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Summary of 5 pages for the course Macroeconomic Analysis at School of Oriental and African Studies (Coursework material)
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Reading 6 – Is the current financial distress caused by the subprime mortgage crisis a Minskymoment? Or is it the result of attempting to securitize illiquid noncommercial mortgage loans? –
Paul Davidson.
Minsky: there is financial instability for this to occur: preconditions that need to happen.
Financial crisis (2008) not a Minsky moment WHY? because such preconditions did not happen.
Instead: it was due to an insolvency problem: due to attempts to make liquid some assets that are
normally illiquid = due to attempts to securitize (make liquid) noncommercial mortgages (illiquid
assets)
Easy money policy = not sufficient so 2 solutions:
- large inflows of new capital into financial institutions
- remove nonperforming loans from their books.
ILLIQUIDITY OR INSOLVENCY?
Financial market in 2007-2008 in disarray
Minsky argued that: in a business cycle financing of new investments followed a specific path
from conservative funding operation (=hedge financing) to more fragile financing of new investment
projects (=speculative + Ponzi financing).
BUT: Papadimitriou + Wray said that according to Minsky:
“[o]ver the course of any expansion, the economy moves from hedge to speculative to Ponzi finance.
Minsky argued that this is a necessary precondition for an unstable financial system”.
Hence: if there is not such precondition (of moving from hedge to speculative to Ponzi financing =
moving to more fragile debt financing operation) then the financial crisis can’t be considered a
Minsky moment because the necessary precondition described has not happened.
The path to a Minsky moment = due to investor-borrowers tying themselves to debt contracts
according to which on specified dates they need to pay (=cash outflows) a certain amount for having
borrowed.
problem is that: these payments have to be done on specific dates indicated in the contracts =
this is a problem
WHY? because sometimes agents do not have enough cash inflows to meet those payments on
those dates even though in the long run the investment is expected to ultimately pay for itself + earn
a respectable profit.
When someone can’t meet its payments on the specified date = they have a LIQUIDITY problem.
Liquidity = needed to meet these payments.
When such phenomenon repeats itself + threatening the stability of the economy central banks
intervention = monetary policy: they issue new liquidity in the market so that economic agents
can easily (=not expensive to obtain it) obtain liquidity + solve their liquidity problems (temporarily
at least).
ARGUMENT: financial crisis = not a Minsky moment WHY? Because no “necessary precondition”
happened = no movement from hedge to speculative to Ponzi.
, Instead 2008 financial market problem: due to INSOLVENCY problems created by attempts of
financial market to transform illiquid noncommercial mortgages into liquid assets via
securitization!!!
When a systemic insolvency problem of financial institutions threatens the stability of the economy
easy monetary policy = not adequate solution. Instead need to increase the net worth of
insolvent entities.
If the net worth of these insolvent financial institutions is increased this will prevent insolvency
problems and thus instability.
1989 = S&L financial crisis: when over 700 S&Ls carried one too many nonperforming mortgage loans
on their books due to nonperforming financial assets
Solution to this insolvency problem (of over 700 S&Ls whose net worth was negative or not enough)
= government sponsored the agency “Resolution Trust Corporation” to:
- remove nonperforming loans from the balance sheets of insolvent S&Ls
- merge the remaining entity with another S&L that did not have any insolvency problem
clearly, the S&L crisis = could not have been solved simply by central banks flooding the
money market with liquidity
2008 financial crisis = due to the same reasons nonperforming financial assets like:
- nonperforming subprime mortgage loans in collateral debt obligations (CDOs)
- structured investment vehicles (SIVs)
- other exotic financial products
= in synthesis due to nonperforming debt obligations
Subprime nonperforming loan problems = insolvency problems for major banks with mortgage-
backed assets.
To sell (=get rid of) these nonperforming mortgage-backed assets (to unsuspecting public):
claimed that they could transform illiquid mortgages into liquid assets via securitization +
to securitize: mean to reassure buyers that they (major banks) would function as a “market
maker” in the market for these assets meaning:
- Market maker = institution guaranteeing holders of assets that the market for resale of their
assets will always be “well organized and orderly”
- If a market = well organized + orderly holders of assets believe they can always make a
fast exit strategy + liquidate their holdings (at a price that represents an orderly movement
from the market price)
EXPLAINING HOW A MINSKY MOMENT OCCURS DURING A BUSINESS CYCLE
Minsky’s financial fragility theory = classification of the financing of large real illiquid assets
(=durable investment goods/projects) in 3 categories Minsky’s taxonomy = hedge, speculative,
Ponzi.
Each finance operation: a buyer issues a security which includes some form of debt (bonds) that ties
the issuer/buyer via a contract to specific cash outflows on specified dates in the future.
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