Week 20 - Short-term fluctuations: Intro Pt2

Question 1

What fueled the rising demand for bundled mortgage securities before the crisis?

Answer 1

Investors sought high returns, leading financial institutions to create more mortgage-backed securities (MBS), including those based on risky subprime mortgages.

Question 2

How did banks respond to the increased demand for mortgage-backed securities?

Answer 2

Banks relaxed lending criteria, offering subprime mortgages to borrowers with poor credit histories and little documentation.

Question 3

What is a subprime mortgage?

Answer 3

A mortgage that does not meet the quality standards of traditional (prime) mortgages, often given to borrowers with low credit scores or unstable incomes.

Question 4

What happened in 2006 that worsened the subprime crisis?

Answer 4

A wave of subprime mortgage foreclosures increased the supply of homes on the market, driving down housing prices.

Question 5

How did falling house prices contribute to the financial crisis?

Answer 5

As home values dropped, more borrowers went underwater, leading to more defaults and foreclosures, worsening the housing glut.

Question 6

Why did banks and financial firms suffer large losses from mortgage-backed securities?

Answer 6

Many held securities backed by subprime loans, and as defaults surged, these securities lost value, causing massive financial losses.

Question 7

How did the subprime crisis act as a trigger for the broader financial crisis?

Answer 7

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.

Question 8

What is a financial panic?

Answer 8

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.

Question 9

How did the falling house prices contribute to the financial panic?

Answer 9

As home prices dropped, mortgage-related securities lost value, leading to large financial losses for banks, investment firms, and credit insurers.

Question 10

Why was the financial system particularly vulnerable during the crisis?

Answer 10

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.

Question 11

How did investors’ uncertainty worsen the financial panic?

Answer 11

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.

Question 12

What happened when financial firms and investors lost confidence in certain institutions?

Answer 12

Runs began, as investors and lenders pulled funding from firms they thought were vulnerable to losses.

Question 13

How did these financial runs affect the broader economy?

Answer 13

The runs put massive pressure on key financial firms and disrupted important financial markets, making it harder for businesses and consumers to access credit.

Question 14

What lesson from the Great Depression applies to financial panics?

Answer 14

In a financial panic, the central bank should lend freely to prevent widespread failures and restore confidence in the financial system.

Question 15

How can monetary policy help during a financial crisis?

Answer 15

A highly accommodative monetary policy (such as lowering interest rates and injecting liquidity) helps support economic recovery and employment.

Question 16

What is the difference between triggers and vulnerabilities in a financial crisis?

Answer 16

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).

Question 17

What were the key triggers of the 2007-2009 financial crisis?

Answer 17

The decline in house prices and the resulting mortgage losses, especially in subprime loans.

Question 18

How did vulnerabilities in the financial system amplify the crisis?

Answer 18

Many borrowers and lenders had taken on excessive debt (leverage), making them more sensitive to shocks in the market.

Question 19

How did banks and financial institutions contribute to the crisis?

Answer 19

They failed to properly monitor and manage risks, such as exposure to subprime mortgages and reliance on short-term funding.

Question 20

Why was short-term funding a major risk for financial firms?

Answer 20

Many firms relied on short-term borrowing (e.g., commercial paper) to fund long-term investments, making them vulnerable to sudden liquidity shortages.

Question 21

How did exotic financial instruments contribute to the crisis?

Answer 21

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.

Question 22

How did falling house prices contribute to the financial crisis?

Answer 22

Falling house prices reduced homeowners’ equity, making it harder for them to refinance or sell their homes, leading to widespread mortgage defaults.

Question 23

What happened to mortgages as home values declined?

Answer 23

Many mortgages, especially subprime ones, became worthless because borrowers owed more than their homes were worth and defaulted.

Question 24

What financial assets suffered major losses during the crisis?

Answer 24

The value of mortgage-backed securities (MBSs) and collateralised debt obligations (CDOs) plummeted as mortgage defaults surged.

Question 25

Why did banks suffer heavy losses in the crisis?

Answer 25

Banks had invested heavily in CDOs, which were backed by risky mortgages. As these assets lost value, banks faced large financial losses.

Question 26

Why did banks stop lending to each other during the crisis?

Answer 26

Since many banks held toxic assets, there was a presumption that all banks were high-risk borrowers, leading to a freeze in interbank lending.

