Further Reading: The Global Financial Crisis

Question 1

What are Coffee’s Three Preconditions for Financial Crisis? (GMR)

Answer 1

1. Gatekeeper Failure.
2. Managerial Failure.
3. Regulatory Failure.

J.C. Coffee Jr. – What Went Wrong? An Inquiry into the Causes of the 2008 Global Financial Crisis (1-3)

Question 2

What were the Acute Preconditions that primed the GFC? (MIC-PS-FI)

Answer 2

In consequential order:

1. US Macroeconomic Imbalances;
2. Very low Interest Rates;
3. Very cheap Credit;
4. Increased investor Profit-Seeking; and
5. Increased Financial Innovation.

Question 3

What enabled Investment Banks to succeed with Securitization?

Answer 3

1. Their ability to sell well-rated securitized assets to investors.
2. Their ability to induce or coerce ratings agencies into rating said assets favorably.

J.C. Coffee Jr. – What Went Wrong? An Inquiry into the Causes of the 2008 Global Financial Crisis (4)

Question 4

What type of Asset Bubble was the GFC, and why?

Answer 4

1. Supply-Side Asset Bubble.
2. The bubble was fueld by originators’ drive for profits and disinterest in performing due diligence.

J.C. Coffee Jr. – What Went Wrong? An Inquiry into the Causes of the 2008 Global Financial Crisis (5)

Question 5

What were the Chief Drawbacks of the Asset-Backed Securitization Strategy for Investment Banks? (DL-DD)

Answer 5

1. Lack of Diversification.
2. Extreme Leverage levels.
3. Disincentivization of Due Diligence.

J.C. Coffee Jr. – What Went Wrong? An Inquiry into the Causes of the 2008 Global Financial Crisis (3-4, 6)

Question 6

Credit Rating Agencies are an example of Gatekeepers. What are the systemic reasons that underlie their falure? (PP-CL-N-CI)

Answer 6

1. Privileged Power gained from a regulatory licence.
2. Lack of Competition.
3. Lack of real Liability.
4. Non-Requirement to verify information provided by lenders.
5. Conflict of Interest that arises from getting paid by the lenders they rate.

J.C. Coffee Jr. – What Went Wrong? An Inquiry into the Causes of the 2008 Global Financial Crisis (7-8)

Question 7

What were the Acutre Reasons that underlaid the Failure of Credit Rating Agencies?

Answer 7

1. Structured finance being a lead revenue source, as it was controlled by a few big banks.
2. New competition, i.e. Fitch, which motivated incumbents to release unduly high ratings.

J.C. Coffee Jr. – What Went Wrong? An Inquiry into the Causes of the 2008 Global Financial Crisis (8-9)

Question 8

What were the core shortcomings of the SEC’s CSE (Consolidated Supervised Entities) Program? (CLMP)

Answer 8

1. Lower Net Capital Standard.
2. Limitless Leverage.
3. Monitoring Inabilities.
4. Power Insufficiencies.

J.C. Coffee Jr. – What Went Wrong? An Inquiry into the Causes of the 2008 Global Financial Crisis (13-14)

Question 9

How did Inter-Bank Competition impact the real-estate asset bubble?

Answer 9

The, “competitive pressure,” lead to reckless expansion.

J.C. Coffee Jr. – What Went Wrong? An Inquiry into the Causes of the 2008 Global Financial Crisis (16)

Question 10

According to Acharya and Richardson, what was the Central Cause of the GFC?

Answer 10

“[B]anks’ efforts to circumvent… capital-adequacy requirements.”

V. Acharya & M. Richardson – Causes of the Financial Crisis (197)

Question 11

What is the Minimum Capital Adequacy Requirement under the Basel Accords?

Answer 11

8%.

Question 12

Why is Maintaining a Capital Buffer Costly for a Bank? (CER)

Answer 12

1. The Capital is static.
2. Taking on Equity dilutes shareholding power.
3. Using Retained earnings stifles future growth.

V. Acharya & M. Richardson – Causes of the Financial Crisis (198)

Question 13

Under the Basel Accords, which assets can comprise a Bank’s Capital Buffer?

