The financial crisis of 2008 originated from the collapse of the US housing market and subprime mortgage crisis. Risky mortgage loans were bundled into securities that were given high credit ratings and sold widely. When housing prices declined and mortgage defaults increased, the value of these securities plummeted. This caused the failure of major financial institutions, a stock market decline, and a recession around the world.

1. Epilogue
Financial Crisis of 2008

2. Objectives of Learning Unit
You have learned various topics in Money &
Banking and acquired tools and methods to
analyze issues in the financial system throughout
this Money & Banking course. On this Learning
Unit, we examine the financial crisis on 2008 and
apply knowledge learned in this course to
•Identify the origin of the problem from the
historical perspective.
•Understand how the financial crisis developed in
context of our financial system.
•Find possible solutions for the financial crisis.

3. Harbingers of Financial Crisis
• Savings & Loan Associations crisis and
development of securitization in 1980s
• Irrational exuberant in 1990s
• Financial Deregulation in late 1990s
• Moral hazard problems in the financial
industry in 2000s
• Financial engineering in 1990s and 2000s
• Excessive expansionary monetary policy in
2000s

4. S&Ls and Mortgage Loans
• Until 1980s, S&Ls and commercial banks
originated significant shares of mortgage loans.
• Most S&Ls held mortgage loans in their portfolio.
Since S&Ls held long-term liabilities, as long as
the yield curve is upward-sloping and stable, they
earned stable profits with low liquidity risk.
• S&Ls must manage default risk on mortgage
loans. S&Ls screened potential borrowers to
reduce adverse selection and moral hazard
problems to prevent default of mortgage loans.

5. S&Ls Crisis and Development of Securitization
• In 1980s, majority of S&Ls in nation went out of business.
• Commercial banks, which own short-term liquidity (e.g.
checking deposits), are reluctant to hold too many
mortgage loans for its liquidity management.
• The mortgage firms earn profits by reselling the mortgage
loans to others, since they do not hold large funds like
commercial banks (e.g. deposits).
• A greater share of mortgage loans became underwritten
by commercial banks and mortgage firms as S&Ls failed.
• Commercial banks and mortgage firms sold them to
public and private securitizing firms (e.g. Fannie Mae,
Freddie Mac, SIVs).
• Commercial banks remain as servicers of mortgage loans.

6. Securitization and Moral Hazard
• Since commercial banks and mortgage firms do
not keep mortgage loans, they were concerned
with default risk of mortgage loans that they
underwrite.
• Lack of incentive to manage default risk lead to
lending to riskier borrowers – less (no) screening,
less (no) monitoring.
• This later led to a creation of high-risk mortgage
loans (e.g. subprime, Alt-A, NINJA).
• Moral hazard problems of commercial banks and
mortgage firms later put securitizing firms at risk.

7. Irrational Exuberance
• The longest economic expansion in the U.S. history from
1992 to 2001.
• Technological advancement: Development of more
powerful and cheaper PCs and Internet led to birth and
expansion of many technology firms.
• Day traders: Development of online trading created risk-
raking ill-informed novice investors (noise traders) who
trade day and night.
• Irrational exuberance: Speculation by day traders
resulted in stock market boom in 1990s.
• Speculative bubble and crash: The stock market crashed
in 1987 and 2001.

8. Financial Deregulation
• Financial deregulation in late 1990s
– Created nationwide megabanks like Bank of America and
Wachovia Bank
– Created universal banks like Citibank and J.P. Morgan Chase.
• Megabanks became too big to fail.
– A failure of one of megabank or universal banks will have
devastating ripple effects in the financial system, and
eventually to the entire economy.
• Universal banks involved in risky activities.
– Non-bank units of universal banks could engage in riskier
activities than traditional commercial banks without
regulation and supervision of the federal government.
– A failure in non-bank unit of the universal banks could lead
to collapse of the entire universal banks and affect
depositors.

