Financial Crisis of 2008 Flashcards
What event led the Federal Reserve to cut interest rates aggressively?
(as an indicator of the 2008 financial crisis)
The 2000-2002 tech bubble burst
stock $ went up dramatically (Internet) then down bc of overvaluation
This was aimed at stimulating the economy.
By how much did U.S. housing prices increase between 1997 and 2007?
(as an indicator of the 2008 financial crisis)
Tripled
due to the low interest rates caused by the tech bubble burst
This increase fueled a housing boom.
What encouraged excessive risk-taking in the mortgage and financial sectors?
Confidence in macroeconomic policies and rising home prices
This environment led to a disregard for potential risks (because of the confidence that property values would keep increasing, many people were willing to take out larger or riskier mortgages).
What replaced traditional mortgage lending during the financial crisis?
Securitization
Agencies like Fannie Mae and Freddie Mac play a big role here. They buy up a lot of mortgages from banks, bundle them, and then sell them as mortgage-backed securities (MBS) to investors. This helps the banks get the money back that they lent out, so they can lend to more people.
As the securitization market grew, even riskier mortgages were included
What types of loans were expanded into private-label securitization?
meaning that private companies also got into the securitization business
Subprime loans
These loans were given to risky borrowers.
What were lax underwriting standards (relaxed rules) during the mortgage lending period?
No-documentation loans (no need to know about borrower’s history etc), high loan-to-value ratios (means that the borrower is borrowing a large portion of the property’s value)
These standards led to risky loans that depended on continuously rising home prices to remain viable.
What are Collateralized Debt Obligations (CDOs)?
Risky subprime loans. A CDO is a type of financial product that is similar to mortgage-backed securities (MBS) but more complex and can include various types of debt, not just mortgages. These debts are packaged together and then divided into different layers, or tranches, each with its own level of risk and return.
CDOs were complex securities that misrepresented risk.
What assumption did credit rating agencies make when giving AAA ratings to senior tranches?
Assuming low default rates
This assumption proved to be overly optimistic.
What happened to the supposedly ‘super safe’ AAA top layers of CDOs when defaults increased?
when people stopped paying those risky mortgages like subprime loans (because house prices dropped)
The whole system fell apart
This was due to insufficient incoming mortgage payments. So, what looked like a safe investment turned out to be much riskier than anyone expected, and everyone who bought those CDOs lost money—causing the financial crisis.
What role did Credit Default Swaps (CDS) play in the crisis?
It’s a financial derivative that allows an investor to “swap” or offset their credit risk with another investor.
Acted as insurance against loan defaults
Companies like AIG sold CDS without sufficient capital.
If you own a bond or have given out a loan, you might worry about the borrower defaulting (not paying back). To protect yourself, you can buy a CDS from another company. By paying a periodic fee (like an insurance premium), you transfer the risk of default to the seller of the CDS.
The seller of the CDS agrees to compensate you if the borrower defaults. In exchange for this guarantee, they collect a fee from you periodically.
What created a fragile financial system during the crisis?
Financing long-term, illiquid assets (like MBS and CDOs) with short-term borrowing
This led to dependency on constant refinancing.
What occurred to housing prices in 2006?
They peaked and began to decline
This decline caused defaults on adjustable-rate mortgages as teaser rates reset higher.
What did homeowners with underwater loans do as housing prices fell?
underwater loans: they owe more than what the house is worth
Walked away from their loans
This action accelerated the financial crisis. Losses on MBS and CDOs surged as mortgage defaults rose.
What significant events occurred in September 2008?
- Fannie Mae and Freddie Mac were placed into conservatorship
- Lehman Brothers declared bankruptcy
- Merrill Lynch was sold to Bank of America.
- AIG required an $85 billion bailout due to CDS liabilities
These events marked the peak of the financial crisis.
- As both entities were at risk of failing, a person or entity is appointed to establish control and oversight over a the companies to put them in a stable and solvent condition.
- When this global financial services firm declared bankruptcy, it had profound effects worldwide, leading to a massive loss of confidence in the financial markets.
- insurance giant that also dealt in complex financial instruments, including CDS. The government had to help (bail them out)
What was a consequence of the failure of Lehman Brothers?
Panic in short-term lending markets, particularly commercial paper.
This led to a liquidity crunch for businesses.
What was the global impact of the financial crisis?
- Credit markets froze, impacting businesses and increasing unemployment.
- Sovereign debt (money that a country’s government has borrowed) crises, particularly in Greece, as they had to borrow a lot for high cost of bailouts.
The crisis also affected European banks (also needed bailouts).
What rescue plan did the U.S. government introduce?
$700 billion rescue plan
This plan aimed to
* purchase toxic assets from banks and other institutions, thus providing them with much-needed cash and helping to clear their balance sheets
* stabilize financial markets.
What was the act (2010) that introduced reforms to prevent future crises?
Dodd-Frank Act (2010)
What did the Dodd-Frank Act (2010) introduce?
Reforms to prevent future crises, including
* stricter capital requirements for banks
* annual stress tests
* the Volcker Rule (limiting proprietary trading).
