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					   Professor Yamin Ahmad, Money and Banking – ECON 354




                      ECON 354
                 Money and Banking
   Financial Crises and the subprime Meltdown. 9



Lecture 8
• Financial Crises.
• The Great Recession of 2007 –
  2009: Part I: Causes and
  Timeline of Events.
• Financial Crises in Emerging
  Market Economies.
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   Professor Yamin Ahmad, Money and Banking – ECON 354




      Role of Financial Intermediaries
Recall:
• Financial intermediaries solve the 2 problems created
  by asymmetric information:
     Adverse Selection.
     Moral Hazard.


• If financial intermediaries are able to solve these
  problems, then why did the economy experience the
  recent financial crisis?.

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Summary: Asymmetric Information Problems and Tools
                to Solve Them




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                  Factors Causing Financial Crises
1. Asset Markets Effects on Balance Sheets:
   A. Stock market decline.
           Decreases net worth of corporations.
   B. Unanticipated decline in the price level.
           Liabilities increase in real terms and net worth decreases.
   C. Unanticipated decline in the value of the domestic
      currency.
           Increases debt denominated in foreign currencies and
            decreases net worth.
   D. Asset write-downs.


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                  Factors Causing Financial Crises

2. Deterioration in Financial Institutions’ Balance
   Sheets.
   Decline in lending.
3. Banking Crisis.
   Loss of information production and disintermediation.
4. Increases in Uncertainty.
   Decrease in lending.


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   Professor Yamin Ahmad, Money and Banking – ECON 354




                  Factors Causing Financial Crises
5. Increases in Interest Rates.
   Increases adverse selection problem.
   Increases need for external funds and
     therefore adverse selection and moral hazard.
6. Government Fiscal Imbalances.
   Create fears of default on government debt.
   Investors might pull their money out of the
     country.

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   Professor Yamin Ahmad, Money and Banking – ECON 354




        Dynamics of past U.S. Financial Crises
• Stage One: Initiation of Financial Crisis.
   Mismanagement of financial liberalization/
    innovation.
   Asset price boom and bust.
   Spikes in interest rates.
   Increase in uncertainty.
• Stage two: Banking Crisis.
• Stage three: Debt Deflation.
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FIGURE 1 Sequence of Events in U.S. Financial Crises




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   Professor Yamin Ahmad, Money and Banking – ECON 354



     The 2007 - 2008 Financial Crisis and
            the Great Recession
Three Parts:
• Part I: Origins of The 2007 – 2008 subprime
  Financial crisis.
    Covered in this lecture.
• Part II: Economic Policies used to tackle the
  global recession.
• Part III: Post Crisis and Future Outlook.


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   Professor Yamin Ahmad, Money and Banking – ECON 354




    Factors leading to the Financial Crisis

PART I: ORIGINS OF THE 2007 – 2008
SUBPRIME FINANCIAL CRISIS.

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                            A Quick Word Cloud …




  Created at Wordle.net          Money & Banking
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                                               Key Factors
• Housing Market and Housing Prices.

• Global Savings Glut.

• Subprime lending and the subsequent
  rise in Interest Rates.
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                           Once Upon A Time …


                                                        $$$


                                                        %




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             Interest Rates Over the Last Two
                         Decades
Percent
12



10                                               Shaded areas represent
                                                      recessions.                                                    Fed Funds Rate

 8



 6



 4



 2



 0
      Q1     Q2     Q3     Q4     Q1     Q2     Q3     Q4     Q1     Q2     Q3     Q4     Q1     Q2     Q3     Q4       Q1     Q2      Q3     Q4
     1985   1986   1987   1988   1990   1991   1992   1993   1995   1996   1997   1998   2000   2001   2002   2003     2005   2006    2007   2008



 Source: Board of Governors, Federal Reserve System
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      The Subprime Financial Crisis of 2007 - 2008

1. Financial innovations emerge in the mortgage
   markets:
   Subprime and (Alternative) Alt -A mortgages.
   Mortgage-backed securities.
   Collateralized debt obligations (CDOs).
2. Housing price bubble forms:
   Increase in liquidity from cash flows surging
    to the United States.
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  Price
                                    House Price Bubble
                           Median Home Prices for Single Family Home in the United States
$275,000

