2008 Financial Crisis

Greenspan lowered interest rates to 1% after dotcome bubble to keep

economy strong => cheap credit
o leveraging increase

CAUSES
subprime mortgages
o sells mortgages to investment bank (they can collect interest)
o securitization: pool lonas into sellable assets => off-loading risky
loans to others (or else loans get tied up for years)
greatest financial innovation
o cut into slices => safe, okay and risky => CDO
collateralized debt obligations (CDO)
o when homeowner pay => money will go to safe tier first
o to compensate for higher risk for the risky tier => high rate of
return (hedge funds want)
o to make safe safer => banks offer to insure it with credit default
swap => credit rating agencies set it AAA
o some homeowners default => sell at cheap prices => housing
prices fall (even lower than mortgage payment)
frozen credit markets
o investors borrowed billions of dollar to buy CDO, but cant pay
back
o even when fed inject money/lend money to banks (with bad CDO
as collateral)
buy they were worried => sat on the borrowed money
credit default swaps

BAILOUT? too big to fail

bailout and rescue packages
SHOULD
SHOULD NOT: the two moral hazards
o tax payers pay
socializing the costs while privatizing the profits
gained all the huge profits in the last 5 years
the banks were the culprits in the first palce
welfare for bondholders/investors/managers
o when the risk hits => still get money back
o X penalize for bad decisions
o ppl expect govt to bailout the private sector in the future
X concerned about risks
bubbles likely to form

THOSE INVOLVED
housing market
o income per capita increase => housing prices increase
 o expecationas + spculations => price increase result in even higher
price increase
=cyclical price increases (characteristic of asset bubble)
o move out of line with economic fundamentals like income
o although construction boom => demand growth outstripped suppl
growth
UK better housing market:
o started earlier => more sustained
o regional pattern uniform
US
o budget deficit => borrow heavily from surplus countries
policymakers/central bank
o regulation on efficiency and equity
o Fed inflating the bubble
set rate too low
cuz thought CPI low
but CPI underrepresented the housing market
o another reason for low rates:
influx of capital from china into US treasury securities
prices increase, yields decrease
(mortgage rates set according to 10-year treasury
securities)
financial regulation (central bank)
o Basel I and II (II = compliance)
o not independent enough: influenced by political influence,
authority, licensing rights
banks
o mergers between insurance companies and investment firms
megabanks, too big to fail
take high risks with federal guarantee
o lobby and campaign for deregulation
o invest in sub-prime
misjudged risks
false sense of security
o bonus schemes offered to CEOs etc.
directly related to revenue/returns/stock prices
take huge risks just for the returns
o exploit asymmetry of info
Ponzi schemes
investors X know exact risk/return of transaction
shadow banking
o investment banks, hedge funds
o Greenspan: core of subprime problem is misjudgements
o innovation: secondary mortgage markets of CDOs
buy mortgages from lenders
asymmetry of info
o sub-prime mortgages: borrower know more than lender about
true risks/return of transactions
o credit rating companies use own rating mechanisms => cannot tell
WHY BANKS FAIL
Alan Greenspan (champion of fre emkt) admitted was wrong
o made mistake in presuming self-interests (esp banks) capable of
protecting own shareholders and their equity
two banks failed: Lehma and HBOS (british retail)
why?
strayed away from core expertise
a. want to gain mkt share
b. focus on small, risky borrowers
c. property lending, mortgage
2. bad risk mgt
a. self-designed risk control systems
i. risk limits ignored
ii. some investments (in property/private equity)
excluded from internal stress tests
iii. hypothetical => milder recession
3. dependend on short-term funding in wholesale mkts
a. vulnerable to loss of investor confidence
b. reluctant to reveal value of assets => afraid will expose
wakness/damage reputation
4. false sense of security
a. thought can handle cycle, smart
b. cuz good econ. conditions, rising prop values
i. they had just been lucky