Special Topics In Banking &

Finance

Dr. Karim Kobeissi

Arts, Sciences and Technology University in
Lebanon

Chapter 2: Financial Crises

K e y w o r d : Assets
An asset is a resource with economic value that an
individual, corporation or country owns or controls
with the expectation that it will provide future benefit .

Assets can be classified as either:

1. Debt instruments

Examples include bonds and deposits.

They specify that the issuer must repay a fixed amount
regardless of economic conditions.

or
2. Equity instruments

Examples include stocks or a title to real estate (property

consisting of land or buildings).
They specify ownership (equity = ownership) of variable
profits or returns, which vary according to economic
conditions.

K e y w o r d : Fi n a n c i a l S e c u r i t y
A financial securityis a tradable asset of any kind.Securities
are broadly categorized into:
1) Debt securities, such as banknote and bond [a debt
investment in which an investor loans money to an entity
(corporate or governmental) that borrows the funds for a
defined period of time at a fixed interest rate].
2) Equity securities, such as common stocks (a security
that represents ownership in a corporation).
3) Derivative contracts: a derivative is a security whose
price is dependent upon the price of another underlying
assets, such as (1) futures, (2) forwards, (3) options and (4)
swaps.

1- Futures Contracts

A future contract is a financial contract obligating the buyer

to purchase an asset (or the seller to sell an asset), such as a
physical

commodity

or

financial

instrument,

at

predetermined future date and price.

Futures can be used either to hedge (to lock in a certain

price and reduce risk) or to speculate on the price
movement of the underlying asset. For example, a producer
of corn could sell a future contract to hedge.

2- Forwards Contracts

A customized contract between two parties to buy or sell an

asset at a specified price on a future date. A forward
contract can be used for hedging or speculation, although
its non-standardized nature makes it particularly apt for
hedging.

Unlike standard futures contracts, a forward contract can be

customized to any commodity, amount and delivery date.

3- Options Contracts
A buyer purchase an option contract to hold the right of
carrying out a certain transaction in a predetermined
period of time and price - hence the name. For example,
let's say you purchase an option on shares of Intel (INTC)
with a strike price of $40 and an expiration date of April 16.
This option would give you the right to purchase 100
shares of Intel at a price of $40 on April 16 (the right to do
this, of course, willbe valuableonlyif Intel is trading above
$40 per share at that point in time).
The seller has the obligation to sell the underlying
asset to the buyer at a specified price by a specified date.

Meanwhile, the buyer of an options contract has

the right, but not the obligation, to complete the
transaction by a specified date. When an option expires, if
it is not in the buyer's best interest to exercise the option,
then he or she is not obligated to do anything.

4- Swaps Contracts
A swap is a derivative in which two counterparties exchange
cash flows of one party's financial instrument for those of
the other party's financial instrument.
Swaps are useful when one company wants to receive a
payment with a variable interest rate, while the other wants
to limit future risk by receiving a fixed-rate payment instead.
Each group has their own priorities and requirements,
so these exchanges can work to the advantage of
both parties. For example, one company may have abond
that pays the London Interbank Offered Rate (LIBOR), while
the other party holds a bond that provides a fixed payment
of 5%. If the LIBOR is expected to stay around 3%, then the
contract would likely explain that the party paying the
varying interest rate will pay LIBOR plus 2%. That way both
parties can expect to receive similar payments. The primary
investment is never traded, but the parties will agree on a
base value (perhaps $1 million) to use to calculate the cash
flows that theyll exchange.

What is a Financial Crisis?

While financial crises have common elements, they do come
in many forms. A financial crisis is often associated with
one or more of the following phenomena: substantial
changes in credit volume and asset prices (decrease in
stock

values);

severe

disturbances

in

financial

intermediation and the supply of external financing to

various actors in the economy; large scale balance sheet
problems

(of

firms,

households

and

financial

intermediaries); and large scale government support (in

the form of liquidity support and recapitalization). As such,
financial crises are typically multidimensional events and
can be hard to characterize using a single indicator.