Question 27

What was the broader economic impact of the banking crisis?

Answer 27

As banks stopped lending to businesses and consumers, economic activity slowed, leading to a sharp contraction in output and a severe recession.

Question 28

How did bank mergers since the 1980s contribute to financial instability?

Answer 28

Mergers created larger banks, increasing their market power and systemic importance, making the financial system more vulnerable to crises.

Question 29

How did deregulation affect the financial sector?

Answer 29

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.

Question 30

What does “too big to fail” mean?

Answer 30

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.

Question 31

How did the “too big to fail” mindset encourage excessive risk-taking?

Answer 31

Banks took on higher risks, assuming the government would bail them out if their bets failed, reducing their incentive for careful financial management.

Question 32

How did governments respond to the financial crisis caused by failing banks?

Answer 32

Governments bailed out major banks using taxpayer money to prevent a total financial collapse and restore confidence in the banking system.

Question 33

How did globalisation contribute to growing inequality?

Answer 33

Globalisation created uneven distribution of gains and losses, with the U.S. experiencing debt-financed consumption and countries like Germany focusing on increased savings.

Question 34

How did global savings contribute to the U.S. housing boom?

Answer 34

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.

Question 35

How did investment banks and hedge funds increase financial risk?

Answer 35

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.

Question 36

Which European countries experienced significant housing price increases during the housing boom?

Answer 36

Ireland, Spain, and Britain saw huge increases in house prices leading up to the financial crisis.

Question 37

Did mortgage-backed securities (MBSs) and collateralised debt obligations (CDOs) play a role in the European housing bubbles?

Answer 37

No, MBSs and CDOs did not play a role in the European housing bubbles, as they were more prevalent in the U.S. market.

Question 38

What happened when the U.S. housing bubble burst?

Answer 38

The burst of the U.S. housing bubble contributed to the collapse of real estate bubbles in Europe, as global markets were interconnected.

Question 39

How did banks in Europe respond to the crisis?

Answer 39

Banks became more cautious in lending, tightening credit in response to rising defaults and the collapse of property values.

Question 40

What happened as house prices fell in Europe?

Answer 40

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.

Question 41

How many jobs were lost in the industrialised world during the financial crisis?

Answer 41

14 million jobs were lost in the industrialised world due to the economic downturn.

Question 42

How did the crisis affect household wealth?

Answer 42

Households saw their wealth diminished due to falling house prices, job losses, and a decline in financial assets.

Question 43

What is the vicious circle of a recessionary spiral?

Answer 43

As income falls, banks increase lending standards, leading to less credit, which causes lower aggregate demand and further employment losses, worsening the recession.

Question 44

How does less credit contribute to the recessionary spiral?

Answer 44

When banks tighten lending, businesses and consumers have less access to credit, which reduces spending and investment, further slowing the economy.

Question 45

How were both the Great Depression and the Great Recession preceded?

Answer 45

Both downturns were preceded by periods of economic strength and growth, which created an illusion of stability before the crises hit.

Question 46

What were some key differences between the Great Depression and the Great Recession?

Answer 46

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.

Question 47

How did government programs help during the Great Recession?

Answer 47

Government programs, including bailouts, stimulus packages, and monetary interventions, helped prevent the downturn from becoming as severe as the Great Depression.

Question 48

Why was the Great Depression more severe than the Great Recession?

Answer 48

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.

Question 49

What is the Dodd-Frank Wall Street Reform and Consumer Protection Act?

Answer 49

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.

Question 50

What regulatory changes were introduced in Europe after the financial crisis?

Answer 50

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.

Question 51

How did the Dodd-Frank Act help reduce mortgage risk?

Answer 51

It required minimum lending standards, making it harder for lenders to offer risky subprime mortgages and reducing the likelihood of widespread defaults.

Question 52

What role did the systemic risk board play in Europe?

Answer 52

It was established to spot and address macroeconomic risks that could destabilise the financial system, helping to prevent future crises.

Question 53

What are some criticisms of current financial regulations?

Answer 53

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.

Question 54

How can finance be redirected to increase overall societal benefits?

Answer 54

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.

Question 55

What is the Tobin tax and how might it help?

Answer 55

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.

Question 56

Why might limiting speculative activities of banks help improve society’s welfare?

Answer 56

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.