Chapter 9 - Chapter 9-Financial Crises and the Subprime...

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Chapter 9 - Financial Crises and the Subprime Meltdown Factors Causing Financial Crises •Asset Markets Effects on Balance Sheets –Stock market decline •Decreases net worth of corporations. –Unanticipated decline in the price level •Liabilities increase in real terms and net worth decreases. –Unanticipated decline in the value of the domestic currency •Increases debt denominated in foreign currencies and decreases net worth. –Asset write-downs. •Deterioration in Financial Institutions’ Balance Sheets –Decline in lending. •Banking Crisis –Loss of information production and disintermediation. •Increases in Uncertainty –Decrease in lending. •Increases in Interest Rates –Increases adverse selection problem –Increases need for external funds and therefore adverse selection and moral hazard. •Government Fiscal Imbalances –Create fears of default on government debt. –Investors might pull their money out of the country. 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 The Subprime Financial Crisis of 2007 - 2008 •Financial innovations emerge in the mortgage markets: –Subprime and Alt-A mortgages –Mortgage-backed securities –Collateralized debt obligations (CDOs)
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