Fa c t o r s C a u s i n g F i n a n c i a l C r i s e s
Many theories have been developed over the years regarding the
underlying causes of financial crises. While fundamental factors
macroeconomic imbalances, internal or external shocksare often
observed, many questions remain on the exact causes of crises.
Financial crises sometimes appear to be driven by irrational factors.
These include sudden runs on banks (a situation that occurs when a
large

number

simultaneously

of

bank's

due to

customers

withdraw

their

deposits

concerns about the bank's solvency),

corruption among financial markets, limits to arbitrage during times

of stress, emergence of asset busts (decrease in values), credit
crunches (a sudden sharp reduction in the availability of money or
credit from banks and other lenders), and fire-sales (sale of goods or
assets at a very low price, typically when the seller is facing
bankruptcy), and other aspects related to financial chaos.

Factors Causing Financial Crises (con)

Financial crises are often preceded by asset and credit
booms that eventually turn into busts (decrease in
values). Many theories focusing on the sources of crises
have recognized the importance of booms in asset and
credit markets. However, explaining why asset price
bubbles or credit booms are allowed to continue and
eventually become unsustainable and turn into busts
has been challenging. This naturally requires answering
why neither financial market participants nor policy
makers foresee the risks and attempt to slow down the
expansion of credit and increase in asset prices.

Dynamics of Financial Crises in Advanced

Economies
Stage One: Initiation of Financial Crisis

Mismanagement of financial innovations (such as

swaps, forwards)
Asset price boom and bust
Spikes (sharp increases) in interest rates
Increase in uncertainty

Stage two: Banking Crisis

Dynamics of Financial Crises in Advanced

Economies

Stage three: Debt Deflation [a theory

of economic cycles, which holds that
recessions and depressions are
due to the overall level of debt
shrinking (deflating): the credit
cycle

is

the

economic cycle].

cause

of

the

Figure 1 Sequence of Events in Financial Crises in Advanced Economies

APPLICATION The Mother of All Financial Crises: The Great

Depression
How did a financial crisis disclose during the Great
Depression and how it led to the worst economic
downturn in U.S. history?
This event was brought on by:
Stock market crash
Bank panics
Continuing decline in stock prices
Debt deflation

Figure 2 Stock Price Data During the Great

Depression Period

Source: Dow-Jones Industrial Average (DJIA). Global Financial Data;

www.globalfinancialdata.com/index_tabs.php?action=detailedinfo&id=1165.

Figure 3 Credit Spreads During the Great

Depression

Source: Federal Reserve Bank of St. Louis FRED database;

http://research.stlouisfed.org/fred2/categories/22.

Application: The Global Financial Crisis of 2007-2009

STAGE ONE: INITIATION OF FINANCIAL CRISE:
1) Financial innovations emerge in the mortgage markets

Subprime : loan arrangements for borrowers with a poor credit history, typically
having unfavourable conditions such as high interest rates.

Alt-A mortgages : the borrowers behind these mortgages will typically have
clean credit histories, but the mortgage itself will generally have some issues that
increase its risk profile.

Mortgage-backed securities: debt obligations that represent claims to the cash

flows from pools of mortgage loans, most commonly on residential property.

Collateralized debt obligations: A structured financial product that pools

together cash flow-generating assets and repackages this asset pool into separate
tranches that can be sold to investors. A collateralized debt obligation (CDO) is socalled because the pooled assets such as mortgages, bonds and loans are
essentially debt obligations that serve as guarantee for the CDO. The tranches in a
CDO vary substantially in their risk profile and the highest rated tranches, referred
to as super senior tranches are the ones that are paid off first and so have the least
risk.

Application: The Global Financial Crisis of 2007-2009

2) Housing price bubble forms
Increase in liquidity from cash flows moving towards the United States.
Development of subprime mortgage market fueled housing demand
and housing prices.
3) Agency problems (a conflict of interest between a company's

management and the company's stockholders ) arise

Originate to distribute model is subject to broker (management)
and mortgage investor (stockholders) problem.
Commercial and investment banks had weak incentives to assess the
quality of securities.
Borrowers had little incentive to disclose information about their ability
to pay.

