Overview
This lecture examines the causes of the 2008 Financial Crisis in the United States, the government response, and key lessons about incentives and regulation.
Background on Mortgages and Lending
- Mortgages are loans for buying homes, repaid monthly with interest; if the borrower defaults, the lender can seize the house.
- Traditionally, only borrowers with good credit or steady jobs could get mortgages.
- In the 2000s, lenders loosened standards, granting mortgages to people with poor credit (sub-prime loans).
Securitization and Financial Innovation
- Banks sold mortgages to third parties, who bundled thousands into mortgage-backed securities (MBS).
- Investors bought MBS for higher returns than government bonds, believing they were low-risk.
- Credit rating agencies gave MBS and collateralized debt obligations (CDOs) high (AAA) ratings, despite rising risks.
- Lenders issued more sub-prime mortgages to create more MBS and CDOs, some using predatory practices.
The Housing Bubble and Its Collapse
- Housing prices soared due to easy credit and high demand, creating a bubble.
- Many borrowers defaulted as they couldn't afford payments, causing home prices to fall and more defaults.
- Financial institutions and investors lost money on MBS and CDOs as defaults increased.
Complex Financial Products and Systemic Risk
- Financial institutions used derivatives like credit default swaps (CDS) as insurance on MBS, often without sufficient capital to cover losses.
- The interconnected web of risky assets led to uncertainty and panic when defaults rose.
- Major financial institutions failed, markets froze, and a severe recession followed.
Government Response and Reforms
- The Federal Reserve provided emergency loans to stabilize banks.
- The Troubled Assets Relief Program (TARP) allocated $700 billion (spent $250 billion) to bail out banks and others.
- Stress tests were conducted on large banks to restore confidence.
- A stimulus package in 2009 injected $800 billion into the economy.
- The 2010 Dodd-Frank Act increased financial regulation, transparency, and consumer protection.
Lessons and Causes
- Perverse incentives led to risky lending, as brokers were rewarded for issuing loans regardless of risk.
- Moral hazard occurred when banks expected bailouts and took extra risks.
- "Too big to fail" institutions took risks expecting government support.
- Systemic failure was due to lax regulation, excessive risk-taking by institutions and individuals, and human errors and unethical behavior.
Key Terms & Definitions
- Mortgage — A loan to buy a home, using the home as collateral.
- Default — Failure to repay a loan.
- Mortgage-backed security (MBS) — An investment made from bundled home loans.
- Sub-prime mortgage — Loans given to borrowers with poor credit.
- Collateralized debt obligation (CDO) — A security made from a pool of debt, including risky loans.
- Credit default swap (CDS) — Financial insurance on debt products like MBS.
- Perverse incentive — A policy that unintentionally encourages harmful behavior.
- Moral hazard — Taking more risks when others bear the consequences.
- Too big to fail — Institutions so large their failure would harm the economy.
- Dodd-Frank Act — 2010 law reforming financial regulation and increasing oversight.
Action Items / Next Steps
- Review additional resources linked in the lecture's video description.
- Read about the Dodd-Frank Act and its effects on financial regulation.
- Reflect on how incentives and risk management affect financial stability.