9. Moral Hazard in Financial Industry
With deregulation and less supervision of financial
service firms, many firms created problems of moral
hazard, principal-agent, and conflict of interest.
•Principal-agent problem: Self-dealing of CEOs and senior
managers at Fannie Mae and Freddie Mac in expense of
shareholders
•Conflict of interest problem: Rating agencies such as
Moody’s and Standard & Poor’s giving higher ratings to
CDOs issued by their clients than actually they are.
•Moral hazard problem: Mortgage firms made loans to risky
borrowers and sold the mortgage loans for fees (profits) to
securitizing firms (e.g. Fannie Mae) without disclosing their
risk. Once sold, it is not a problem of mortgage firms, but of
securitizing firms if borrowers default. More they gave loans
and sold to securitization firms, more profits they made!

10. Financial Engineering
• Advancement in financial economics and computer
technology led to creation of new types of financial
instruments – derivatives – and new investment strategies –
hedging and program trading/portfolio insurance.
• New types of derivatives such as credit-default swaps were
created by nonbank financial institutions and not regulated by
the federal government or the Federal Reserves.
• Derivatives valuation and hedging strategies are based on
“rocket science” financial engineering and executed by
computer, and opened up opportunities to make million dollar
profits in seconds (so as million dollar losses in seconds).
• CEOs and traders did not have full understanding on them,
and little was known of its systemic risk.
• LTCM (Long Term Capital management), which dealt with
hedging, collapsed in 1998, and led to the stock market crash
of 1998.

11. AIG and Credit Default Swaps (CDSs)
• AIG insured CDOs and CMOs through credit default swaps.
• On CDSs, AIG was supposed to hold Treasury securities
and swap interest payment flows. If AIG purchased and
held Treasury securities, AIG’s funds would be tied to
Treasury securities and AIG could not provide more CDSs.
• AIG decided not to hold Treasury securities, but swap
interest payments out of its cash reserves as if it held
Treasury securities. This allowed AIG to issue unlimited
amount of CDSs and to make huge profits as long as
interest payments on CDOs and CMOs were more than
those of Treasury securities.
• Without government oversight of CDS market and
through accounting manipulation, AIG was able to hide
huge potential loss on CDSs. This put AIG shareholders at
risk, while CEO and managers received huge bonuses.

12. Excessive Expansionary Monetary Policy
• U.S. economy fell in a recession in 2002 due to
– Technology stock market crash in 2001
– 9/11 terrorist attach in NYC and DC
• The Federal Reserves, led by Chairman Alan
Greenspan, took aggressive expansionary
monetary policy to stimulate the economy.
– Interest rates fell to the historical low over long
period of time, while the federal government ran
huge budget deficit through increased spending
and tax cuts.

13. Globalization and Chimerica
• China became major exporter of inexpensive
goods to the U.S.
• With low interest rate and fiscal stimulus, U.S.
consumers began to borrow and spend more
(saving rate became negative).
• With huge surplus of U.S. dollars, China invested
dollars in the U.S. financial market – purchased
Treasury bonds and CMOs issued by Fannie Mae
and Freddie Mac.
• Funds invested by China were used to provide
more mortgage loans through Fannie Mae and
Freddie Mac.

14. Real Estate Market Boom
• Low interest rates ignited real estate market boom in
mid-2000s.
• Deregulation and securitization encouraged mortgage
firms to extend mortgage loans to riskier borrowers.
• Many risky borrowers did not fully understand repayment
schedules and took the adjustable rate mortgage loans
because of extremely low initial interest rate (e.g. zero
percent introductory rate, no down payment, interest
only loan, reverse mortgage).
• Many real estate speculators knowingly took adjustable
rate mortgage (ARM) loans (at almost zero introductory
rate) in hope of making profits from rising real estate
prices and selling houses at higher prices before the ARM
loan rates are reset to higher interest rates.

15. False Belief of Safe Securities
• Securitization process was considered to reduce risk on
CDOs and CMOs through diversification.
• Rating agencies gave AAA ratings to CDOs and CMOs.
• Bond insurers insured many CDOs and CMOs, and also
AIG insured other CDOs and CMOs through credit
default swaps (CDS).
• Although Fannie Mae and Fannie Mae are independent
government-sponsored agencies and there was no
explicit guarantee by the federal government, securities
issued by Fannie Mae and Freddie Mac were thought to
be backed by the U.S. government and were thought
almost as safe as Treasury securities.

