Book: Economics of Money, Banking and Financial Markets, 12e eText. This chapter is between pages from page 270-290. So, You just need write a page number between this scale when you cite from this book, What Is a Financial Crisis? 1. 12.1 Define the term financial crisis. In Chapter 8, we saw that a well-functioning financial system solves asymmetric information problems (moral hazard and adverse selection) so that capital is allocated to its most productive uses. These asymmetric information problems, which act as a barrier to efficient allocation of capital, are often described by economists as financial frictions. When financial frictions increase, financial markets are less capable of channeling funds efficiently from savers to households and firms with productive investment opportunities, with the result that economic activity declines. A financial crisis occurs when information flows in financial markets experience a particularly large disruption, with the result that financial frictions increase sharply and financial markets stop functioning. Then economic activity collapses. Dynamics of Financial Crises 1. 12.2 Identify the key features of the three stages of a financial crisis. As earth-shaking and headline-grabbing as the most recent financial crisis was, it was only one of a number of financial crises that have hit industrialized countries like the United States over the years. These experiences have helped economists uncover insights into present-day economic turmoil. Financial crises in advanced economies have progressed in two and sometimes three stages. To understand how these crises have unfolded, refer to Figure 1, which traces the stages and sequence of events in financial crises in advanced economies. MyLab Economics Mini-lecture Figure 1 Sequence of Events in Financial Crises in Advanced Economies The solid arrows trace the sequence of events during a typical financial crisis; the dotted arrows show the additional set of events that occurs if the crisis develops into a debt deflation. The sections separated by the dashed horizontal lines show the different stages of a financial crisis. Stage One: Initial Phase Financial crises can begin in two ways: credit boom and bust, or a general increase in uncertainty caused by failures of major financial institutions. Credit Boom and Bust The seeds of a financial crisis are often sown when an economy introduces new types of loans or other financial products, known as financial innovation, or when countries engage in financial liberalization, the elimination of restrictions on financial markets and institutions. In the long run, financial liberalization promotes financial development and encourages a wellrun financial system that allocates capital efficiently. However, financial liberalization has a dark side: In the short run, it can prompt financial institutions to go on a lending spree, called a credit boom. Unfortunately, lenders may not have the expertise, or the incentives, to manage risk appropriately in these new lines of business. Even with proper management, credit booms eventually outstrip the ability of institutions—and government regulators—to screen and monitor credit risks, leading to overly risky lending. As we learned in Chapter 10, government safety nets, such as deposit insurance, weaken market discipline and increase the moral hazard incentive for banks to take on greater risk than they otherwise would. Because lender-savers know that government-guaranteed insurance protects them from losses, they will supply even undisciplined banks with funds. Without proper monitoring, risk taking grows unchecked. Eventually, losses on loans begin to mount, and the value of the loans (on the asset side of the balance sheet) falls relative to liabilities, thereby driving down the net worth (capital) of banks and other financial institutions. With less capital, these financial institutions cut back on their lending to borrower-spenders, a process called deleveraging. Furthermore, with less capital, banks and other financial institutions become riskier, causing lender-savers and other potential lenders to these institutions to pull out their funds. Fewer funds mean fewer loans to fund productive investments and a credit freeze: The lending boom turns into a lending crash. When financial institutions stop collecting information and making loans, financial frictions rise, limiting the financial system’s ability to address the asymmetric information problems of adverse selection and moral hazard (as shown in the arrow pointing from the first factor, “Deterioration in Financial Institutions’ Balance Sheets,” in the top row of Figure 1). As loans become scarce, borrower-spenders are no longer able to fund their productive investment opportunities and they decrease their spending, causing economic activity to contract. Asset-Price Boom and Bust Prices of assets such as equity shares and real estate can be driven by investor psychology (dubbed “irrational exuberance” by Alan Greenspan when he was chairman of the Federal Reserve) well above their fundamental economic values, that is, their values based on realistic expectations of the assets’ future income streams. The rise of asset prices above their fundamental economic values is an asset-price bubble. Examples of asset-price bubbles are the tech stock market bubble of the late 1990s and the recent housing price bubble that we will discuss later in this chapter. Asset-price bubbles are often also driven by credit booms, in which the large increase in credit is used to fund purchases of assets, thereby driving up their price. When the bubble bursts and asset prices realign with fundamental economic values, stock and real estate prices tumble, companies see their net worth (the difference between their assets and their liabilities) decline, and the value of collateral these companies can pledge drops. Now these companies have less at stake because they have less “skin in the game,” and so they are more likely to make risky investments because they have less to lose, the problem of moral hazard. As a result, financial institutions tighten lending standards for these borrower-spenders and lending contracts (as shown by the downward arrow pointing from the second factor, “Asset-Price Decline,” in the top row of Figure 1). The asset-price bust also causes a decline in the value of financial institutions’ assets, thereby causing a decline in the institutions’ net worth and hence a deterioration in their balance sheets (shown by the arrow from the second factor to the first factor in the top row of Figure 1), which causes them to deleverage, steepening the decline in economic activity. Increase in Uncertainty Financial crises in the United States have usually begun in periods of high uncertainty, such as just after the start of a recession, a crash in the stock market, or the failure of a major financial institution. Crises began after the failure of Ohio Life Insurance and Trust Company in 1857; the Jay Cooke and Company in 1873; Grant and Ward in 1884; the Knickerbocker Trust Company in 1907; the Bank of the United States in 1930; and Bear Stearns, Lehman Brothers, and AIG in 2008. With information hard to come by in a period of high uncertainty, financial frictions increase, reducing lending and economic activity (as shown by the arrow pointing from the last factor, “Increase in Uncertainty,” in the top row of Figure 1). Stage Two: Banking Crisis Deteriorating balance sheets and tougher business conditions lead some financial institutions into insolvency, which happens when their net worth becomes negative. Unable to pay off depositors or other creditors, some banks go out of business. If severe enough, these factors can lead to a bank panic in which multiple banks fail simultaneously. The source of the contagion is asymmetric information. In a panic, depositors, fearing for the safety of their deposits (in the absence of or with limited amounts of deposit insurance) and not knowing the quality of banks’ loan portfolios, withdraw their deposits to the point that the banks fail. Uncertainty about the health of the banking system in general can lead to runs on banks, both good and bad, which forces banks to sell off assets quickly to raise the necessary funds. These fire sales of assets may cause their prices to decline so much that more banks become insolvent and the resulting contagion can then lead to multiple bank failures and a full-fledged bank panic. With fewer banks operating, information about the creditworthiness of borrower-spenders disappears. Increasingly severe adverse selection and moral hazard problems in financial markets deepen the financial crisis, causing declines in asset prices and the failure of firms throughout the economy that lack funds for productive investment opportunities. Figure 1represents this progression in the stage two portion. Bank panics were a feature of all U.S. financial crises during the nineteenth and twentieth centuries, occurring every 20 years or so until World War II—1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930–1933. (The 1933 establishment of federal deposit insurance, which protects depositors from losses, has prevented subsequent bank panics in the United States.) Eventually, public and private authorities shut down insolvent firms and sell them off or liquidate them. Uncertainty in financial markets declines, the stock market recovers, and balance sheets improve. Financial frictions diminish and the financial crisis subsides. With the financial markets able to operate well again, the stage is set for an economic recovery. Stage Three: Debt Deflation If, however, the economic downturn leads to a sharp decline in the price level, the recovery process can be short-circuited. In stage three of Figure 1, debt deflation occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firms’ net worth because of the increased burden of indebtedness. In economies with moderate inflation, which characterizes most advanced countries, many debt contracts with fixed interest rates are typically of fairly long maturity, ten years or more. Because debt payments are contractually fixed in nominal terms, an unanticipated decline in the price level raises the value of borrowing firms’ and households’ liabilities in real terms (increases the burden of the debt) but does not raise the real value of their assets. The borrowers’ net worth in real terms (the difference between assets and liabilities in real terms) thus declines. To better understand how this decline in net worth occurs, consider what happens if a firm in 2019 has assets of $100 million (in 2019 dollars) and $90 million of long-term liabilities, so that it has $10 million in net worth (the difference between the values of assets and liabilities). If the price level falls by 10% in 2020, the real value of the liabilities would rise to $99 million in 2019 dollars, while the real value of the assets would remain unchanged at $100 million. The result would be that real net worth in 2019 dollars would fall from $10 million to $1 million ($100 million minus $99 million). The substantial decline in the real net worth of borrowers caused by a sharp drop in the price level creates an increase in adverse selection and moral hazard problems for lenders. Lending and economic activity decline for a long time. The most significant financial crisis that displayed debt deflation was the Great Depression, the worst economic contraction in U.S. history. Application The Mother of All Financial Crises: The Great Depression With our framework for understanding financial crises in place, we are prepared to analyze how a financial crisis unfolded during the Great Depression and how it led to the worst economic downturn in U.S. history. Stock Market Crash In 1928 and 1929, U.S. stock prices doubled. Federal Reserve officials viewed the stock market boom as caused by excessive speculation. To curb it, they pursued a tightening of monetary policy to raise interest rates in an effort to limit the rise in stock prices. The Fed got more than it bargained for when the stock market crashed in October 1929, falling by 40% by the end of 1929, as shown in Figure 2. Stock prices crashed in 1929, falling by 40% by the end of 1929, and then continued to fall to only 10% of their peak value by 1932. Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/M1109AUSM293NNBR. Bank Panics By the middle of 1930, stocks had recovered almost half of their losses and credit market conditions had stabilized. What might have been a normal recession turned into something far worse, however, when severe droughts in the Midwest led to a sharp decline in agricultural production, with the result that farmers could not pay back their bank loans. The resulting defaults on farm mortgages led to large loan losses on bank balance sheets in agricultural regions. The general weakness of the economy, and of the banks in agricultural regions in particular, prompted substantial withdrawals from banks, building to a full-fledged panic in November and December of 1930, with the stock market falling sharply. For more than two years, the Fed sat idly by through one bank panic after another, the most severe spate of panics in U.S. history. After what would be the era’s final panic in March 1933, President Franklin Delano Roosevelt declared a bank holiday, a temporary closing of all banks. “The only thing we have to fear is fear itself,” Roosevelt told the nation. The damage was done, however, and more than one-third of U.S. commercial banks had failed. Continuing Decline in Stock Prices Stock prices kept falling. By mid-1932, stocks had declined to 10% of their value at the 1929 peak (as shown in Figure 2), and the increase in uncertainty from the unsettled business conditions created by the economic contraction worsened adverse selection and moral hazard problems in financial markets. With a greatly reduced number of financial intermediaries still in business, adverse selection and moral hazard problems intensified even further. Financial markets struggled to channel funds to borrowerspenders with productive investment opportunities. The amount of outstanding commercial loans fell by half from 1929 to 1933, and investment spending collapsed, declining by 90% from its 1929 level. A manifestation of the rise in financial frictions is that lenders began charging businesses much higher interest rates to protect themselves from credit losses. The resulting rise in the credit spread—the difference between the interest rate on loans to households and businesses and the interest rate on completely safe assets that are sure to be paid back, such as U.S. Treasury securities—is shown in Figure3, which displays the difference between interest rates on corporate bonds with a Baa (medium-quality) credit rating and rates on similar-maturity Treasury bonds. (Note the credit spread is closely related to the risk premium discussed in Chapter6.) Figure 3 Credit Spreads During the Great Depression Credit spreads (the difference between rates on Baa corporate bonds and U.S. Treasury bonds) rose sharply during the Great Depression. Debt Deflation The ongoing deflation that accompanied declining economic activity eventually led to a 25% decline in the price level. This deflation short-circuited the normal recovery process that occurs in most recessions. The huge decline in prices triggered a debt deflation in which real net worth fell because of the increased burden of indebtedness borne by firms and households. The decline in net worth and the resulting increase in adverse selection and moral hazard problems in the credit markets led to a prolonged economic contraction in which unemployment rose to 25% of the labor force. The financial crisis of the Great Depression was the worst ever experienced in the United States, which explains why the economic contraction was also the most severe ever experienced by the nation. International Dimensions Although the Great Depression started in the United States, it was not just a U.S. phenomenon. Bank panics in the United States also spread to the rest of the world, and the contraction of the U.S. economy sharply decreased the demand for foreign goods. The worldwide depression caused great hardship, with millions upon millions of people out of work, and the resulting discontent led to the rise of fascism and World War II. The consequences of the Great Depression financial crisis were disastrous. The Global Financial Crisis of 2007– 2009 1. 12.3 Describe the causes and consequences of the global financial crisis of 2007–2009. For many years, most economists thought that financial crises of the type experienced during the Great Depression were a thing of the past for advanced countries like the United States. Unfortunately, the financial crisis that engulfed the world in 2007–2009 proved them wrong. Causes of the 2007–2009 Financial Crisis We begin our look at the 2007–2009 financial crisis by examining three central factors: financial innovation in mortgage markets, agency problems in mortgage markets, and the role of asymmetric information in the credit-rating process. Financial Innovation in the Mortgage Markets As we saw in Chapter 11, starting in the early 2000s advances in information technology made it easier to securitize subprime mortgages, leading to an explosion in subprime mortgage-backed securities. Financial innovation didn’t stop there. Financial engineering, the development of new, sophisticated financial instruments, led to structured credit products that paid out income streams from a collection of underlying assets, designed to have particular risk characteristics that appealed to investors with differing preferences. The most notorious of these products were collateralized debt obligations (CDOs) (discussed in the FYI box, “Collateralized Debt Obligations). FYI Collateralized Debt Obligations (CDOs) The creation of a collateralized debt obligation involves a corporate entity called a special purpose vehicle (SPV), which buys a collection of assets such as corporate bonds and loans, commercial real estate bonds, and mortgage-backed securities. The SPV then separates the payment streams (cash flows) from these assets into a number of buckets that are referred to as tranches. The highest-rated tranches, called super senior tranches, are the ones that are paid off first and so have the least risk. The super senior CDO is a bond that pays out these cash flows to investors, and because it has the least risk, it also has the lowest interest rate. The next bucket of cash flows, known as the senior tranche, is paid out next; the senior CDO has a little more risk and pays a higher interest rate. The next tranche of payment streams, the mezzanine tranche of the CDO, is paid out after the super senior and senior tranches and so it bears more risk and has an even higher interest rate. The lowest tranche of the CDO is the equity tranche; this is the first set of cash flows that are not paid out if the underlying assets go into default and stop making payments. This tranche has the highest risk and is often not traded. If all of this sounds complicated, it is. Tranches also included CDO s and CDO s that sliced and diced risk even further, paying out the cash flows from CDOs to CDO s and from CDO s to CDO s. Although financial engineering carries the potential benefit of creating products and services that match investors’ risk appetites, it also has a dark side. Structured products like CDOs, CDO s, and CDO s can get so complicated that it becomes hard to value the cash flows of the underlying assets for a security or to determine who actually owns these assets. Indeed, in October 2007, Ben Bernanke, then chairman of the Federal Reserve, joked that he “would like to know what those damn things are worth.” In other words, the increased complexity of structured products can actually reduce the amount of information in financial markets, thereby worsening asymmetric information in the financial system and increasing the severity of adverse selection and moral hazard problems. 2 3 2 2 3 2 3 Agency Problems in the Mortgage Markets The mortgage brokers who originated the mortgage loans often did not make a strong effort to evaluate whether a borrower could pay off the mortgage, since they planned to quickly sell (distribute) the loans to investors in the form of mortgage-backed securities. This originate-todistribute business model was exposed to the principal–agent problem of the type discussed in Chapter 8, in which the mortgage brokers acted as agents for investors (the principals) but did not have the investors’ best interests at heart. Once the mortgage broker earns his or her fee, why should the broker care if the borrower makes good on the payment? The more volume the broker originates, the more money the broker makes. Not surprisingly, adverse selection became a major problem. Risk-loving real-estate investors lined up to obtain loans to acquire houses that would be very profitable if housing prices went up, knowing they could “walk away” if housing prices went down. The principal–agent problem also created incentives for mortgage brokers to encourage households to take on mortgages they could not afford or to commit fraud by falsifying information on borrowers’ mortgage applications in order to qualify them for mortgages. Compounding this problem was lax regulation of originators, who were not required to disclose information to borrowers that would have helped them assess whether they could afford the loans. The agency problems went even deeper. Commercial and investment banks, which were earning large fees by underwriting mortgage-backed securities and structured credit products like CDOs, also had weak incentives to make sure that the ultimate holders of the securities would be paid off. Financial derivatives, financial instruments whose payoffs are linked to (i.e., derived from) previously issued securities, also were an important source of excessive risk taking. Large fees from writing a type of financial insurance contract called a credit default swap, a financial derivative that provides payments to holders of bonds if they default, also drove units of insurance companies like AIG to write hundreds of billions of dollars’ worth of these risky contracts. Asymmetric Information and Credit-Rating Agencies Credit-rating agencies, who rate the quality of debt securities in terms of the probability of default, were another contributor to asymmetric information in financial markets. The rating agencies advised clients on how to structure complex financial instruments, like CDOs, while at the same time they were rating these identical products. The rating agencies were thus subject to conflicts of interest because the large fees they earned from advising clients on how to structure products that they themselves were rating meant that they did not have sufficient incentives to make sure their ratings were accurate. The result was wildly inflated ratings that enabled the sale of complex financial products that were far riskier than investors recognized. Effects of the 2007–2009 Financial Crisis Consumers and businesses alike suffered as a result of the 2007–2009 financial crisis. The impact of the crisis was most evident in five key areas: the U.S. residential housing market, financial institutions’ balance sheets, the shadow banking system, global financial markets, and the headline-grabbing failures of major firms in the financial industry. Residential Housing Prices: Boom and Bust The subprime mortgage market took off after the recession ended in 2001. By 2007, it had become over a trillion-dollar market. The development of the subprime mortgage market was encouraged by economists and politicians alike because it led to a “democratization of credit” and helped raise U.S. homeownership rates to the highest levels in history. The asset-price boom in housing (see Figure 4), which took off after the 2000–2001 recession was over, also helped stimulate the growth of the subprime mortgage market. High housing prices meant that subprime borrowers could refinance their houses with even larger loans when their homes appreciated in value. With housing prices rising, subprime borrowers were also unlikely to default because they could always sell their house to pay off the loan, making investors happy because the securities backed by cash flows from subprime mortgages had high returns. The growth of the subprime mortgage market, in turn, increased the demand for houses and so fueled the boom in housing prices, resulting in a housing-price bubble. Figure 4 Housing Prices and the Financial Crisis of 2007–2009 Housing prices boomed from 2002 to 2006, fueling the market for subprime mortgages and forming an asset-price bubble. Housing prices began declining in 2006, falling by more than 30% subsequently, which led to defaults by subprime mortgage holders. Source: Case-Shiller U.S. National Composite House Price Index from Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/SPCS20RSA. Description Further stimulus for the inflated housing market came from low interest rates on residential mortgages, which were the result of several different forces. First were the huge capital inflows into the United States from countries like China and India. Second was congressional legislation that encouraged Fannie Mae and Freddie Mac to purchase trillions of dollars of mortgage-backed securities.2 Third was Federal Reserve monetary policy that made it easy to lower interest rates. The low cost of financing for housing purchases that resulted from these forces further stimulated the demand for housing, pushing up housing prices. (A highly controversial issue is whether the Federal Reserve was to blame for the housing price bubble, and this is discussed in the Inside the Fed box.) Inside the Fed Was the Fed to Blame for the Housing Price Bubble? Some economists—most prominently, John Taylor of Stanford University—have argued that the low interest rate policy of the Federal Reserve in the 2003–2006 period caused the housing price bubble.