2008 Financial Crisis

2008 Financial Crisis

1. Deregulation 1980s-
2. Collapse in housing market

The Great American Housing Bubble

• Low interest rates through 200s, and large capital inflows from other countries, especially China created a housing boom.
• As home prices rose, more people started buying houses expecting prices to rise further, fueling the bubbe.

Shadow Banking

• Financial institutions that do not accept deposits but borrow short term assets and buy longer-term assests. Investment banks, hedge funds are part of shadow banking.
• Do not accept deposits, and they are not subject to strong regulations, not FDIC insured.
• But they are subject to similar :bank runs”
• After 1980, steady rise of shadow banking
• Investment banks, hedge funds, special investment vehicles

Role of Shadow banking

• Perverse incentives: Investment banks were repacking these loans and selling them and charging a fee.
• Banks began to rely more on fee income from securitization. Higher the number of loans processed greater the income, and fees did not have to be returned if the securities they sell face losses later.
• Most traders and investment bankers knew that the complex securities they were selling were highly risky
• Credit Default Swaps to insure themselves if the value of CDOS falls. CDS were insured through institutions like AIG. Investment banks could insure CDOs they did not even own!

Credit Rating Agencies

• The Big Three: Moody’s Standard and Poor and Fitch make 95% of market share
• Play a very important role in financial markets. They provide analysis on the risk associated with different financial assets
• Credit rating agencies gave AAA ratings to 80% of the tranches, signifying very low risk.
• Perverse incentives: Credit rating agencies were being paid by the investment banks whose products they rate.