12.3 Financial Panics #Notebook

12.3 Financial Panics #Notebook

Financial panic occurs when leveraged financial intermediaries and investors must sell assets quickly to meet lenders’ calls, or ask for repayment. It happens when interest rates increase or when the value of collateral pledged sinks.

Calls may all come due to some bursting of an asset bubble, often triggered by an obvious shock, like a natural catastrophe or a huge failure.

During a panic, almost everybody must sell, so prices plummet, triggering more selling.

Panics often cause rapid deleveraging during a credit crunch....

Usually, highly leveraged investors cannot sell assets quickly enough, to “meet the call” and repay their loans. Banks and lenders begin to suffer defaults. As asymmetric information and uncertainty reign supreme, lenders restrict credit.

A negative bubble

When high interest rates, tight credit and expectations of lower asset prices in the future, asset values trend to go downward, even below the values indicated by underlying economic fundamentals. 

In New York in 1764, interest rates spiked from 6% to 12% and expected revenues from land plummeted by about 25%. What happened?

Obviously, it must drop because it was more expensive to borrow money. Thus, the total cost of real estate ownership will increase. In addition, the expectation of yield revenues from the land was lower.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.