Application: The Global Financial Crisis of 2007 2009 (con)

4) Information problems appear
5) Housing price bubble bursts
6) Crisis spreads globally
Sign of the globalization of financial markets

Application: The Global Financial Crisis of 2007 2009 (con)

STAGE TWO: BANKING CRISIS

1) Banks balance sheets deteriorate

Write downs
Sell of assets and credit restriction

2) High-profile firms fail

Fannie Mae and Freddie Mac; Lehman Brothers.

3)

Bailout package debated

House of Representatives voted down the $700
billion bailout package on September 29, 2008. It
passed on October 3.
Congress approved a $787 billion economic stimulus
plan on February 13, 2009.

Application: The Global Financial Crisis of 2007 2009 (con)

STAGE THREE: DEBT DEFLATION
1) Assets and commodities prices decrease
2) The economy enter a recession stage (2008-2009)

Figure 4 Housing Prices and the Financial Crisis of

20072009

Source: Case-Shiller U.S. National Composite House Price Index;

www.macromarkets.com/csi_housing/index.asp.

Figure 5 Stock Prices and the Financial

Crisis of 20072009

Source: Dow-Jones Industrial Average (DJIA). Global Financial Data; www.globalfinancialdata.com/index_tabs.php?action

=detailedinfo&id=1165.

Figure 6 Credit Spreads and the 20072009

Financial Crisis

Source: Federal Reserve Bank of St. Louis FRED database; http://research.stlouisfed.org/fred2/categories/22.

Dynamics of Financial Crises in Emerging

Market Economies

Stage one: Initiation of Financial

Crisis
Path one: mismanagement of financial
liberalization:
Weak supervision and lack of expertise leads to a
lending boom.
Domestic banks borrow from foreign banks.
Fixed exchange rates give a sense of lower risk.
Banks play a more important role in emerging
market economies, since securities markets are
not well developed yet.

Dynamics of Financial Crises in Emerging Market

Economies (con)

Path two: severe fiscal imbalances:

Governments in need of funds sometimes force
banks to buy government debt.
When government debt loses value (due to
inflation), banks lose and their net worth
decreases Deterioration of bank balance
sheets.

Additional factors:
Increase in interest rates (from abroad)
Asset price decrease
Uncertainty linked to unstable political systems

Dynamics of Financial Crises in Emerging Market

Economies (con)

Stage two: currency crisis

Deterioration of bank balance sheets
triggers currency crises:
Government cannot raise interest rates (doing
so forces banks into insolvency)
and speculators expect a devaluation.
Foreign and domestic investors sell the
domestic currency (Foreign exchange crisis).

Dynamics of Financial Crises in Emerging Market

Economies (con)

Stage three: Full-Fledged (developed)

Financial Crisis:
The debt burden in terms of domestic
currency increases (net worth decreases).
Increase in expected and actual inflation
reduces firms cash flow.
Banks are more likely to fail (Banking Crisis):
Individuals are less able to pay off their debts
(value of assets fall).
Debt denominated in foreign currency increases
(value of liabilities increase).

Figure 7 Sequence of Events in Emerging Market

Financial Crises

APPLICATION Financial Crises in Mexico, 19941995;

East Asia, 19971998; and Argentina, 20012002
Mexico: Financial liberalization in the early 1990s:

Lending boom, coupled with weak

supervision and lack of expertise.
Banks accumulated losses and their net
worth declined.
Rise in interest rates abroad.
Uncertainty increased (political instability).
Domestic currency devaluated on December 20,
1994.
Rise in actual and expected inflation.

APPLICATION Financial Crises in Mexico, 19941995;

East Asia, 19971998; and Argentina, 20012002 (con)

East Asia: Financial liberalization in the early

1990s:
Lending boom, coupled with weak supervision and lack of
expertise.
Banks accumulated losses and their net worth declined.

Uncertainty increased (stock market declines and

failure of prominent firms).
Domestic currencies devaluated by 1997.
Rise in actual and expected inflation.

APPLICATION Financial Crises in Mexico, 19941995;

East Asia, 19971998; and Argentina, 20012002 (con)

Argentina: Government forced banks to absorb

large amounts of debt due to fiscal imbalances.
Rise in interest rates abroad.
Uncertainty increased (ongoing recession).
Domestic currency devaluated on January 6, 2002
Rise in actual and expected inflation.