$250,000

$225,000                Inflation-adjusted house prices
                        Nominal house prices                                  Housing Market Bubble?
$200,000

$175,000

$150,000

$125,000

$100,000

 $75,000

 $50,000

 $25,000

      $0
        1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008


                                                                                                             Year
  Sources: National Association of Realtors, Standard & Poors, Federal Housing Finance Agency, Freddie Mac



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      The Subprime Financial Crisis of 2007 - 2008
2. Housing price bubble forms (cont’d).
   Development of subprime mortgage market
    fueled housing demand and housing prices.
3. Agency problems arise.
   “Originate to distribute” model is subject to
    principal (investor) agent (mortgage broker)
    problem.
   Borrowers had little incentive to disclose
    information about their ability to pay.
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               Financial Crisis: How it Happened
    Investment in high                                                              Asset (Mortgage)
    risk (subprime)                                                                 Backed Securities sold
    sectors                                                                         globally to investors



                                                                                  CDOs
                                     Credit



                                    $$$                                             $$$

    Subprime
    Mortgages


• Banks/Lenders make high risk loans to people with poor
  credit histories (subprime mortgages).
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                          Middle of this Decade




• These sub-prime mortgages, other loans, bonds and
  other assets are bundled into portfolios or Collateralized
  Debt Obligations (CDOs) and sold to investors globally.
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      The Subprime Financial Crisis of 2007 - 2008

3. Agency problems arise (cont’d)
    – Commercial and investment banks (as well as rating
      agencies) had weak incentives to assess the quality of
      securities.
• Information problems surface.
• Housing price bubble bursts.



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      Professor Yamin Ahmad, Money and Banking – ECON 354




 Beginning of the Subprime Problem: 2004 - 2006
 Price     Median Home Prices for Single Family Home in the
                           United States                           Percent
$275,000                                                           12

$250,000
                      Inflation-adjusted house prices                                               Shaded areas
                                                                   10                                 represent
$225,000              Nominal house prices
                                                                                                     recessions.                    Fed
                                                                                                                                    Funds
$200,000                                                                                                                            Rate
                                                                    8
$175,000

$150,000
                                                                    6
$125,000

$100,000                                                            4

 $75,000

 $50,000                                                            2

 $25,000
                                                                    0
     $0
                                                                         Q1     Q3     Q1     Q3       Q1     Q3     Q1     Q3     Q1     Q3
       1970 1974 1978 1982 1986 1990 1994 1998 2002 2006
                                                                        1985   1987   1990   1992     1995   1997   2000   2002   2005   2007



 • Between 2004–2006, US interest rates rose from 1% to 5.35%,
   triggering a slowdown in the US housing market.
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   Professor Yamin Ahmad, Money and Banking – ECON 354



Beginning of the Subprime Problem: 2004 - 2006

Falling house prices


                                                         CDOs
                                     Credit



                                    $$$                    $$$

Default on Subprime Mortgages
• Falling house prices and rising interest rates lead to a large number
  of people who cannot repay their mortgage in the subprime sector.
• In addition, for many in the subprime sector, mortgage rates
  become adjustable (after initially being fixed), which worsens the
  problem. lecture notes areMoney & Banking having attended lectures
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           The Beginnings of a Global Credit Crunch

Falling house prices


                                                                                   CDOs
                                      Credit




                                                                                     $$$

Default on Sub-prime Mortgages
• As mortgage default rates rise, investors holding these mortgage
  backed securities suffer losses, making them more reluctant to take
  on CDOs.
• Credit markets start to freeze as banks are reluctant to lend to each
                            many
  other, not knowing howBanking bad loans they may be carrying.
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    Timeline of Key Events; Advent of a Global Recession

PART II: TIMELINE OF EVENTS


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      The Subprime Financial Crisis of 2007 - 2008

• Banks’ balance sheets deteriorate.
    Write downs.
    Sell of assets and credit restriction.
• High-profile firms fail.
    Bear Stearns (March 2008).
    Fannie Mae and Freddie Mac (July 2008).
    Lehman Brothers, Merrill Lynch, AIG, Reserve Primary
     Fund (mutual fund) and Washington Mutual
     (September 2008).
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      Key Events in the Economic Crisis




Early Warning Signs
• Early 2007: Several large subprime mortgage lenders started to report losses, e.g.
     HSBC on 8th February 2007.
     New Century Financial (one of the largest subprime lenders in the US) files
      for Chapter 11 bankruptcy on April 2nd 2007, signaling to other lenders that
      something is wrong in the US subprime industry.
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      The Subprime Financial Crisis of 2007 - 2008

• Crisis spreads globally
    Sign of the globalization of financial markets.

