CHAPTER 9

Terms Definitions
A major disruption in financial markets characterized by sharp declines in asset prices and firm failures is called a
financial crisis
A financial crisis occurs when an increase in asymmetric information from a disruption in the financial system
causes severe adverse selection and moral hazard problems that make financial markets incapable of channeling funds efficiently
A serious consequence of a financial crisis is
a contraction in economic activity
A sharp decline in the stock market means that the _____ of corporations has fallen making lenders _____ willing to lend
net worth; less
A sharp stock market decline increases moral hazard incentives
since borrowing firms have lass to lose if their investments fail
An unanticipated decline in the price level increases the burden of debt on borrowing firms but doesn't raise the real value of borrowing firms' assets. The result is
that net worth in real terms declines
If debt contracts are denominated in foreign currency, then an unanticipated decline in the value of the domestic currency results in
a decline in a firm's net worth
Factors that lead to worsening conditions in financial markets include:
the deterioration in bank's balance sheets
In a bank panic, the source of contagion is the
asymmetric information problem
A bank panic can lead to a severe contraction in economic activity due to
a decline in lending for productive investment
In addition to having a direct effect on increasing adverse selection problems, increases in interest rates also promote financial crises by _____ firms' and households' interest payments, thereby _____ their cash flow
increasing; decreasing
In emerging economies, government fiscal imbalances may cause fears of
default on government debt
When financial institutions go on a lending spree and expand their lending at a rapid pace they are participating in a
credit boom
When the value of loans begins to drop, the net worth of financial institutions falls causing them to cut back on lending in a process called
deleveraging
When financial intermediaries deleverage, firms can't fund investment opportunities resulting in
a contraction of economic activity
When financial intermediaries deleverage, firms can't fund investment opportunities resulting in
a contraction of economic activity
A credit boom can lead to a(n) _____ such as we saw in the tech stock market in the late 1990s
asset-price bubble
Many 19th century U.S. financial crises were started by
spikes in interest rates
Most U.S. financial crises have started during periods of _____ either after the start of a recession or a stock market crash
high uncertainty
If uncertainty about banks' health causes depositors to begin to withdraw their funds from banks, the country experiences a(n)
banking crisis
Debt delation occurs when
an economic downturn causes the price level to fall and a deterioration in firms' net worth because of the increased burden of indebtedness
A substantial decrease in the aggregate price level that reduces firms' net worth may stall a recovery from a recession. This process is called
debt deflation
A possible sequence for the three stages of a financial crisis in the U.S. might be _____ leads to _____ leads to _____
asset price declines; banking crises; unanticipated decline in price level
The economy recovers quickly from most recessions, but the increase in adverse selection and moral hazard problems in the credit markets caused by _____ led to the severs economic contraction known as The Great Depression
debt deflation
Financial innovations that emerged after 2000 in the mortgage markets included all of the following except
adjustable-rate mortgages
_____ is a process of bundling together smaller loans (like mortgages) into standard debt securities
Securitization
A _____ pays out cash flows from subprime mortgage-backed securities in different tranches, with the highest-rated tranch paying out first, while lower ones paid out less if there were losses on the mortgage-backed securities
Collateralized debt obligation (CDO)
The growth of the subprime mortgage market led to
increased demand for houses and helped fuel the boom in housing prices
The originate-to-distribute business model has a serious _____ problem since the mortgage broker has little incentive to make sure that the mortgagee is a good credit risk
principal-agent
Mortgage brokers often didn't make a strong effort to evaluate whether the borrower could pay off the loan. This created a
severe adverse selection problem
Agency problems in the subprime mortgage market included all of the following except
homeowners could refinance their houses with larger loans when their homes appreciated in value
When housing prices began to declining after their peak in 2006, many subprime borrowers found that their mortgages were "underwater." This meant that
the value of the house fell below the amount of the mortgage
Although the subprime mortgage market problem began in the U.S., the first indication of the seriousness of the crisis began in
Europe
Like a CDO, a structured investment vehicle pays off cash flows from pools of assets, however, rather than long-term debt the structured investment vehicle backs
commercial paper
Which investment bank filed for bankruptcy on 9/15/08 making it the largest bankruptcy filing in U.S. history?
Lehman Brothers
The largest bank failure in U.S. history was _____ which went into receivership by the FDIC on 9/25/08.
Washington Mutual
Credit market problems of adverse selection and moral hazard increased as a result of all of the following except
increase in housing market prices
The Economic Recovery Act of 2008 had several provisions to promote recovery from the subprime financial crisis. These provisions included all of the following except
guaranteed all the deposits of the commercial banks
The government bailout of troubled financial institutions occurred in the U.S. and many other countries. Which country saw their banking system collapse requiring the government to take over its three largest banks?
Iceland
Financial crises generally develop along two basic paths:
mismanagement of financial liberalization/globalizations and severe fiscal imbalances
In emerging market countries, the deterioration in bank's balance sheets has more _____ effects on lending and economic activity than in advanced countries
negative
The mismanagement of financial liberalization in emerging market countries can be understood as a severe _____
principal/agent problem
Factors likely to cause a financial crisis in emerging market countries include
fiscal imbalances
The two key factors that trigger speculative attacks on emerging market currencies are
deterioration in bank balance sheets and severe fiscal imbalances
Severe fiscal imbalances can directly trigger a currency crisis since
investors fear that the government may not be able to pay back the debt and so being to sell domestic currency
In emerging market countries, many firms have debt denominated in foreign currency like the dollar or yen. A depreciation of the domestic currency
results in increases in the firm's indebtedness in domestic currency terms, even though the value of their assets remains unchanged
A sharp depreciation of the domestic currency after a currency crisis leads to
higher inflation
The key factor leading to the financial crises in Mexico and the East Asian countries was
a deterioration in banks' balance sheets because of increasing loan lossses
Factors that led to worsening conditions in Mexico's 1994-1995 financial markets include
increased uncertainty from political shocks
Factors that led to worsening financial market conditions in East Asia in 1997-1998 include
weak supervision by bank regulators
Factors that led to worsening conditions in Mexico's '94-'95 financial markets, but didn't lead to worsening financial market conditions in East Asia in '97-'98 include
rise in interest rates abroad
Argentina's financial crisis was due to
fiscal imbalances
A feature of debt markets in emerging-market countries is that debt contracts are typically
very short term
The economic hardship resulting from a financial crises is severe, however, there are also social consequences such as
increased crime
Before the South Korean financial crisis, sales by the top five chaebols (family-owned conglomerates) were
nearly 50% of GDP
The chaebols encouraged the Korean government to open up Korean financial markets to foreign capital. The Korean government responded by
allowing unlimited short-term foreign borrowing but maintained quantity restrictions on long-term foreign borrowing by financial institutions
At the times of the South Korean financial crisis, the government allowed many chaebol owned finance companies to convert to merchant banks. Finance companies _____ allowed to borrow abroad and merchant banks _____.
were not; could borrow abroad
At the time of the South Korean financial crisis, the merchant banks were
almost virtually unregulated
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