24%20Financial%20Crisis%20and%20the%20Economy,%20Part%202

24%20Financial%20Crisis%20and%20the%20Economy,%20Part%202 -...

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1 24-1 Financial Crises and the Economy, Part 2 24-2 Agenda 1. The 2007 – 2009 Financial Crisis 2. No Depression this Time—Why Not? 3. Policy Response to Asset-Price Bubbles 24-3 The 2007 – 2009 Financial Crisis The 2007–2009 financial crisis was rooted in: 1. Mismanagement of the financial innovation in the mortgage market, 2. Agency problems in the mortgage market, and 3. Asymmetrical information problems associated with the credit rating agencies. 24-4 Financial Innovation Financial innovation in the mortgage market included: 1. Securitization of individual mortgages, 2. Introduction of alternative mortgage products , 3. Financial engineering of new financial products.
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2 24-5 Financial Innovation 1. Securitization of mortgages: Securitization is a process that bundles smaller loans into standardized debt securities. Mortgage backed securities bundle individual mortgages into standardized debt securities. The cash flows from the individual underlying mortgages are allocated sequentially to different “tranches” of the security. 24-6 Financial Innovation 2. Introduction of alternative mortgage products Alternatives to the 30-year fixed rate mortgage were introduced, including: a. Variable rate mortgages, b. Subprime mortgages , and c. Negative amortization mortgages. 24-7 Financial Innovation 3. Financial engineering allowed new financial products to be developed with very complex income steams and risk profiles, including: a. Structured credit products , and b. Credit default swaps . 24-8 Principal-Agent Problems Principal-Agent problems abound in the mortgage market. 1. The agents are the mortgage brokers/investment bankers who originate/securitize loans. 2. The principals are the investors in this loans.
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3 24-9 Principal-Agent Problems The mortgage market can be described by an originate-to-distribute model . The idea of the model is that when a loan is made, it is immediately sold to someone else. 1. An investor who will hold the loan, or more likely 2. An investment banker who may securitize the loan before selling it to an investor. 24-10 Principal-Agent Problems A principal-agent problem arises because once the loan is sold, the agent (i.e., the originator) would not care about the credit- worthiness of the borrower. The same is true for the investment banker who is securitizing the loan; once the pieces of the mortgage-backed security are sold, the investment banker would not care about the underlying cash flows of the security. 24-11 Principal-Agent Problems A principal-agent problem also arises when banks or investment banks earn fees by underwriting mortgage-backed securities. 24-12 Principal-Agent Problems A principal-agent problem can also arises when financial products like credit default swaps are introduced.
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This note was uploaded on 09/05/2011 for the course ECON 100B taught by Professor Wood during the Spring '08 term at University of California, Berkeley.

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24%20Financial%20Crisis%20and%20the%20Economy,%20Part%202 -...

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