Lecture Notes: 2008 Financial Crisis - Issues and Lessons

Introduction

• Finance often overlooks historical lessons.
• History offers guidance amid changing financial rules, products, and services.

Early 2000s Financial Context

• Investors seek safe returns post-tech bubble.
• Mortgages become attractive due to regular interest payments and real estate as collateral.

Rise of Mortgage-Backed Securities (MBS)

• Investment banks bundle mortgages into MBS for investors.
• Government entities (Fannie Mae and Freddie Mac) support this strategy.

Mortgage Lending Boom

• Lenders face high demand for mortgage securities.
• Endless demand leads to rapid mortgage lending and home buying.

Credit Default Swaps and Insurance

• Insurers sell credit default swaps as hedges against defaults.
• Excessive policies sold per mortgage without sufficient coverage.

Risky Loans and Subprime Mortgages

• Lenders lose incentive to avoid risky borrowers due to mortgage resale.
• High-risk (subprime) borrowers given loans, often under predatory conditions.

Investment Bank Practices

• Investment banks sell Collateralized Debt Obligations (CDOs) filled with risky assets.
• Complex derivatives like synthetic CDOs increase speculative risks.

Role of Rating Agencies

• Fail to accurately assess risk, granting high ratings to toxic assets.

Subprime Borrower Defaults

• By October 2007, significant defaults and foreclosures occur.
• Real estate market becomes saturated with foreclosed homes.

2008 Financial Crisis

• Housing prices drop sharply in 2008.
• Domino effect triggers the financial crisis.
• Massive defaults on CDOs despite high safety ratings.
• Lehman Brothers declares bankruptcy on September 15, 2008.

Global Impact

• Global economic slowdown and loss of American jobs.
• Financial institutions receive government bailouts.

Aftermath and Regulation

• Dodd-Frank Act introduced in 2010 to regulate financial practices.
• Lessons highlight the importance of preventing greed from overriding common sense.