THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 228

CHAPTER Financial Crises and the Subprime Meltdown LE A RNI NG OB J ECTI VES After studying this chapter you should be able to discuss the factors that lead to financial crises explain how increases in adverse selection and moral hazard cause financial crises discuss the most recent financial crisis, the subprime financial crisis of 2007 2008, which led to a number of banking crises around the world and a decline in global economic activity PRE VI EW 196 Financial crises are major disruptions in financial markets characterized by sharp declines in asset prices and firm failures Beginning in August of 2007, defaults in the subprime mortgage market in the United States (for borrowers with weak credit records) sent a shudder through the financial markets, leading to the worst financial crisis since the Great Depression and to a number of banking crises throughout the world In Congressional testimony, Alan Greenspan, former Chairman of the U.S Federal Reserve, described the subprime financial crisis as a once-in-a-century credit tsunami Wall Street firms and commercial banks suffered hundreds of billions of dollars of losses Households and businesses found they had to pay higher rates on their borrowings and it was much harder to get credit Stock markets crashed all over the world, falling by over 40% from their peak Many financial firms, including commercial banks, investment banks, and insurance companies, went belly up Why did this financial crisis occur? Why have financial crises been so prevalent throughout history, and what insights they provide on the current crisis? Why are financial crises almost always followed by severe contractions in economic activity? We will examine these questions in this chapter by developing a framework to understand the dynamics of financial crises Building on Chapter 8, we make use of agency theory, the economic analysis of the effects of asymmetric information (adverse selection and moral hazard) on financial markets and the economy, to see why financial crises occur and why they have such devastating economic effects We will then apply the analysis to explain the course of events in a number of past financial crises throughout the world, including the most recent subprime crisis in the United States