    TED spread (3 months interest rate on Eurodollar
     minus 3 months Treasury bills interest rate) increased
     from 40 basis points to almost 240 in August 2007.




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  Treasury Bill–to–Eurodollar Rate (TED)
                  Spread




Source: www.federalreserve.gov/releases/h15/data.htm

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     Key Events in the Economic Crisis




Early Warning Signs
• Mid (July/August) 2007, credit spreads (spread between risky and risk-
  free bonds) begin to widen.
• Federal Reserve chairman, Ben Bernanke, warns of an impending
  crisis in the subprime lending market that could cost up to $100bn of
  losses (July 20th). Money & Banking
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     Key Events in the Economic Crisis




Crisis Trigger: 9th August 2007
• French investment bank BNP Paribas temporarily halts redemptions from two of
  its hedge funds because it cannot reliably value the assets backed by US
  subprime mortgage debt held in those funds.
• There is a “complete evaporation of liquidity” in the credit markets.
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   Key Events in the Economic Crisis
August 9th 2007
• When an investment bank like BNP Paribas took such a step,
  others worldwide began to question the value of collateral
  they had been accepting in their lending operations, and
  consequently started to worry about the value of the assets
  on their balance sheets.

• Uncertainty about portfolios containing subprime mortgage
  backed securities spreads.
        Banks come reluctant to lend to each other not knowing how much
         bad loans could be in their borrower’s books.
        Interbank lending literally came to a halt overnight as the credit
         market started to freeze.
        This led to severe liquidity constraints on many financial institutions.
Sources: Cecchetti (2009), BBC , CNN, Newsweek, Bloomberg
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Global Event… Subprime Crisis Spreads




• The impact of the subprime mortgage crisis has repercussions
  beyond the United States. Losses are felt by investment banks even
  in Australia.
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                                          Bond Spreads
       Mature Credit Markets                                                             Emerging Markets




   Sources: Bloomberg Financial Markets, Bank of Japan, European Central Bank, Federal
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   Reserve Board of Governors, and
     Note:                         areIMF’s World Economic having
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     Key Events in the Economic Crisis
August 9th 2007
• Contraction in short-term funds causes overnight interest rates to shoot
  up, e.g. the 3 month London Interbank Offered Rate (LIBOR).

• ECB pumps approx €95 billion worth of overnight repos (largest short-
  term liquidity injection in its 9 year history).

• Over the next few days, they add a further €108.7 billion.

• In addition, the US Federal Reserve, the Bank of Canada and the Bank of
  Japan begin to intervene in the markets.

• August 17th: In a surprise move, the Fed cuts the primary lending
  (discount) rate by 50 basis points from 6.25% to 5.75% and warns that
  the credit crunch could be a risk to growth.
  Sources: Cecchetti (2009), BBC , CNN, Newsweek, Bloomberg
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    Key Events in the Economic Crisis




Banks worry about runs on the bank
• 13th September 2007: In the UK, savers start to withdraw their savings
  from the Northern Rock Building Society after news emerges that it
  received emergency financial support from the Bank of England. A bank
  run ensues.
• Northern Rock ends up being nationalized later (on 17th February 2008).
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     Key Events in the Economic Crisis




Central Bank Interventions in Financial Markets
• December 13th 2007: US Federal Reserve , ECB, Bank of England, Bank of Canada
  and Central bank of Switzerland co-ordinate efforts in an unprecedented action
  to offer billions of dollars in loans to banks.
• They attempt to bolster the money markets by making funds available for banks
  to borrow on more favorable terms, whilst cutting interest rates.
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    Key Events in the Economic Crisis




Banks in Turmoil
• Despite the short term injections of liquidity, credit crunch continues as banks
  remain cautious about lending to each other.
• March 13th 2008: Wall Street’s fifth largest bank, Bear Stearns is acquired by
  larger rival JP Morgan Chase for $240 million, in a deal brokered by the Fed.
  Bear Stearns hadMoney & Banking having attended lectures
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 Treasury Bill–to–Eurodollar Rate (TED)
                 Spread




Source: www.federalreserve.gov/releases/h15/data.htm

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    Professor Yamin Ahmad, Money and Banking – ECON 354




     Key Events in the Economic Crisis
• April 8th 2008: The International Monetary Fund (IMF) warns that the
  potential losses resulting from the credit crunch could exceed $1 trillion.