* Taylor argues that the low federal funds rate led to low mortgage rates that stimulated housing demand and encouraged the issuance of subprime mortgages, both of which led to rising housing prices and a bubble. In a speech given in January 2010, then-Federal Reserve Chairman Ben Bernanke countered this argument.† He concluded that monetary policy was not to blame for the housing price bubble. First, he said, it is not at all clear that the federal funds rate was too low during the 2003–2006 period. Rather, the culprits were the proliferation of new mortgage products that lowered mortgage payments, a relaxation of lending standards that brought more buyers into the housing market, and capital inflows from countries such as China and India. Bernanke’s speech was very controversial, and the debate over whether monetary policy was to blame for the housing price bubble continues to this day. As housing prices rose and profitability for mortgage originators and lenders grew higher, the underwriting standards for subprime mortgages fell lower and lower. High-risk borrowers were able to obtain mortgages, and the amount of the mortgage relative to the value of the house, the loan-to-value ratio (LTV), rose. Borrowers were often able to get piggyback, second, and third mortgages on top of their original 80% loan-to-value mortgage so that they had to put almost no money down. When asset prices rise too far out of line with fundamentals—in the case of housing, the cost of purchasing a home relative to the cost of renting it, or the cost of houses relative to households’ median income—they must come down. Eventually, the housing price bubble burst. With housing prices falling after their peak in 2006 (see Figure 4), the rot in the financial system began to reveal itself. The decline in housing prices led many subprime borrowers to find that their mortgages were “underwater”—that is, the value of the house was below the amount of the mortgage. When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender. Defaults on mortgages shot up sharply, eventually leading to foreclosures on millions of mortgages. Deterioration of Financial Institutions’ Balance Sheets The decline in U.S. housing prices led to rising defaults on mortgages. As a result, the values of mortgage-backed securities and CDOs collapsed, leaving banks and other financial institutions holding those securities with a lower value of assets and thus a lower net worth. With weakened balance sheets, these banks and other financial institutions began to deleverage, selling off assets and restricting the availability of credit to both households and businesses. With no one else able to step in to collect information and make loans, the reduction in bank lending meant that financial frictions increased in financial markets. Run on the Shadow Banking System The sharp decline in the values of mortgages and other financial assets triggered a run on the shadow banking system, composed of hedge funds, investment banks, and other nondepository financial firms, which are not as tightly regulated as banks. Funds from shadow banks flowed through the financial system and for many years supported the issuance of low-interest-rate mortgages and auto loans. These securities were funded primarily by repurchase agreements (repos), short-term borrowing that, in effect, uses assets like mortgage-backed securities as collateral. Rising concern about the quality of a financial institution’s balance sheet led lenders to require larger amounts of collateral, known as haircuts. For example, if a borrower took out a $100 million loan in a repo agreement, the borrower might have to post $105 million of mortgage-backed securities as collateral, for a haircut of 5%. Rising defaults on mortgages caused the values of mortgage-backed securities to fall, which then led to a rise in haircuts. At the start of the crisis, haircuts were close to zero, but eventually they rose to nearly 50%.3 The result was that financial institutions could borrow only half as much with the same amount of collateral. Thus, to raise funds, financial institutions had to engage in fire sales and sell off their assets very rapidly. Because selling assets quickly requires lowering their price, the fire sales led to a further decline in financial institutions’ asset values. This decline lowered the value of collateral further, raising haircuts and thereby forcing financial institutions to scramble even more for liquidity. The result was similar to the run on the banking system that occurred during the Great Depression, causing massive deleveraging that resulted in a restriction of lending and a decline in economic activity. The decline in asset prices in the stock market (which fell by over 50% from October 2007 to March 2009, as shown in Figure 5) and the more than 30% drop in residential house prices (shown in Figure 4), along with the fire sales resulting from the run on the shadow banking system, weakened both firms’ and households’ balance sheets. This worsening of financial frictions manifested itself in widening credit spreads, causing higher costs of credit for households and businesses and tighter lending standards. The resulting decline in lending meant that both consumption expenditure and investment fell, causing the economy to contract.4 Figure 5 Stock Prices and the Financial Crisis of 2007–2009 Stock prices fell by 50% from October 2007 to March 2009. Global Financial Markets Although the problem originated in the United States, the wake-up call for the financial crisis came from Europe, a sign of how extensive the globalization of financial markets had become. After Fitch and Standard & Poor’s announced ratings downgrades on mortgage-backed securities and CDOs totaling more than $10 billion, on August 7, 2007, a French investment house, BNP Paribas, suspended redemption of shares held in some of its money market funds, which had sustained large losses. The run on the shadow banking system began, only to become worse and worse over time. Despite huge injections of liquidity into the financial system by the European Central Bank and the Federal Reserve, banks began to horde cash and were unwilling to lend to each other. The drying up of credit led to the first major bank failure in the United Kingdom in over 100 years when Northern Rock, which had relied on short-term borrowing in the repo market rather than deposits for its funding, collapsed in September 2007. A string of other European financial institutions then failed as well. Particularly hard hit were countries like Greece, Ireland, Portugal, and Spain. The resulting crisis in markets for government-issued (sovereign) debt in Europe is described in the Global box, “The European Sovereign Debt Crisis.” Global The European Sovereign Debt Crisis The global financial crisis of 2007–2009 led not only to a worldwide recession but also to a sovereign debt crisis that still threatens to destabilize Europe today. Up until 2007, all of the countries that had adopted the euro found their interest rates converging to very low levels, but with the onset of the global financial crisis, several of these countries were hit very hard by the contraction in economic activity, which reduced tax revenues at the same time that government bailouts of failed financial institutions required additional government outlays. The resulting surge in budget deficits then led to fears that the governments of these hard-hit countries would default on their debt. The result was a surge in interest rates that threatened to spiral out of control.* Greece was the first domino to fall in Europe. In September 2009, with an economy weakened by reduced tax revenues and increased spending demands, the Greek government was projecting a budget deficit for the year of 6% and a debt-to-GDP ratio near 100%. However, when a new government was elected in October, it revealed that the budget situation was far worse than anyone had imagined, because the previous government had provided misleading numbers about both the budget deficit, which was at least double the 6% number, and the amount of government debt, which was ten percentage points higher than previously reported. Despite austerity measures aimed at dramatically cutting government spending and raising taxes, interest rates on Greek debt soared, eventually rising to nearly 40%, and the debt-to-GDP ratio climbed to 160% of GDP in 2012. Even with bailouts from other European countries and liquidity support from the European Central Bank, Greece was forced to write down the value of its debt held in private hands by more than half, and the country was subject to civil unrest, with massive strikes and the resignation of the prime minister. The sovereign debt crisis spread from Greece to Ireland, Portugal, Spain, and Italy. The governments of these countries were forced to embrace austerity measures to shore up their public finances while interest rates climbed to double-digit levels. Only with a speech in July 2012 by Mario Draghi, the president of the European Central Bank, in which he stated that the ECB was ready to do “whatever it takes” to save the euro, did the markets begin to calm down. Nonetheless, despite a sharp decline in interest rates in these countries, they experienced severe recessions, with unemployment rates rising to double-digit levels and Spain’s unemployment rate exceeding 25%. The stresses that the European sovereign debt crisis produced for the euro zone, the countries that have adopted the euro, has raised doubts about whether the euro will survive. Failure of High-Profile Firms The impact of the financial crisis on firms’ balance sheets forced major players in the financial markets to take drastic action. In March 2008, Bear Stearns, the fifth-largest investment bank in the United States, which had invested heavily in subprime-related securities, had a run on its repo funding and was forced to sell itself to J.P. Morgan for less than one-tenth of its worth just a year earlier. To broker the deal, the Federal Reserve had to take over $30 billion of Bear Stearns’s hard-to-value assets. In July, Fannie Mae and Freddie Mac, the two privately owned, government-sponsored enterprises that together insured over $5 trillion of mortgages or mortgage-backed assets, were propped up by the U.S. Treasury and the Federal Reserve after suffering substantial losses from their holdings of subprime securities. In early September 2008, Fannie Mae and Freddy Mac were put into conservatorship (in effect, run by the government). On Monday, September 15, 2008, after suffering losses in the subprime market, Lehman Brothers, the fourth-largest investment bank by asset size with over $600 billion in assets and 25,000 employees, filed for bankruptcy, making it the largest bankruptcy filing in U.S. history. The day before, Merrill Lynch, the third-largest investment bank, which had also suffered large losses on its holdings of subprime securities, announced its sale to Bank of America for a price 60% below its value a year earlier. On Tuesday, September 16, AIG, an insurance giant with assets of over $1 trillion, suffered an extreme liquidity crisis when its credit rating was downgraded. It had written over $400 billion of insurance contracts (credit default swaps) that had to make payouts on possible losses from subprime mortgage securities. The Federal Reserve then stepped in with an $85 billion loan to keep AIG afloat (with total government loans later increased to $173 billion). Height of the 2007–2009 Financial Crisis The financial crisis reached its peak in September 2008 after the House of Representatives, fearing the wrath of constituents who were angry about the Wall Street bailout, voted down a $700 billion dollar bailout package proposed by the Bush administration. The Emergency Economic Stabilization Act was finally passed nearly a week later. The stock market crash accelerated, with the week beginning October 6, 2008, showing the worst weekly decline in U.S. history. Credit spreads went through the roof over the next three weeks, with the spread between Baa corporate bonds (just above investment grade) and U.S. Treasury bonds going to over 5.5 percentage points (550 basis points), as illustrated by Figure 6. Credit spreads (the difference between rates on Baa corporate bonds and U.S. Treasury bonds) rose by more than 4 percentage points (400 basis points) during the crisis. Debate over the bailout package and the stock market crash caused credit spreads to peak in December 2008. Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/BAA10Y. Description The impaired financial markets and surging interest rates faced by borrower-spenders led to sharp declines in consumer spending and investment. Real GDP declined sharply, falling at a −1.3% annual rate in the third quarter of 2008 and then at a −5.4% and −6.4% annual rate in the next two quarters. The unemployment rate shot up, going over the 10% level in late 2009. The recession that started in December 2007 became the worst economic contraction in the United States since World War II and as a result is now referred to as the “Great Recession.” Government Intervention and the Recovery Although the recession produced by the global financial crisis was very severe, the economic contraction was far smaller in magnitude than during the Great Depression because of massive interventions by governments to prop up financial markets and stimulate the economy. As we will see in Chapter 15, the Federal Reserve took extraordinary actions to contain the crisis, actions involving both monetary policy to stimulate the economy and liquidity provision to support orderly functioning of financial markets. In addition, the U.S. government engaged in massive bailouts, with over $150 billion of loans to AIG and the Troubled Asset Relief Program (TARP), the most important provision of the Bush administration’s Emergency Economic Stabilization Act passed in October 2008, which authorized the Treasury to spend $700 billion purchasing subprime mortgage assets from troubled financial institutions or to inject capital into these institutions—the route actually followed. In addition, the act raised the federal deposit insurance limit temporarily from $100,000 to $250,000 in order to limit withdrawals from banks. Shortly thereafter, the FDIC put in place a guarantee for certain debt newly issued by banks, and the Treasury guaranteed for a year money market mutual fund shares at par value. Similarly, European governments conducted massive bailouts, in excess of $10 trillion, in order to prop up their banking systems (see the Global box, “Worldwide Government Bailouts During the 2007–2009 Financial Crisis”). Global Worldwide Government Bailouts During the 2007–2009 Financial Crisis The spreading bank failures in Europe in the fall of 2008 led to massive bailouts of financial institutions: the Netherlands, Belgium, and Luxembourg injected $16 billion to prop up Fortis, a major European bank; the Netherlands injected $13 billion into ING, a banking and insurance giant; Germany provided a $50 billion rescue package for Hypo Real Estate Holdings; and Iceland took over its three largest banks after its banking system collapsed. Ireland’s government guaranteed all the deposits of its commercial banks as well as interbank lending, as did Greece. Spain implemented a bailout package similar to the United States’ to buy up to 50 billion euros ($70 billion) of assets in its banks in order to encourage them to lend. The U.K. Treasury set up a bailout plan similar to that of the U.S. Treasury’s plan with a price tag of 400 billion pounds ($699 billion). It guaranteed 250 billion pounds of bank liabilities, added 100 billion pounds to a facility that swaps these assets for government bonds, and allowed the U.K. government to buy up to 50 billion pounds of equity stakes in British banks. Bailout plans to the tune of over $100 billion in South Korea, $200 billion in Sweden, $400 billion in France, and $500 billion in Germany, all of which guaranteed the debt of their banks as well as the injection of capital into them, then followed. Both the scale of these bailout packages and the degree of international coordination was unprecedented. Fiscal policy aimed at stimulating the economy was another key piece of the U.S. government’s response to the crisis. In February 2008, Congress passed the Bush administration’s Economic Stimulus Act of 2008, whereby the government gave out one-time tax rebates totaling $78 billion by sending $600 checks to individual taxpayers. Shortly after coming to office, the Obama administration proposed the American Recovery and Reinvestment Act of 2009, a much bigger, $787 billion fiscal stimulus package passed by Congress that to this day is highly controversial. This stimulus package is discussed more extensively in Part 6 of the book. With the government bailouts, the Fed’s extraordinary actions, and fiscal stimulus, a bull market in stocks got under way starting in March 2009 (see Figure 5), and credit spreads began to fall (Figure 6). With the recovery of financial markets, the economy also started to recover, but unfortunately the pace of recovery has been slow. Response of Financial Regulation 1. 12.4 Summarize the changes to financial regulation that occurred in response to the global financial crisis of 2007–2009. Given the cost to the economy of the 2007–2009 financial crisis, the size of the bailouts, and the nationalization of so many financial institutions, the system of financial regulation is currently undergoing dramatic changes. Macroprudential Versus Microprudential Supervision Before the global financial crisis, regulatory authorities engaged in microprudential supervision, which focuses on the safety and soundness of individual financial institutions. Microprudential supervision looks at each individual institution separately and assesses the riskiness of its activities and whether it complies with disclosure requirements. Most importantly, microprudential supervision checks whether a particular institution satisfies capital ratios and, if it does not, either engages in prompt corrective action to force the institution to raise its capital ratios or the supervisor closes it down, along the lines we have discussed in Chapter 10. A focus on microprudential supervision is not enough to prevent financial crises. The run on the shadow banking system illustrates how the problems of one financial institution can harm other financial institutions that are otherwise healthy. When the troubled financial institution is forced to engage in fire sales and sell off assets in order to meet target capital ratios or haircut requirements, this leads to a decline in asset values. The decline in asset values then causes other institutions to engage in fire sales, leading to a rapid deleveraging process and a systemic crisis. In situations like this, even institutions that have high capital ratios and would normally be healthy may find themselves in trouble. The global financial crisis has therefore made it clear that there is a need for macroprudential supervision, which focuses on the safety and soundness of the financial system in the aggregate. Rather than focusing on the safety and soundness of individual institutions, macroprudential supervision seeks to mitigate systemwide fire sales and deleveraging by assessing the overall capacity of the financial system to avoid them. In addition, because many institutions that were well capitalized faced liquidity shortages and found that their access to short-term funding was cut off, macroprudential supervision focuses not only on capital adequacy as a whole but also on whether the financial system has sufficient liquidity. Macroprudential policies can take several forms. The run-up to the global financial crisis included a so-called leverage cycle, in which a feedback loop resulted from a boom in issuing credit, which led to higher asset prices, which resulted in higher capital buffers at financial institutions, which supported further lending in the context of unchanging capital requirements, which then raised asset prices further, and so on; in the bust, the opposite occurs, with the value of the capital dropping precipitously, leading to a cut in lending. To short-circuit this leverage cycle, macroprudential policies make capital requirements countercyclical; that is, they are adjusted upward during a boom and downward during a bust. In addition, during the upward swing in the leverage cycle, macroprudential policies might involve forcing financial institutions to tighten credit standards or even direct limits on the growth of credit. In the downward swing, macroprudential supervision might be needed to force the banking system as a whole to raise an aggregate amount of new capital so that banks will not curtail lending in order to reduce the level of their assets and raise capital ratios. To ensure that financial institutions have enough liquidity, macroprudential policies could require that financial institutions have a sufficiently low net stable funding ratio (NSFR), which is the percentage of the institution’s short-term funding in relation to total funding. Macroprudential policies of the type discussed here are being considered as part of the Basel 3 framework but have not yet been completely worked out. