Overview
This lecture explains the causes, events, and consequences of the 2008 financial crisis, emphasizing the roles of deregulation, risky mortgage lending, and flawed financial products.
Roots of the Crisis
- After the 2000 dotcom crash, interest rates were cut to 1.75%, spurring borrowing and investment.
- US policies promoted homeownership, pushing lenders to issue more mortgages, including to risky borrowers.
- Lending standards eroded, leading to "subprime" (bad/no credit) and "NINJA" (no income, job, assets) loans.
- A shadow banking system developed, taking risks outside traditional regulations.
- In 2004, the SEC allowed investment banks to leverage beyond previous limits, increasing risk.
Financial Engineering and Risk
- Banks bundled risky loans into mortgage-backed securities (MBS) and collateralized debt obligations (CDOs).
- Credit rating agencies, paid by banks, gave AAA ratings to toxic securities due to flawed models.
- Investors worldwide bought these assets, believing they were safe due to high ratings.
- The logic held that spreading risk would make it disappear, but it instead obscured underlying problems.
Collapse of the Housing Market
- By 2006, warning signs appeared: the yield curve inverted, signaling recession risk.
- Home prices peaked, then fell in 2007, triggering a wave of mortgage defaults and foreclosures.
- Subprime loans made up a small percentage of all loans but caused most foreclosures.
- Financial firms holding MBS and CDOs suffered huge losses, leading to failures of firms like Bear Stearns.
The Financial Panic of 2008
- In September 2008, Lehman Brothers filed for bankruptcy; AIG was bailed out by the Fed.
- Panic spread as credit markets froze and banks feared lending to each other.
- The US government created a $700 billion bailout (TARP) to stabilize banks.
- Stock markets crashed worldwide, unemployment soared, and global trade contracted sharply.
Lessons and Regulatory Response
- Key failures included deregulation, inadequate risk assessment, and reliance on flawed ratings.
- The Fed kept interest rates too low for too long, fueling asset bubbles.
- The Dodd-Frank Act (2010) imposed major financial reforms, stricter oversight, and created consumer protections.
- International rules (Basel III) required banks to hold more capital to reduce risk.
- Recovery was slow; public anger over bailouts and moral hazard persisted.
Key Terms & Definitions
- Subprime Mortgage — A loan given to borrowers with poor or limited credit histories.
- Mortgage-Backed Security (MBS) — An investment product made from bundled home loans.
- Collateralized Debt Obligation (CDO) — A complex financial product consisting of pooled loans sold to investors.
- Shadow Banking System — Non-bank financial institutions operating outside regular banking regulations.
- Yield Curve Inversion — When short-term interest rates exceed long-term rates, often a recession indicator.
- TARP (Troubled Asset Relief Program) — US government’s $700 billion bank bailout.
- Dodd-Frank Act — 2010 law reforming financial regulation to prevent future crises.
- Moral Hazard — Risk that security from consequences encourages reckless behavior.
Action Items / Next Steps
- Review details of subprime lending and financial products for exam.
- Read about the Dodd-Frank Act and Basel III reforms.