• April – July 2008: House prices continue to slow. More news of
  foreclosures. Deterioration continues in values of asset backed
  securities.

• July 14th 2008: US Treasury steps in to assist the two largest mortgage
  companies in the US:- Freddie Mac and Fannie Mae.
     As owners or guarantors of $5 trillion worth of home loans, they play a crucial
      role in the US housing market, and steps are taken to ensure they do not fail.


• September 5th, 2008: US labor market figure show unemployment rate
   rising to 6.1%; Unemployment numbers are also starting to climb in the
   G7 countries.
  Sources: Cecchetti (2009), BBC , CNN, Newsweek, Bloomberg
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    Key Events in the Economic Crisis
• September 7th 2008: US Government take Fannie Mae and
  Freddie Mac into temporary public ownership after they
  reveal huge losses on the US subprime mortgage market.

    It is one of the largest bailouts to date in US history.

    If they had failed, it might have triggered a run on the
     dollar, since many foreign governments had bought their
     bonds believing they were guaranteed by the government.

• September 10th 2008: Wall Street Bank Lehman Brothers
  post a loss of $3.9 billion for the three months to August.
 Sources: Cecchetti (2009), BBC , CNN, Newsweek, Bloomberg
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    Key Events in the Economic Crisis




September 15th 2008: Investment Banks in Turmoil
• The US’ fourth largest investment bank, Lehman Brothers, files for Chapter 11
  bankruptcy protection after the US government refuses to bail it out. It
  becomes the first major bank to collapse since the start of the credit crisis.
• Merrill Lynch agrees to be taken over by Bank of America for $50bn.
  Share prices plummet across the world markets.
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    Key Events in the Economic Crisis
September 16th 2008:
• US Federal Reserve announces an $85bn rescue package for AIG,
  the country’s biggest insurance company to save it from
  bankruptcy.
    AIG had issued approximately $440bn worth of Credit Default
     Swaps (kind of like insurance for debt instruments) for
     mortgage backed securities to investment banks, insurance
     companies and other lenders; it defaulted on approximately
     $14bn worth of CDs.
    AIG who had trillions of dollars in assets, policy holders in
     more than 100 countries and insures bank loans, deals and
     investments around the world was not to fail. Its failure would
     have had more far reaching consequences than say the failure
     of Lehman Brothers.
    Government gets 80% stake in AIG.
 Sources: Cecchetti (2009), BBC , CNN, Newsweek, Bloomberg
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    Key Events in the Economic Crisis




September 17th 2008: Lloyds takes over HBOS in the UK
• Lloyds agrees to a £12.2bn takeover of Halifax Bank of Scotland (HBOS), the UK’s
  largest mortgage lender after its shares drop over concerns about the firm’s
  future.
• The UK government invokes a “national interest” clause to bypass competition
  law since the bank is now responsible for approximately one third of the UK’s
  savings and mortgage market.
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    Professor Yamin Ahmad, Money and Banking – ECON 354



     Key Events in the Economic Crisis
September 28th 2008:
• Credit crunch hits Europe’s banking sector as the European bank
  and insurance giant, Fortis, is partly nationalized.
    – The ECB, as well as the governments of the Netherlands, Belgium and
      Luxembourg, stepped in after a bidder for the whole of the Fortis group
      could not be found.

• Plans announced for $700 billion package to buy mortgage backed
  securities (to be approved by Congress).
September 29th 2008:
• US House of representatives reject $700 billion rescue plan for US
  Financial system; stock market plummet further.

  Sources: Cecchetti (2009), BBC , CNN, Newsweek, Bloomberg
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      Key Events in the Economic Crisis




October 3rd 2008: US Congress approves bailout
• US House of representatives pass a revised version of the $700bn funds for
  Troubled Asset Relief Program (TARP).
• The bill includes a provision for the FDIC to raise deposit insurance limits from
  $100 000 per account to $250 000 per account.
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     Key Events in the Economic Crisis
Early October 2008: Banks in Trouble
• Irish government says it will guarantee all deposits in the country’s main
  bank for two years.

