timeline of the GFC
○ Summer 2007 – Rising defaults in subprime mortgages ○ Autumn 2007 – Failure of 2 large hedge funds and the Northern Rock Bank (NRB) Run
○ Summer 2008 – Fannie Mae and Freddie Mac nationalized
○ September 2008 – Bankruptcy of Lehman Brothers
○ October 2008 – Bank bailout program
○ Autumn 2008 – Spring 2009 – Crisis transmitted to the real economy. There was a global credit crunch and banks stopped lending to firms and consumers, leading to the worst downturn since the Great Depression
2 Popular Misconceptions of causes of the GFC
- Subprime mortgages caused the crisis – in reality, the causes of the crisis were far more fundamental and structural
- reckless greed and risk-taking
Laeven and Valencia (IMF, 2013):
Financial crises have led affected economies into deep recessions. They have often been preceded by excessive credit booms. Most of the recessions studied were preceded by credit booms. The credit boom eventually led to a financial crisis, or at least there is a correlation between credit booms and financial crises
Claessens, Kose, and Terrones (IMF, 2008)
- In countries that simultaneously experienced a house-price bubble and a credit boom, the credit boom was much more pronounced
A speculative asset price bubble occurs when
Asset prices depart significantly from their fundamental value
fundamental value of an asset
the fundamental value of an asset depends on the stream of cashflows generated by that asset in the future. You can think of the fundamental value as the long-run equilibrium value of the asset at the intersection of long-run supply and long-run demand.
During 1997 – 2006, US house prices increased by ___%
132
How do fundamentals increase?
Fundamentals increase with things like better technology or population growth, or finding new physical assets (oil, coal, etc.)
Explain the anatomy of the price-optimism feedback loop
house prices rise > inducing optimism, increased investment through leveraging > investors make capital gains on speculative investments > demand for housing increases, leading to higher prices. Banks also extend more credit, leading to more borrowing and higher prices
Explain the “excessive optimism” part of the price-optimism feedback loop
- An asset price bubble occurs through misperception that rising prices are driven by fundamentals, when in reality they are driven by speculation, one of the price-optimism feedback loop components
- Sustained asset price inflation generates excessive optimism that an improvement in fundamentals has occurred
- This is compounded by “new era” stories – there is always some story that accompanies bubbles that convinces people that fundamentals have improved (when they really have not) – the great moderation
What was the Great Moderation and how did it feed into the POFL?
people became convinced due to a period of unprecedented macroeconomic stability that the business cycle was dead and risk had been vanquished.
Leveraging
Leveraging is the use of borrowed funds for the purpose of investment in houses or financial assets. You take out a loan and use it to purchase a house in anticipation that prices will increase. Once prices increase, you sell, get your capital gains, repay the loan and are left with the profit. To ensure that borrowers repay their loans, banks require they post collateral, usually their house.
The Passive Credit View (Foote et al., 2012)
Under the passive-credit view, credit growth was an effect of the housing bubble and was demand driven. In this point of view, banks were not to blame – they simply responded to the increasing demand for leveraging. They were innocent bystanders, and it was the speculators who were at fault
Active Credit Views (Mian and Sufi, 2014)
Under the active-credit view, credit growth was directly driven by the banks and the housing price bubble was a response to this (supply driven)
Was the active or passive credit view correct and how do we know?
- Mian and Sufi argue that there is evidence supporting the active credit view –subprime mortgages swelled to 40% of market share from 10% in the period 2002-2006 and Justiniano et al. (2016) found that mortgage interest rates fell sharply during 2002-2005
- Expansion in credit quantity and decline in the interest rate is a classic signal of an outward shift in the credit supply curve. A combination of increased subprime mortgages and falling mortgages interest rates point to the active credit view being correct
loan to value ratio
max. loan amount/collateral value
Why is it “good” that the crisis was largely supply driven?
policymakers can restrain bank credit expansion through macroprudential regulation, but its hard to restrain speculative investment
Informational Casade
- An information cascade, also known as herding, occurs when people disregard their own individually collected information because they feel that everyone else simply could not be wrong –they follow the crowd. With prices rising and rising through a process of the informational cascade, this drives optimism and the cycle repeats
The Oil Non-Bubble
- Following a debate on the possibility of an ongoing oil price bubble in 2008 with rising oil prices, Paul Krugman claimed in the NYT that there were no speculative bubbles and oil price increases were driven by fundamentals –his argument was based on the fact that oil stockpiles in private inventories had not soared, implying that speculators were not hoarding oil supplies and therefore did not actively affect the demand for oil
- Many economists disagreed – what if the oil producers themselves were engaging in speculation? Sure, the oil stockpiles above ground were not soaring in inventories, but if oil producers cut their drilling back, then basically the oil is being stored in the ground
Leaning Against the Wind
Using monetary policy to deal with credit –Increasing interest rates higher than required to meet the inflation target during a boom phase. LATW might require tightening monetary policy during a recession –this is known as the problem of “two targets and one instrument”
Mopping up the Mess
Using monetary policy to deal with credit – Do nothing to interest rates during boom phases, but cut interest rates aggressively should the asset price bubble burst
Macroprudential Policy
Macroprudential policy is the application of financial regulation to protect the real economy from swings and cycles in the financial system
the primary objective on macroprudential policy
- Its primary objective is to restrain credit growth during a boom phase (allowing monetary policy to focus primarily on inflation)
The PS-FS Model
The BoE recently developed the PS-FS Model to illustrate the interaction between monetary policy and macroprudential policy
