Week 20 - Short-term fluctuations: Intro Pt2 Flashcards
What fueled the rising demand for bundled mortgage securities before the crisis?
Investors sought high returns, leading financial institutions to create more mortgage-backed securities (MBS), including those based on risky subprime mortgages.
How did banks respond to the increased demand for mortgage-backed securities?
Banks relaxed lending criteria, offering subprime mortgages to borrowers with poor credit histories and little documentation.
What is a subprime mortgage?
A mortgage that does not meet the quality standards of traditional (prime) mortgages, often given to borrowers with low credit scores or unstable incomes.
What happened in 2006 that worsened the subprime crisis?
A wave of subprime mortgage foreclosures increased the supply of homes on the market, driving down housing prices.
How did falling house prices contribute to the financial crisis?
As home values dropped, more borrowers went underwater, leading to more defaults and foreclosures, worsening the housing glut.
Why did banks and financial firms suffer large losses from mortgage-backed securities?
Many held securities backed by subprime loans, and as defaults surged, these securities lost value, causing massive financial losses.
How did the subprime crisis act as a trigger for the broader financial crisis?
The collapse of mortgage-backed securities caused bank failures, credit market freezes, and a loss of investor confidence, leading to the 2008 global financial crisis.
What is a financial panic?
A situation where providers of short-term credit (such as depositors or investors) lose confidence in borrowers (such as banks) and rapidly withdraw their funds.
How did the falling house prices contribute to the financial panic?
As home prices dropped, mortgage-related securities lost value, leading to large financial losses for banks, investment firms, and credit insurers.
Why was the financial system particularly vulnerable during the crisis?
Many institutions were heavily invested in complex mortgage-backed securities, and when their value plummeted, no one knew how big the losses would be or which firms would fail.
How did investors’ uncertainty worsen the financial panic?
Because mortgage-backed securities were complex and risk monitoring was poor, investors and firms were unsure where the biggest losses would occur, leading to widespread fear and rapid withdrawal of funds.
What happened when financial firms and investors lost confidence in certain institutions?
Runs began, as investors and lenders pulled funding from firms they thought were vulnerable to losses.
How did these financial runs affect the broader economy?
The runs put massive pressure on key financial firms and disrupted important financial markets, making it harder for businesses and consumers to access credit.
What lesson from the Great Depression applies to financial panics?
In a financial panic, the central bank should lend freely to prevent widespread failures and restore confidence in the financial system.
How can monetary policy help during a financial crisis?
A highly accommodative monetary policy (such as lowering interest rates and injecting liquidity) helps support economic recovery and employment.
What is the difference between triggers and vulnerabilities in a financial crisis?
Triggers are immediate events that set off the crisis (e.g., falling house prices), while vulnerabilities are underlying weaknesses that make the system fragile (e.g., excessive debt and poor risk management).
What were the key triggers of the 2007-2009 financial crisis?
The decline in house prices and the resulting mortgage losses, especially in subprime loans.
How did vulnerabilities in the financial system amplify the crisis?
Many borrowers and lenders had taken on excessive debt (leverage), making them more sensitive to shocks in the market.
How did banks and financial institutions contribute to the crisis?
They failed to properly monitor and manage risks, such as exposure to subprime mortgages and reliance on short-term funding.
Why was short-term funding a major risk for financial firms?
Many firms relied on short-term borrowing (e.g., commercial paper) to fund long-term investments, making them vulnerable to sudden liquidity shortages.
How did exotic financial instruments contribute to the crisis?
Complex financial products (e.g., mortgage-backed securities (MBS) and credit default swaps (CDS)) concentrated risk, making losses more severe when the housing market collapsed.
How did falling house prices contribute to the financial crisis?
Falling house prices reduced homeowners’ equity, making it harder for them to refinance or sell their homes, leading to widespread mortgage defaults.
What happened to mortgages as home values declined?
Many mortgages, especially subprime ones, became worthless because borrowers owed more than their homes were worth and defaulted.
What financial assets suffered major losses during the crisis?
The value of mortgage-backed securities (MBSs) and collateralised debt obligations (CDOs) plummeted as mortgage defaults surged.
Why did banks suffer heavy losses in the crisis?
Banks had invested heavily in CDOs, which were backed by risky mortgages. As these assets lost value, banks faced large financial losses.
Why did banks stop lending to each other during the crisis?
Since many banks held toxic assets, there was a presumption that all banks were high-risk borrowers, leading to a freeze in interbank lending.
What was the broader economic impact of the banking crisis?
As banks stopped lending to businesses and consumers, economic activity slowed, leading to a sharp contraction in output and a severe recession.
How did bank mergers since the 1980s contribute to financial instability?
Mergers created larger banks, increasing their market power and systemic importance, making the financial system more vulnerable to crises.
How did deregulation affect the financial sector?
Deregulation removed restrictions on banking activities, allowing banks to take on more risk and expand into complex financial products like derivatives and mortgage-backed securities.
What does “too big to fail” mean?
It refers to financial institutions that are so large and interconnected that their failure would cause widespread economic harm, leading governments to intervene and prevent collapse.