• Germany announces a 50bn euro plan to save one of the country’s
  biggest banks – Hypo Real Estate.

• Iceland announces part of a plan to shore up its troubled banking sector
  and takes control over Landsbanki, the country’s second largest bank.

• The UK government announces details of a rescue package for the
  banking system worth at least £50bn and also offers £200bn in short
  term lending support.
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     Key Events in the Economic Crisis




October 13th 2008: UK government rescues RBS and Lloyds-HBOS
• The UK government steps in to rescue two of the UK’s major banks – the Royal
  Bank of Scotland (RBS), who had merged with ABN-AMRO, and Lloyds-TSB who
  just took over HBOS in September.
• The UK government injects £37bn in order to stabilize both banks and
  nationalizes them, with a 60% stake in RBS and 40% stake in Lloyds-HBOS.
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       Key Events in the Economic Crisis
• October 14th, 2008: US Government unveils $250bn plan to
  purchase stakes in a wide variety of banks in order to restore
  confidence in the banking sector.
• October 24th 2008: The UK appears to be on the brink of a
  recession based on figures released by the Office of National
  Statistics.
      – The economy shrank for the first time in 16 years between July and
•
        September as economic growth falls by 0.5%.
Early November:
• The Fed, Bank of England, ECB and other central banks slash
  interest rates.
• China sets out a two-year $586bn economic stimulus package to
  help boost its economy.
    Sources: Cecchetti (2009), BBC, CNN, Newsweek, Bloomberg
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     Key Events in the Economic Crisis
November 12th, 2008:
• US Treasury Secretary Henry Paulson says that the government will not use all
  the TARP funds to buy back troubled assets; instead the money will be used to
  help improve the flow of credit for the US consumer.

November 14th:
• Eurozone officially slips into a recession after EU figures show that the economy
  shrank by 0.2% in the third quarter.

Late November 2008:
• US Federal Reserve announces that it will inject another $800bn into the
  economy. Approx $600bn will be used to buy mortgage backed securities;
  $200bn will be used to unfreeze consumer credit market.

• The European Commission unveils an economic recovery plan worth 200bn
  Euros aimed to stimulate spending and boost consumer confidence.
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    Professor Yamin Ahmad, Money and Banking – ECON 354




     Key Events in the Economic Crisis
December 2008:
• December 1st, 2008: The US is recession is officially declared by the
  NBER. The NBER business cycle dating committee concludes that the US
  economy started to contract in December 2007.

• December 4th 2008: French president Nicolas Sarkozy announces a 26bn
  euro stimulus plan to help France.

Late December: Central Banks around the world slash
  interest rates.
• The US Federal reserve lowers the fed funds rate to a range of 0 – 0.25%,
  the lowest in recorded history.
• The Bank of England follows suit in early February of 2009, to a record
  low of 1%.
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    Professor Yamin Ahmad, Money and Banking – ECON 354




     Key Events in the Economic Crisis




February 14th 2009: US Congress passes $787bn Stimulus Package
• Congress approves a huge economic recovery package aimed at preventing the
  US falling into a recession.
• February 17th 2009: US President Barack Obama signs $787bn economic
  stimulus package into law.
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    Professor Yamin Ahmad, Money and Banking – ECON 354




     Key Events in the Economic Crisis




March 14th 2009: G20 finance ministers meet in London
• Finance ministers from the G20 group pledge to make a “sustained effort” to pull
  the world economy out of a recession.
April 2nd 2009: G20 leaders meet in London
• Leaders of the worlds largest economies reach an agreement at the summit to
  tackle the global financial crisis, with measures worth $1.1 trillion.
                                   Money & Banking
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       Note:                                                                       52
   Professor Yamin Ahmad, Money and Banking – ECON 354



             Policy Measures Used To Tackle
                    Financial Crisis?.
Three Parts:
• Part I: Origins of The 2007 – 2008 subprime
  Financial crisis.
• Part II: Economic Policies used to tackle the
  global recession.
• Part III: Post Crisis and Future Outlook.
    We will return to Parts II and III once we cover
     monetary policy and central banking in a later lecture.