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 The global financial crisis raised calls for a new regulatory structure that would make a repeat of the crisis less likely. The result was the Dodd-Frank bill, which was passed in July 2010 after more than a year of discussion. It is the most comprehensive financial reform legislation since the Great Depression. The bill addresses seven different categories of regulation, which are discussed next. Consumer Protection Dodd-Frank created a new Consumer Financial Protection Bureau that is funded and housed within the Federal Reserve, although it is a completely independent agency. It has the authority to examine and enforce regulations on all businesses with more than $10 billion in assets that are engaged in issuing residential mortgage products, as well as on issuers of other financial products marketed to low-income people. The legislation requires lenders to make sure borrowers can repay residential mortgages by requiring verification of their income, credit history, and job status. It also bans payments to brokers for pushing borrowers into higher-priced loans. It allows states to impose stricter consumer protection laws on national banks and gives state attorneys general the power to enforce certain rules issued by the new bureau. It also permanently increased the level of federal deposit insurance to $250,000. Annual Stress Tests Dodd-Frank requires that banks with assets of more than $10 billion be subject every year to stress tests, a supervisory assessment of whether banks have sufficient bank capital if they are faced with a scenario of bad macroeconomic outcomes, such as a collapse in housing prices or a severe recession. Not only are the results of these stress tests published every year but if a bank “fails” the stress test and is found to have insufficient capital, it also has to restrict the amount of dividends it pays out and come up with a plan to raise new capital to eliminate this deficiency. Stress tests were first conducted for 19 banks at the height of the financial crisis in the first half of 2009. When the results were announced in May 2009, they were well received by market participants, enabling these banks to raise substantial amounts of capital from private capital markets. The stress tests were a key factor that helped increase the amount of information in the marketplace, thereby reducing asymmetric information and adverse selection and moral hazard problems. Their success led to Dodd-Frank making them a regular exercise on an annual basis. Resolution Authority Before the new legislation was passed, the FDIC had the authority to seize failing banks and wind them down, but it did not have such resolution authority over the largest financial institutions—those structured as holding companies. Indeed, the U.S. Treasury and the Federal Reserve argued that one reason they were unable to rescue Lehman Brothers, and instead had to let it go into bankruptcy, was that they did not have the legal means with which to take over Lehman and break it up. The Dodd-Frank bill now provides the U.S. government this resolution authority, called the Orderly Liquidation Authority, for financial firms that are deemed systemic—that is, firms that pose a risk to the overall health of the financial system because their failure would cause widespread economic damage. It also gives regulators the right to levy fees on financial institutions with more than $50 billion in assets to recoup any losses. Limits on Federal Reserve Lending As we have seen, during the financial crisis, the Federal Reserve made loans to individual firms such as Bear Stearns and AIG under an emergency lending authority. Because of concerns that this Fed lending to individual firms entailed a bailout that would encourage firms to take on excessive risk in the future, the Dodd-Frank bill directed the Federal Reserve to limit emergency lending to “broad-based” programs rather than to individual firms. Systemic Risk Regulation The Dodd-Frank bill created a Financial Stability Oversight Council, chaired by the Treasury secretary, that monitors markets for asset-price bubbles and the buildup of systemic risk. In addition, it designates which financial firms are systemically important and so receive the official designation of systemically important financial institutions (SIFIs). These firms are subject to additional regulation by the Federal Reserve, which includes higher capital standards and stricter liquidity requirements, along with the requirement that such firms draw up a “living will,” that is, a plan for orderly liquidation if the firm gets into financial difficulties. Volcker Rule Under the new legislation, banks are limited in the extent of their proprietary trading—that is, trading with their own money—and are allowed to own only a small percentage of hedge and private equity funds. These provisions are named after Paul Volcker, a former chairman of the Board of Governors of the Federal Reserve, who argued that banks should not be allowed to take large trading risks when they receive the benefits of federal deposit insurance. Derivatives As discussed in Chapter 11, derivatives such as credit default swaps ended up being “weapons of mass destruction” that helped lead to a financial meltdown when AIG had to be rescued after making overly extensive use of them. To prevent this from happening again, the Dodd-Frank bill requires that many standardized derivative products be traded on exchanges to make their trading more transparent and also requires that they be cleared through clearinghouses to reduce the risk of losses if one counterparty in the derivative transaction goes bankrupt. More customized derivative products are subject to higher capital requirements. Banks are banned from some of their derivative-dealing operations, such as those involving riskier swaps. In addition, the bill imposes capital and margin requirements on firms dealing in derivatives and forces them to disclose more information about their activities. Too-Big-to-Fail and Future Regulation 1. 12.5 Identify the gaps in current financial regulation and how those gaps may be addressed with future regulatory changes. The Dodd-Frank bill leaves out many of the details of future regulation, and there are doubts as to whether it has dealt sufficiently with the too-big-to-fail problem, which, as we have seen, was an important factor that contributed to the global financial crisis. Here we discuss some possible measures to reduce the too-big-to-fail problem and explore several areas in which regulation might be heading in the future. What Can Be Done About the Too-Big-toFail Problem? Three approaches to solving the too-big-to-fail problem have been actively debated. Break Up Large, Systemically Important Financial Institutions One way to eliminate the too-big-to-fail problem is to make sure that no financial institution is so large that it can bring down the financial system. Then, regulators will no longer see the need to bail out these institutions if they fail, thereby subjecting them to market discipline. One way to shrink overly large institutions is to reimpose the restrictions that were in place before GlassSteagall was repealed, thereby forcing these large SIFIs to break up their different activities into smaller, cohesive companies. Alternatively, regulations could specify that no financial institution can have assets over a specified maximum limit, forcing SIFIs to break up into smaller pieces. Not surprisingly, both of these approaches have been vehemently opposed by the largest financial institutions. Although breaking up SIFIs would eliminate the too-big-to-fail problem, if there are synergies available that might enable large institutions to manage risk better or to provide financial services at a lower cost, then breaking up SIFIs might decrease the efficiency of the financial system rather than increase it. Higher Capital Requirements Because institutions that are “too big to fail” have incentives to take on excessive risk, another way to reduce their risk taking is to impose higher capital requirements on them. With higher capital, not only will these institutions have a larger buffer with which to withstand losses if they occur but they will also have more to lose and hence have more “skin in the game,” thereby reducing moral hazard and giving them less incentive to take on excessive risk. Another way of describing this approach is to say that higher capital requirements reduce the subsidy to risk taking for institutions that are too big to fail. In addition, because risk taking by SIFIs is far greater during booms, capital requirements could be increased when credit is expanding rapidly and reduced when credit is contracting. Such measures would cause capital requirements to become more countercyclical and could help restrain the boom-bust credit cycle. The Swiss central bank has been a leader in this kind of approach: It has the highest capital requirements among advanced countries for its largest banks, and it raises them when credit markets become particularly frothy. Legislation has been proposed in the U.S. Congress to double capital requirements for large financial institutions, legislation that these institutions vigorously oppose. Leave It to Dodd-Frank Another view is that Dodd-Frank has effectively eliminated the too-big-to-fail problem by making it harder for the Federal Reserve to bail out financial institutions, by imposing stricter regulations on SIFIs, and through application of the Volcker rule. Indeed, the authors of the bill have declared that Dodd-Frank will “end too-big-to-fail as we know it.” Although the provisions of Dodd-Frank do take away some of the incentives for excessive risk taking by large, systemically important financial institutions, there are doubts that this bill completely removes the too-big-to-fail problem. Beyond Dodd-Frank: Where Might Regulation Head in the Future? In February 2017, the new president, Donald Trump, signed an executive order directing the Secretary of the Treasury to review the financial regulations in the Dodd-Frank bill. Critics of Dodd-Frank, such as the Trump administration, have argued that many of its regulations have restricted banks from lending, especially to households, making it harder for them to borrow. Supporters of Dodd-Frank argue that it has made the financial system sounder, reducing the likelihood of a financial crisis. After this review is completed, major changes in financial regulation might be implemented. Here we examine debates about where regulation should head in the future in several areas. Consumer Protection Congressional critics of the Consumer Financial Protection Bureau argue that its regulations, such as those requiring lenders to make sure that borrowers have the ability to repay loans and mortgages, have led banks to be overly conservative in extending credit to consumers. Some of these critics would even go beyond restraining the Consumer Financial Protection Bureau and would like to see it abolished, arguing that this would promote more lending to households. Advocates for consumer protection have vowed to fight to retain these regulations and the Consumer Financial Protection Bureau because they argue that not only will these regulations and the Consumer Financial Protection Bureau protect consumers from fraud and deception but they will also make the financial system safer because fraudulent practices helped promote the subprime lending boom and the global financial crisis. Resolution Authority There are proposals in the U.S. Congress to abolish the Orderly Liquidation Authority. Advocates for these proposals argue that the Orderly Liquidation Authority legitimizes federal bailouts of large financial firms and therefore increases the too-big-to-fail problem. Instead they propose an enhanced bankruptcy procedure for failing financial firms that would be determined by the courts. Defenders of a federal resolution authority argue that although the Orderly Liquidation Authority can be improved, it is still needed because bankruptcy, even an enhanced procedure, is a messy legal process that makes orderly resolutions of failing financial institutions in a crisis extremely difficult. Without an Orderly Liquidation Authority, the failure of a major financial institution is more likely to cause a financial crisis to spin out of control. Volcker Rule The Volcker rule to limit banks from proprietary trading with their own money, which has the advantage of limiting excessive risk taking by banks, has come under attack for several reasons. First, regulators have found it very difficult to differentiate proprietary trading from banks trading for their customers, so the Volcker rule has resulted in very complex regulations that might be very difficult and costly to enforce. Second, it limits banks from engaging in a profitable activity that could offset possible losses from lending. Third, critics of the Volcker rule argue that by limiting trading, it has reduced liquidity in many financial markets. Derivatives Trading Proposals in Congress seek to roll back the Dodd-Frank rules on derivatives trading. Their proponents argue that these rules have hurt the ability of financial institutions in the United States to make these trades, with the result that derivatives trading, particularly in credit default swaps, has moved overseas, making it harder for American financial firms to make profits and reducing the ability of U.S. nonfinancial firms to insure against risk. Supporters of the DoddFrank rules on derivatives trading argue that they make derivatives trading more transparent and safer, thereby reducing the likelihood of future financial crises. Government-Sponsored Enterprises (GSEs) A major gap in the Dodd-Frank bill is that it does not address privately owned, governmentsponsored enterprises, such as Fannie Mae and Freddie Mac. During the global financial crisis, both of these firms got into serious financial trouble and had to be taken over by the government, with massive loans and government guarantees needed to prop them up. To prevent this from occurring again, there are proposals to reform the GSEs by four different routes: 1. Fully privatize GSEs by taking away their government sponsorship, thereby removing the implicit backing for their debt 2. Completely nationalize them by taking away their private status and making them government agencies 3. Leave them as privately owned GSEs, but strengthen regulations to restrict the amount of risk they take and to impose higher capital standards 4. Leave them as privately owned GSEs, but force them to shrink dramatically so that they no longer expose the taxpayer to huge losses or pose a systemic risk to the financial system when they fail However, supporters of the current status of the GSEs argue against these reforms because they would limit GSE activity, thereby making it harder for households to get credit. Book: Economics of Money, Banking and Financial Markets, 12e eText. This chapter is between pages from page 270-290. So, You just need write a page number between this scale when you cite from this book, What Is a Financial Crisis? 