How did the “too big to fail” mindset encourage excessive risk-taking?
Banks took on higher risks, assuming the government would bail them out if their bets failed, reducing their incentive for careful financial management.
How did governments respond to the financial crisis caused by failing banks?
Governments bailed out major banks using taxpayer money to prevent a total financial collapse and restore confidence in the banking system.
How did globalisation contribute to growing inequality?
Globalisation created uneven distribution of gains and losses, with the U.S. experiencing debt-financed consumption and countries like Germany focusing on increased savings.
How did global savings contribute to the U.S. housing boom?
Savings from other parts of the world, particularly from countries with trade surpluses, flowed into the U.S., contributing to the housing boom and inflating asset prices.
How did investment banks and hedge funds increase financial risk?
These institutions accumulated large amounts of capital, using leverage to take on more risk and multiply returns, which amplified the potential for massive losses during the crisis.
Which European countries experienced significant housing price increases during the housing boom?
Ireland, Spain, and Britain saw huge increases in house prices leading up to the financial crisis.
Did mortgage-backed securities (MBSs) and collateralised debt obligations (CDOs) play a role in the European housing bubbles?
No, MBSs and CDOs did not play a role in the European housing bubbles, as they were more prevalent in the U.S. market.
What happened when the U.S. housing bubble burst?
The burst of the U.S. housing bubble contributed to the collapse of real estate bubbles in Europe, as global markets were interconnected.
How did banks in Europe respond to the crisis?
Banks became more cautious in lending, tightening credit in response to rising defaults and the collapse of property values.
What happened as house prices fell in Europe?
As house prices declined, households started defaulting on their mortgages, and property developers defaulted on their loans, leading to banking crises in several European countries.
How many jobs were lost in the industrialised world during the financial crisis?
14 million jobs were lost in the industrialised world due to the economic downturn.
How did the crisis affect household wealth?
Households saw their wealth diminished due to falling house prices, job losses, and a decline in financial assets.
What is the vicious circle of a recessionary spiral?
As income falls, banks increase lending standards, leading to less credit, which causes lower aggregate demand and further employment losses, worsening the recession.
How does less credit contribute to the recessionary spiral?
When banks tighten lending, businesses and consumers have less access to credit, which reduces spending and investment, further slowing the economy.
How were both the Great Depression and the Great Recession preceded?
Both downturns were preceded by periods of economic strength and growth, which created an illusion of stability before the crises hit.
What were some key differences between the Great Depression and the Great Recession?
Social safety nets (such as unemployment insurance and welfare) were in place during the Great Recession.
Government regulations existed to protect ordinary citizens and the financial system.
Activist macroeconomic policy, including fiscal stimulus and monetary intervention, was used during the Great Recession.
How did government programs help during the Great Recession?
Government programs, including bailouts, stimulus packages, and monetary interventions, helped prevent the downturn from becoming as severe as the Great Depression.
Why was the Great Depression more severe than the Great Recession?
The lack of a social safety net, limited government intervention, and inadequate regulations during the Great Depression made it deeper and longer, while the Great Recession benefited from stronger policy responses.
What is the Dodd-Frank Wall Street Reform and Consumer Protection Act?
A U.S. law passed to prevent another financial crisis, including measures like:
Minimum criteria for lending to prospective homeowners.
Commercial banks being exposed to a limited amount of mortgage default risk.
Restrictions on credit default swaps (CDSs) to reduce excessive risk-taking.
What regulatory changes were introduced in Europe after the financial crisis?
Creation of pan-European institutions to coordinate financial sector regulation.
Establishment of a systemic risk board to monitor and mitigate macroeconomic risks in the financial system.
Limits on executive compensation in the financial sector.
Stricter regulation of derivative markets to reduce systemic risk.
New rules for rating agencies to improve transparency and accountability.
How did the Dodd-Frank Act help reduce mortgage risk?
It required minimum lending standards, making it harder for lenders to offer risky subprime mortgages and reducing the likelihood of widespread defaults.
What role did the systemic risk board play in Europe?
It was established to spot and address macroeconomic risks that could destabilise the financial system, helping to prevent future crises.
What are some criticisms of current financial regulations?
The regulations create significant costs for financial firms, potentially slowing down business and job creation.
The legislation is often too complex, making it difficult to enforce effectively.
Regulations have been “watered down” due to lobbying efforts by financial firms.
How can finance be redirected to increase overall societal benefits?
Limit speculative activities of banks to reduce excessive risk-taking.
Ban overly complex or risky products that can destabilize the financial system.
Impose a modest tax on financial transactions (the Tobin tax) to discourage excessive short-term speculation.
What is the Tobin tax and how might it help?
The Tobin tax is a modest tax on financial transactions, particularly on currency trades, designed to reduce excessive speculation and stabilize financial markets while raising revenue for public goods.
Why might limiting speculative activities of banks help improve society’s welfare?
Reducing speculation can lead to more stable financial markets, lower risks of bubbles, and more resources directed toward productive investments that benefit society rather than speculative profits.