Answer 13

1. Equity.
2. Retained Earnings.

Question 14

How has Securitization evolved the Full Intermediation model?

Answer 14

By enabling self-underwriting, securitization allowed banks to intermediate between both depositors and investors and borrowers.

V. Acharya & M. Richardson – Causes of the Financial Crisis (199)

Question 15

Who were the Primary Purchasers of Asset-Backed Securities, and what was their Goal?

Answer 15

Banks themselves, having the goal of circumventing capital adequacy requirements.

V. Acharya & M. Richardson – Causes of the Financial Crisis (200)

Question 16

How did Banks go about purchasing asset-backed securities?

Answer 16

Through the use of off-balance-sheet-vehicles (OBSVs), e.g. special investment vehicles (SIVs).

V. Acharya & M. Richardson – Causes of the Financial Crisis (201)

Question 17

How did OBSVs enable Investment Banks to become their own Underwriters?

Answer 17

The SIVs would utilize their asset-backed securities to issue asset-backed commerical paper, which the investment bank would then underwrite.

V. Acharya & M. Richardson – Causes of the Financial Crisis (201)

Question 18

What was the Effect of Investment Banks effectively becoming their Own Underwriters?

Answer 18

1. Reinternalization of the ABSs’ original risk.
2. Legitimization of the ABSs in the eyes of ratings agencies.

V. Acharya & M. Richardson – Causes of the Financial Crisis (201)

Question 19

Why, amongst others, were subprime mortgages particularly the asset of choice for CDO origination?

Answer 19

1. High risk premium.
2. Capital adequacy requirements circumvention.

V. Acharya & M. Richardson – Causes of the Financial Crisis (204-205)

Question 20

Upon what Theoretical Foundation was the Pre-2008 Regulatory Infrastructure predicated upon?

Answer 20

The Efficient Market Hypothesis, alongside its corollaries and regulatory implications.

James Crotty – Structural Causes of the Global Financial Crisis – A Critical Assessment of the ‘New Financial Architecture’ (564)

Question 21

From a Corporate Governance perspective, which issues does the GFC emblemize? (ST-IIC)

Answer 21

1. Short-Termism.
2. Perversion of Incentives.
3. Regulatory Impotence.
4. Regulatory Capture.

Question 22

From the perspective of pricing, how are CDOs problematic?

Answer 22

Their inherent complexity and opacity makes them virtually impossible to accurately price.

James Crotty – Structural Causes of the Global Financial Crisis – A Critical Assessment of the ‘New Financial Architecture’ (566-567)

Question 23

According to Crotty, Why did Banks hold on to MBSs and CDOs? (PARLDF)

Answer 23

1. High-Risk Premium.
2. Assets just piled up.
3. Reduce CARs.
4. Legitimize the assets.
5. Downplay moral hazard.
6. MBSs were CDO Fodder.

James Crotty – Structural Causes of the Global Financial Crisis – A Critical Assessment of the ‘New Financial Architecture’ (568-569)

Question 24

According to Crotty, what are the Flaws of Bank Self-Evaluation of Risk, i.e. Value at Risk (VAR)? (OHAA)

Answer 24

1. Off-the-books assets were unaccounted for.
2. Historical data is ≠ current risk levels.
3. Asset-price correlation matrices ≠ real asset prices during crises.
4. Abnoraml distribution of security prices.

James Crotty – Structural Causes of the Global Financial Crisis – A Critical Assessment of the ‘New Financial Architecture’ (571-572)

Question 25

How did Globalization exacerbate the Global Financial Crisis?

Answer 25

It created worldwide in-roads for financial contagion to spread.

James Crotty – Structural Causes of the Global Financial Crisis – A Critical Assessment of the ‘New Financial Architecture’ (572-573)

Question 26

To Summarize, what were the Causes of the Global Financial Crisis? (URCC)

Answer 26

1. Lax Underwriting Standards.
2. Poor Regulatory Performance.
3. Complexification of securitized products.
4. Collateralization using increasingly poor assets.

IMF, “Containing Systemic Risks and Restoring Financial Soundness” (2008) Global Financial Stability Report (xiii– xiv).