                                  Money & Banking
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      Note:                                                                       53
  Professor Yamin Ahmad, Money and Banking – ECON 354




PART II: FINANCIAL CRISES IN
EMERGING MARKET ECONOMIES

10/18/2012                          Money & Banking     54
   Professor Yamin Ahmad, Money and Banking – ECON 354




Dynamics of Financial Crises in Emerging
          Market Economies
• Stage one: Initiation of Financial Crisis
   Path      one:     mismanagement                                              of   financial
    liberalization/globalization:
          • Weak supervision and lack of expertise leads to a lending
            boom.
          • Domestic banks borrow from foreign banks.
          • Fixed exchange rates give a sense of lower risk.
          • Banks play a more important role in emerging market
            economies, since securities markets are not well developed
            yet.
                                  Money & Banking
 10/18/2012 These lecture notes are incomplete without having attended lectures
      Note:                                                                                 55
  Professor Yamin Ahmad, Money and Banking – ECON 354




Dynamics of Financial Crises in Emerging
          Market Economies
   Path two: severe fiscal imbalances:
           • Governments in need of funds sometimes force banks to
             buy government debt.
           • When government debt loses value, banks lose and their
             net worth decreases.
   Additional factors:
           • Increase in interest rates (from abroad).
           • Asset price decrease.
           • Uncertainty linked to unstable political systems.


                                 Money & Banking
10/18/2012 These lecture notes are incomplete without having attended lectures
     Note:                                                                       56
   Professor Yamin Ahmad, Money and Banking – ECON 354




Dynamics of Financial Crises in Emerging
          Market Economies
• Stage two: currency crisis
    Deterioration of bank balance sheets triggers currency
     crises:
            • Government cannot raise interest rates (doing so forces
              banks into insolvency)…
            • … and speculators expect a devaluation.
    How severe fiscal imbalances triggers currency crises:
            • Foreign and domestic investors sell the domestic currency.



                                  Money & Banking
 10/18/2012 These lecture notes are incomplete without having attended lectures
      Note:                                                                       57
   Professor Yamin Ahmad, Money and Banking – ECON 354




Dynamics of Financial Crises in Emerging
          Market Economies
• Stage three: Full-Fledged Financial Crisis:
   The debt burden in terms of domestic currency
    increases (net worth decreases).
   Increase in expected and actual inflation reduces
    firms’ cash flow.
   Banks are more likely to fail:
          • Individuals are less able to pay off their debts (value of
            assets fall).
          • Debt denominated in foreign currency increases (value of
            liabilities increase).
                                  Money & Banking
 10/18/2012 These lecture notes are incomplete without having attended lectures
      Note:                                                                       58
   Professor Yamin Ahmad, Money and Banking – ECON 354




            Financial Crises: Mexico 1994-1995
• Financial liberalization in the early 1990s:
    – Lending boom, coupled with weak supervision and
      lack of expertise.
    – Banks accumulated losses and their net worth
      declined.
• Rise in interest rates abroad.
• Uncertainty increased (political instability).
• Domestic currency devaluated on December 20,
  1994.
• Rise in actual and expected inflation.
                                  Money & Banking
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      Note:                                                                       59
   Professor Yamin Ahmad, Money and Banking – ECON 354




          Financial Crises: East Asia 1997-1998
• Financial liberalization in the early 1990s:
   – Lending boom, coupled with weak supervision and
     lack of expertise.
   – Banks accumulated losses and their net worth
     declined.
• Uncertainty increased (stock market declines and
  failure of prominent firms).
• Domestic currencies devaluated by 1997.
• Rise in actual and expected inflation.
                                  Money & Banking
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      Note:                                                                       60
   Professor Yamin Ahmad, Money and Banking – ECON 354




        Financial Crises: Argentina 2001-2002
• Government coerced banks to absorb large
  amounts of debt due to fiscal imbalances.
• Rise in interest rates abroad.
• Uncertainty increased (ongoing recession).
• Domestic currency devaluated on January 6,
  2002
• Rise in actual and expected inflation.


                                  Money & Banking
 10/18/2012 These lecture notes are incomplete without having attended lectures
      Note:                                                                       61
  Professor Yamin Ahmad, Money and Banking – ECON 354



        FIGURE 3 Sequence of Events in
        Emerging Market Financial Crises




                                 Money & Banking
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     Note:                                                                       62

				
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