1. 12.1 Define the term financial crisis. In Chapter 8, we saw that a well-functioning financial system solves asymmetric information problems (moral hazard and adverse selection) so that capital is allocated to its most productive uses. These asymmetric information problems, which act as a barrier to efficient allocation of capital, are often described by economists as financial frictions. When financial frictions increase, financial markets are less capable of channeling funds efficiently from savers to households and firms with productive investment opportunities, with the result that economic activity declines. A financial crisis occurs when information flows in financial markets experience a particularly large disruption, with the result that financial frictions increase sharply and financial markets stop functioning. Then economic activity collapses. Dynamics of Financial Crises 1. 12.2 Identify the key features of the three stages of a financial crisis. As earth-shaking and headline-grabbing as the most recent financial crisis was, it was only one of a number of financial crises that have hit industrialized countries like the United States over the years. These experiences have helped economists uncover insights into present-day economic turmoil. Financial crises in advanced economies have progressed in two and sometimes three stages. To understand how these crises have unfolded, refer to Figure 1, which traces the stages and sequence of events in financial crises in advanced economies. MyLab Economics Mini-lecture Figure 1 Sequence of Events in Financial Crises in Advanced Economies The solid arrows trace the sequence of events during a typical financial crisis; the dotted arrows show the additional set of events that occurs if the crisis develops into a debt deflation. The sections separated by the dashed horizontal lines show the different stages of a financial crisis. Stage One: Initial Phase Financial crises can begin in two ways: credit boom and bust, or a general increase in uncertainty caused by failures of major financial institutions. Credit Boom and Bust The seeds of a financial crisis are often sown when an economy introduces new types of loans or other financial products, known as financial innovation, or when countries engage in financial liberalization, the elimination of restrictions on financial markets and institutions. In the long run, financial liberalization promotes financial development and encourages a wellrun financial system that allocates capital efficiently. However, financial liberalization has a dark side: In the short run, it can prompt financial institutions to go on a lending spree, called a credit boom. Unfortunately, lenders may not have the expertise, or the incentives, to manage risk appropriately in these new lines of business. Even with proper management, credit booms eventually outstrip the ability of institutions—and government regulators—to screen and monitor credit risks, leading to overly risky lending. As we learned in Chapter 10, government safety nets, such as deposit insurance, weaken market discipline and increase the moral hazard incentive for banks to take on greater risk than they otherwise would. Because lender-savers know that government-guaranteed insurance protects them from losses, they will supply even undisciplined banks with funds. Without proper monitoring, risk taking grows unchecked. Eventually, losses on loans begin to mount, and the value of the loans (on the asset side of the balance sheet) falls relative to liabilities, thereby driving down the net worth (capital) of banks and other financial institutions. With less capital, these financial institutions cut back on their lending to borrower-spenders, a process called deleveraging. Furthermore, with less capital, banks and other financial institutions become riskier, causing lender-savers and other potential lenders to these institutions to pull out their funds. Fewer funds mean fewer loans to fund productive investments and a credit freeze: The lending boom turns into a lending crash. When financial institutions stop collecting information and making loans, financial frictions rise, limiting the financial system’s ability to address the asymmetric information problems of adverse selection and moral hazard (as shown in the arrow pointing from the first factor, “Deterioration in Financial Institutions’ Balance Sheets,” in the top row of Figure 1). As loans become scarce, borrower-spenders are no longer able to fund their productive investment opportunities and they decrease their spending, causing economic activity to contract. Asset-Price Boom and Bust Prices of assets such as equity shares and real estate can be driven by investor psychology (dubbed “irrational exuberance” by Alan Greenspan when he was chairman of the Federal Reserve) well above their fundamental economic values, that is, their values based on realistic expectations of the assets’ future income streams. The rise of asset prices above their fundamental economic values is an asset-price bubble. Examples of asset-price bubbles are the tech stock market bubble of the late 1990s and the recent housing price bubble that we will discuss later in this chapter. Asset-price bubbles are often also driven by credit booms, in which the large increase in credit is used to fund purchases of assets, thereby driving up their price. When the bubble bursts and asset prices realign with fundamental economic values, stock and real estate prices tumble, companies see their net worth (the difference between their assets and their liabilities) decline, and the value of collateral these companies can pledge drops. Now these companies have less at stake because they have less “skin in the game,” and so they are more likely to make risky investments because they have less to lose, the problem of moral hazard. As a result, financial institutions tighten lending standards for these borrower-spenders and lending contracts (as shown by the downward arrow pointing from the second factor, “Asset-Price Decline,” in the top row of Figure 1). The asset-price bust also causes a decline in the value of financial institutions’ assets, thereby causing a decline in the institutions’ net worth and hence a deterioration in their balance sheets (shown by the arrow from the second factor to the first factor in the top row of Figure 1), which causes them to deleverage, steepening the decline in economic activity. Increase in Uncertainty Financial crises in the United States have usually begun in periods of high uncertainty, such as just after the start of a recession, a crash in the stock market, or the failure of a major financial institution. Crises began after the failure of Ohio Life Insurance and Trust Company in 1857; the Jay Cooke and Company in 1873; Grant and Ward in 1884; the Knickerbocker Trust Company in 1907; the Bank of the United States in 1930; and Bear Stearns, Lehman Brothers, and AIG in 2008. With information hard to come by in a period of high uncertainty, financial frictions increase, reducing lending and economic activity (as shown by the arrow pointing from the last factor, “Increase in Uncertainty,” in the top row of Figure 1). Stage Two: Banking Crisis Deteriorating balance sheets and tougher business conditions lead some financial institutions into insolvency, which happens when their net worth becomes negative. Unable to pay off depositors or other creditors, some banks go out of business. If severe enough, these factors can lead to a bank panic in which multiple banks fail simultaneously. The source of the contagion is asymmetric information. In a panic, depositors, fearing for the safety of their deposits (in the absence of or with limited amounts of deposit insurance) and not knowing the quality of banks’ loan portfolios, withdraw their deposits to the point that the banks fail. Uncertainty about the health of the banking system in general can lead to runs on banks, both good and bad, which forces banks to sell off assets quickly to raise the necessary funds. These fire sales of assets may cause their prices to decline so much that more banks become insolvent and the resulting contagion can then lead to multiple bank failures and a full-fledged bank panic. With fewer banks operating, information about the creditworthiness of borrower-spenders disappears. Increasingly severe adverse selection and moral hazard problems in financial markets deepen the financial crisis, causing declines in asset prices and the failure of firms throughout the economy that lack funds for productive investment opportunities. Figure 1represents this progression in the stage two portion. Bank panics were a feature of all U.S. financial crises during the nineteenth and twentieth centuries, occurring every 20 years or so until World War II—1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930–1933. (The 1933 establishment of federal deposit insurance, which protects depositors from losses, has prevented subsequent bank panics in the United States.) Eventually, public and private authorities shut down insolvent firms and sell them off or liquidate them. Uncertainty in financial markets declines, the stock market recovers, and balance sheets improve. Financial frictions diminish and the financial crisis subsides. With the financial markets able to operate well again, the stage is set for an economic recovery. Stage Three: Debt Deflation If, however, the economic downturn leads to a sharp decline in the price level, the recovery process can be short-circuited. In stage three of Figure 1, debt deflation occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firms’ net worth because of the increased burden of indebtedness. In economies with moderate inflation, which characterizes most advanced countries, many debt contracts with fixed interest rates are typically of fairly long maturity, ten years or more. Because debt payments are contractually fixed in nominal terms, an unanticipated decline in the price level raises the value of borrowing firms’ and households’ liabilities in real terms (increases the burden of the debt) but does not raise the real value of their assets. The borrowers’ net worth in real terms (the difference between assets and liabilities in real terms) thus declines. To better understand how this decline in net worth occurs, consider what happens if a firm in 2019 has assets of $100 million (in 2019 dollars) and $90 million of long-term liabilities, so that it has $10 million in net worth (the difference between the values of assets and liabilities). If the price level falls by 10% in 2020, the real value of the liabilities would rise to $99 million in 2019 dollars, while the real value of the assets would remain unchanged at $100 million. The result would be that real net worth in 2019 dollars would fall from $10 million to $1 million ($100 million minus $99 million). The substantial decline in the real net worth of borrowers caused by a sharp drop in the price level creates an increase in adverse selection and moral hazard problems for lenders. Lending and economic activity decline for a long time. The most significant financial crisis that displayed debt deflation was the Great Depression, the worst economic contraction in U.S. history. Application The Mother of All Financial Crises: The Great Depression With our framework for understanding financial crises in place, we are prepared to analyze how a financial crisis unfolded during the Great Depression and how it led to the worst economic downturn in U.S. history. Stock Market Crash In 1928 and 1929, U.S. stock prices doubled. Federal Reserve officials viewed the stock market boom as caused by excessive speculation. To curb it, they pursued a tightening of monetary policy to raise interest rates in an effort to limit the rise in stock prices. The Fed got more than it bargained for when the stock market crashed in October 1929, falling by 40% by the end of 1929, as shown in Figure 2. Stock prices crashed in 1929, falling by 40% by the end of 1929, and then continued to fall to only 10% of their peak value by 1932. Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/M1109AUSM293NNBR. Bank Panics By the middle of 1930, stocks had recovered almost half of their losses and credit market conditions had stabilized. What might have been a normal recession turned into something far worse, however, when severe droughts in the Midwest led to a sharp decline in agricultural production, with the result that farmers could not pay back their bank loans. The resulting defaults on farm mortgages led to large loan losses on bank balance sheets in agricultural regions. The general weakness of the economy, and of the banks in agricultural regions in particular, prompted substantial withdrawals from banks, building to a full-fledged panic in November and December of 1930, with the stock market falling sharply. For more than two years, the Fed sat idly by through one bank panic after another, the most severe spate of panics in U.S. history. After what would be the era’s final panic in March 1933, President Franklin Delano Roosevelt declared a bank holiday, a temporary closing of all banks. “The only thing we have to fear is fear itself,” Roosevelt told the nation. The damage was done, however, and more than one-third of U.S. commercial banks had failed. Continuing Decline in Stock Prices Stock prices kept falling. By mid-1932, stocks had declined to 10% of their value at the 1929 peak (as shown in Figure 2), and the increase in uncertainty from the unsettled business conditions created by the economic contraction worsened adverse selection and moral hazard problems in financial markets. With a greatly reduced number of financial intermediaries still in business, adverse selection and moral hazard problems intensified even further. Financial markets struggled to channel funds to borrowerspenders with productive investment opportunities. The amount of outstanding commercial loans fell by half from 1929 to 1933, and investment spending collapsed, declining by 90% from its 1929 level. A manifestation of the rise in financial frictions is that lenders began charging businesses much higher interest rates to protect themselves from credit losses. The resulting rise in the credit spread—the difference between the interest rate on loans to households and businesses and the interest rate on completely safe assets that are sure to be paid back, such as U.S. Treasury securities—is shown in Figure3, which displays the difference between interest rates on corporate bonds with a Baa (medium-quality) credit rating and rates on similar-maturity Treasury bonds. (Note the credit spread is closely related to the risk premium discussed in Chapter6.) Figure 3 Credit Spreads During the Great Depression Credit spreads (the difference between rates on Baa corporate bonds and U.S. Treasury bonds) rose sharply during the Great Depression. Debt Deflation The ongoing deflation that accompanied declining economic activity eventually led to a 25% decline in the price level. This deflation short-circuited the normal recovery process that occurs in most recessions. The huge decline in prices triggered a debt deflation in which real net worth fell because of the increased burden of indebtedness borne by firms and households. The decline in net worth and the resulting increase in adverse selection and moral hazard problems in the credit markets led to a prolonged economic contraction in which unemployment rose to 25% of the labor force. The financial crisis of the Great Depression was the worst ever experienced in the United States, which explains why the economic contraction was also the most severe ever experienced by the nation. International Dimensions Although the Great Depression started in the United States, it was not just a U.S. phenomenon. Bank panics in the United States also spread to the rest of the world, and the contraction of the U.S. economy sharply decreased the demand for foreign goods. The worldwide depression caused great hardship, with millions upon millions of people out of work, and the resulting discontent led to the rise of fascism and World War II. The consequences of the Great Depression financial crisis were disastrous. The Global Financial Crisis of 2007– 2009 1. 12.3 Describe the causes and consequences of the global financial crisis of 2007–2009. For many years, most economists thought that financial crises of the type experienced during the Great Depression were a thing of the past for advanced countries like the United States. Unfortunately, the financial crisis that engulfed the world in 2007–2009 proved them wrong. Causes of the 2007–2009 Financial Crisis We begin our look at the 2007–2009 financial crisis by examining three central factors: financial innovation in mortgage markets, agency problems in mortgage markets, and the role of asymmetric information in the credit-rating process. Financial Innovation in the Mortgage Markets As we saw in Chapter 11, starting in the early 2000s advances in information technology made it easier to securitize subprime mortgages, leading to an explosion in subprime mortgage-backed securities. Financial innovation didn’t stop there. Financial engineering, the development of new, sophisticated financial instruments, led to structured credit products that paid out income streams from a collection of underlying assets, designed to have particular risk characteristics that appealed to investors with differing preferences. The most notorious of these products were collateralized debt obligations (CDOs) (discussed in the FYI box, “Collateralized Debt Obligations). FYI Collateralized Debt Obligations (CDOs) The creation of a collateralized debt obligation involves a corporate entity called a special purpose vehicle (SPV), which buys a collection of assets such as corporate bonds and loans, commercial real estate bonds, and mortgage-backed securities. The SPV then separates the payment streams (cash flows) from these assets into a number of buckets that are referred to as tranches. The highest-rated tranches, called super senior tranches, are the ones that are paid off first and so have the least risk. The super senior CDO is a bond that pays out these cash flows to investors, and because it has the least risk, it also has the lowest interest rate. The next bucket of cash flows, known as the senior tranche, is paid out next; the senior CDO has a little more risk and pays a higher interest rate. The next tranche of payment streams, the mezzanine tranche of the CDO, is paid out after the super senior and senior tranches and so it bears more risk and has an even higher interest rate. The lowest tranche of the CDO is the equity tranche; this is the first set of cash flows that are not paid out if the underlying assets go into default and stop making payments. This tranche has the highest risk and is often not traded. If all of this sounds complicated, it is. Tranches also included CDO s and CDO s that sliced and diced risk even further, paying out the cash flows from CDOs to CDO s and from CDO s to CDO s. Although financial engineering carries the potential benefit of creating products and services that match investors’ risk appetites, it also has a dark side. Structured products like CDOs, CDO s, and CDO s can get so complicated that it becomes hard to value the cash flows of the underlying assets for a security or to determine who actually owns these assets. Indeed, in October 2007, Ben Bernanke, then chairman of the Federal Reserve, joked that he “would like to know what those damn things are worth.” In other words, the increased complexity of structured products can actually reduce the amount of information in financial markets, thereby worsening asymmetric information in the financial system and increasing the severity of adverse selection and moral hazard problems. 2 3 2 2 3 2 3 Agency Problems in the Mortgage Markets The mortgage brokers who originated the mortgage loans often did not make a strong effort to evaluate whether a borrower could pay off the mortgage, since they planned to quickly sell (distribute) the loans to investors in the form of mortgage-backed securities. This originate-todistribute business model was exposed to the principal–agent problem of the type discussed in Chapter 8, in which the mortgage brokers acted as agents for investors (the principals) but did not have the investors’ best interests at heart. Once the mortgage broker earns his or her fee, why should the broker care if the borrower makes good on the payment? The more volume the broker originates, the more money the broker makes. Not surprisingly, adverse selection became a major problem. Risk-loving real-estate investors lined up to obtain loans to acquire houses that would be very profitable if housing prices went up, knowing they could “walk away” if housing prices went down. The principal–agent problem also created incentives for mortgage brokers to encourage households to take on mortgages they could not afford or to commit fraud by falsifying information on borrowers’ mortgage applications in order to qualify them for mortgages. Compounding this problem was lax regulation of originators, who were not required to disclose information to borrowers that would have helped them assess whether they could afford the loans. The agency problems went even deeper. Commercial and investment banks, which were earning large fees by underwriting mortgage-backed securities and structured credit products like CDOs, also had weak incentives to make sure that the ultimate holders of the securities would be paid off. Financial derivatives, financial instruments whose payoffs are linked to (i.e., derived from) previously issued securities, also were an important source of excessive risk taking. Large fees from writing a type of financial insurance contract called a credit default swap, a financial derivative that provides payments to holders of bonds if they default, also drove units of insurance companies like AIG to write hundreds of billions of dollars’ worth of these risky contracts. Asymmetric Information and Credit-Rating Agencies Credit-rating agencies, who rate the quality of debt securities in terms of the probability of default, were another contributor to asymmetric information in financial markets. The rating agencies advised clients on how to structure complex financial instruments, like CDOs, while at the same time they were rating these identical products. The rating agencies were thus subject to conflicts of interest because the large fees they earned from advising clients on how to structure products that they themselves were rating meant that they did not have sufficient incentives to make sure their ratings were accurate. The result was wildly inflated ratings that enabled the sale of complex financial products that were far riskier than investors recognized. Effects of the 2007–2009 Financial Crisis Consumers and businesses alike suffered as a result of the 2007–2009 financial crisis. The impact of the crisis was most evident in five key areas: the U.S. residential housing market, financial institutions’ balance sheets, the shadow banking system, global financial markets, and the headline-grabbing failures of major firms in the financial industry. Residential Housing Prices: Boom and Bust The subprime mortgage market took off after the recession ended in 2001. By 2007, it had become over a trillion-dollar market. The development of the subprime mortgage market was encouraged by economists and politicians alike because it led to a “democratization of credit” and helped raise U.S. homeownership rates to the highest levels in history. The asset-price boom in housing (see Figure 4), which took off after the 2000–2001 recession was over, also helped stimulate the growth of the subprime mortgage market. High housing prices meant that subprime borrowers could refinance their houses with even larger loans when their homes appreciated in value. With housing prices rising, subprime borrowers were also unlikely to default because they could always sell their house to pay off the loan, making investors happy because the securities backed by cash flows from subprime mortgages had high returns. The growth of the subprime mortgage market, in turn, increased the demand for houses and so fueled the boom in housing prices, resulting in a housing-price bubble. Figure 4 Housing Prices and the Financial Crisis of 2007–2009 Housing prices boomed from 2002 to 2006, fueling the market for subprime mortgages and forming an asset-price bubble. Housing prices began declining in 2006, falling by more than 30% subsequently, which led to defaults by subprime mortgage holders. Source: Case-Shiller U.S. National Composite House Price Index from Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/SPCS20RSA. Description Further stimulus for the inflated housing market came from low interest rates on residential mortgages, which were the result of several different forces. First were the huge capital inflows into the United States from countries like China and India. Second was congressional legislation that encouraged Fannie Mae and Freddie Mac to purchase trillions of dollars of mortgage-backed securities.2 Third was Federal Reserve monetary policy that made it easy to lower interest rates. The low cost of financing for housing purchases that resulted from these forces further stimulated the demand for housing, pushing up housing prices. (A highly controversial issue is whether the Federal Reserve was to blame for the housing price bubble, and this is discussed in the Inside the Fed box.) Inside the Fed Was the Fed to Blame for the Housing Price Bubble? Some economists—most prominently, John Taylor of Stanford University—have argued that the low interest rate policy of the Federal Reserve in the 2003–2006 period caused the housing price bubble.* Taylor argues that the low federal funds rate led to low mortgage rates that stimulated housing demand and encouraged the issuance of subprime mortgages, both of which led to rising housing prices and a bubble. In a speech given in January 2010, then-Federal Reserve Chairman Ben Bernanke countered this argument.† He concluded that monetary policy was not to blame for the housing price bubble. First, he said, it is not at all clear that the federal funds rate was too low during the 2003–2006 period. Rather, the culprits were the proliferation of new mortgage products that lowered mortgage payments, a relaxation of lending standards that brought more buyers into the housing market, and capital inflows from countries such as China and India. Bernanke’s speech was very controversial, and the debate over whether monetary policy was to blame for the housing price bubble continues to this day. As housing prices rose and profitability for mortgage originators and lenders grew higher, the underwriting standards for subprime mortgages fell lower and lower. High-risk borrowers were able to obtain mortgages, and the amount of the mortgage relative to the value of the house, the loan-to-value ratio (LTV), rose. Borrowers were often able to get piggyback, second, and third mortgages on top of their original 80% loan-to-value mortgage so that they had to put almost no money down. When asset prices rise too far out of line with fundamentals—in the case of housing, the cost of purchasing a home relative to the cost of renting it, or the cost of houses relative to households’ median income—they must come down. Eventually, the housing price bubble burst. With housing prices falling after their peak in 2006 (see Figure 4), the rot in the financial system began to reveal itself. The decline in housing prices led many subprime borrowers to find that their mortgages were “underwater”—that is, the value of the house was below the amount of the mortgage. When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender. Defaults on mortgages shot up sharply, eventually leading to foreclosures on millions of mortgages. Deterioration of Financial Institutions’ Balance Sheets The decline in U.S. housing prices led to rising defaults on mortgages. As a result, the values of mortgage-backed securities and CDOs collapsed, leaving banks and other financial institutions holding those securities with a lower value of assets and thus a lower net worth. With weakened balance sheets, these banks and other financial institutions began to deleverage, selling off assets and restricting the availability of credit to both households and businesses. With no one else able to step in to collect information and make loans, the reduction in bank lending meant that financial frictions increased in financial markets. Run on the Shadow Banking System The sharp decline in the values of mortgages and other financial assets triggered a run on the shadow banking system, composed of hedge funds, investment banks, and other nondepository financial firms, which are not as tightly regulated as banks. Funds from shadow banks flowed through the financial system and for many years supported the issuance of low-interest-rate mortgages and auto loans. These securities were funded primarily by repurchase agreements (repos), short-term borrowing that, in effect, uses assets like mortgage-backed securities as collateral. Rising concern about the quality of a financial institution’s balance sheet led lenders to require larger amounts of collateral, known as haircuts. For example, if a borrower took out a $100 million loan in a repo agreement, the borrower might have to post $105 million of mortgage-backed securities as collateral, for a haircut of 5%. Rising defaults on mortgages caused the values of mortgage-backed securities to fall, which then led to a rise in haircuts. At the start of the crisis, haircuts were close to zero, but eventually they rose to nearly 50%.3 The result was that financial institutions could borrow only half as much with the same amount of collateral. Thus, to raise funds, financial institutions had to engage in fire sales and sell off their assets very rapidly. Because selling assets quickly requires lowering their price, the fire sales led to a further decline in financial institutions’ asset values. This decline lowered the value of collateral further, raising haircuts and thereby forcing financial institutions to scramble even more for liquidity. The result was similar to the run on the banking system that occurred during the Great Depression, causing massive deleveraging that resulted in a restriction of lending and a decline in economic activity. The decline in asset prices in the stock market (which fell by over 50% from October 2007 to March 2009, as shown in Figure 5) and the more than 30% drop in residential house prices (shown in Figure 4), along with the fire sales resulting from the run on the shadow banking system, weakened both firms’ and households’ balance sheets. This worsening of financial frictions manifested itself in widening credit spreads, causing higher costs of credit for households and businesses and tighter lending standards. The resulting decline in lending meant that both consumption expenditure and investment fell, causing the economy to contract.4 Figure 5 Stock Prices and the Financial Crisis of 2007–2009 Stock prices fell by 50% from October 2007 to March 2009. Global Financial Markets Although the problem originated in the United States, the wake-up call for the financial crisis came from Europe, a sign of how extensive the globalization of financial markets had become. After Fitch and Standard & Poor’s announced ratings downgrades on mortgage-backed securities and CDOs totaling more than $10 billion, on August 7, 2007, a French investment house, BNP Paribas, suspended redemption of shares held in some of its money market funds, which had sustained large losses. The run on the shadow banking system began, only to become worse and worse over time. Despite huge injections of liquidity into the financial system by the European Central Bank and the Federal Reserve, banks began to horde cash and were unwilling to lend to each other. The drying up of credit led to the first major bank failure in the United Kingdom in over 100 years when Northern Rock, which had relied on short-term borrowing in the repo market rather than deposits for its funding, collapsed in September 2007. A string of other European financial institutions then failed as well. Particularly hard hit were countries like Greece, Ireland, Portugal, and Spain. The resulting crisis in markets for government-issued (sovereign) debt in Europe is described in the Global box, “The European Sovereign Debt Crisis.” Global The European Sovereign Debt Crisis The global financial crisis of 2007–2009 led not only to a worldwide recession but also to a sovereign debt crisis that still threatens to destabilize Europe today. Up until 2007, all of the countries that had adopted the euro found their interest rates converging to very low levels, but with the onset of the global financial crisis, several of these countries were hit very hard by the contraction in economic activity, which reduced tax revenues at the same time that government bailouts of failed financial institutions required additional government outlays. The resulting surge in budget deficits then led to fears that the governments of these hard-hit countries would default on their debt. The result was a surge in interest rates that threatened to spiral out of control.* Greece was the first domino to fall in Europe. In September 2009, with an economy weakened by reduced tax revenues and increased spending demands, the Greek government was projecting a budget deficit for the year of 6% and a debt-to-GDP ratio near 100%. However, when a new government was elected in October, it revealed that the budget situation was far worse than anyone had imagined, because the previous government had provided misleading numbers about both the budget deficit, which was at least double the 6% number, and the amount of government debt, which was ten percentage points higher than previously reported. Despite austerity measures aimed at dramatically cutting government spending and raising taxes, interest rates on Greek debt soared, eventually rising to nearly 40%, and the debt-to-GDP ratio climbed to 160% of GDP in 2012. Even with bailouts from other European countries and liquidity support from the European Central Bank, Greece was forced to write down the value of its debt held in private hands by more than half, and the country was subject to civil unrest, with massive strikes and the resignation of the prime minister. The sovereign debt crisis spread from Greece to Ireland, Portugal, Spain, and Italy. The governments of these countries were forced to embrace austerity measures to shore up their public finances while interest rates climbed to double-digit levels. Only with a speech in July 2012 by Mario Draghi, the president of the European Central Bank, in which he stated that the ECB was ready to do “whatever it takes” to save the euro, did the markets begin to calm down. Nonetheless, despite a sharp decline in interest rates in these countries, they experienced severe recessions, with unemployment rates rising to double-digit levels and Spain’s unemployment rate exceeding 25%. The stresses that the European sovereign debt crisis produced for the euro zone, the countries that have adopted the euro, has raised doubts about whether the euro will survive. Failure of High-Profile Firms The impact of the financial crisis on firms’ balance sheets forced major players in the financial markets to take drastic action. In March 2008, Bear Stearns, the fifth-largest investment bank in the United States, which had invested heavily in subprime-related securiti...
Purchase answer to see full attachment