16. Financial Crisis of 2008
The U.S. financial system faced its greatest
threat since the stock market crash of 1929.
•Real estate market crash
•Subprime mortgage loan market meltdown
•Investment bank and commercial bank failures
•Credit –default swap crash and AIG bailout
•Stock market free fall

17. Changes in Economic Climate
• In mid-2000s the economic conditions in the U.S.
improved significantly and enjoyed another
expansion.
• The Federal Reserves started rising the market
interest rates to slow down excessive spending of
consumers and to prevent inflation.
• Global economic expansion, in particular China
and India, lead to sudden rise in commodity prices
(e.g. high oil and food prices in 2007), which made
U.S. households cut in spending, affecting some
firms like GM and pushing the U.S. economy
down.

18. Real Estate Market Crash
• In mid-2000s, some ARM loans became to reset
their interest rates to much higher rates. Many risky
borrowers found out themselves not being able to
continue to pay back their mortgage loans and
turned to foreclose their houses.
• With higher interest rates, suddenly demand for real
estates declined throughout the nation and the
market prices of real estates fell.
• Many real estate speculators became insolvent (the
market value of house fell below the mortgage loan
balance – “underwater”) and chose to foreclose
rather than pay back.
• Increasing number of foreclosures led to real estate
market crash in 2007.

19. Failure of Mortgage Firms
• With drop in demand for real estates, mortgage
firms could not underwrite any more mortgage
loans.
• Realizing high default risk of mortgage loans
underwritten by mortgage firms, the securitizing
firms no longer purchased risky subprime loans
from mortgage firms.
• Loss of revenues brought mortgage firms, which
stuck with underwritten risky mortgage loans, to
bankruptcy (e.g. Countrywide, Golden West
Financial).

20. Collapse of CDO Markets
• With mortgage loan defaults spread across the
nation, investors who purchased the mortgage-
backed securities (CMOs) realized that CMOs
were riskier than they thought and their value
fell.
• Many other CDOs backed by CMOs also became
risky and their value fell together.
• Without anyone willing to purchase risky CMOs
and CDOs, the market of CDOs and CMOs
collapsed and it became impossible to sell them –
lack of liquidity.

21. Failures of Bond Insurers
• Traditionally, bond insurers insured municipal bonds
with low risk.
• As CDO and CMO markets developed and expanded,
the bond insurers began to insure AAA-rated CDOs and
CMOs which seem less risky that corporate bonds.
• As many CDOs and CMOs defaulted, most bond
insurers were overwhelmed with their obligation and
became insolvent (e.g. ACA Financial Guaranty Corp.
and Ambac Financial Group Inc.)
• Most bond insurers stopped underwrite any more
insurance to even municipal bonds, resulting in higher
cost of borrowing for state governments or even
unable to borrow (e.g. State of California).

22. Credit & Liquidity Crisis of SIVs
• Most of SIVs (structured investment vehicles) holding
large amounts of CDOs and CMOs became insolvent as
value of CDOs and CMOs fell.
• SIVs financed through short-term commercial papers
(CPs) to purchase CDOs and CMOs. As existing CPs
became matured, SIVs must issue another CPs (roll over
its debt).
• Credit crunch: Because of insolvency, no investors
wanted to purchase CPs issued by SIVs
• Liquidity problem: Because of collapse of CDO and CMO
markets, SIVs could not sell their CDOs or CMOs, either.
• Defaulting CPs led SIVs to become bankrupted.

23. Failures of GSE
• Government-sponsored entities such as Fannie Mae and
Freddie Mac became insolvent as a result of large
numbers of default of mortgage loans.
• Defaulting securities issued by Fannie Mae and Freddie
Mac would lead to inability and unwillingness of China
to continue to lend to the U.S.
• The U.S. government ran huge deficit to help failing
financial institutions and to support the U.S. economy
and must continue to issue more Treasury securities to
finance its deficit.
• If China were to stop purchasing Treasury securities, it
would have affected the federal government’s ability to
tackle the on-going financial crisis.

24. Investment Bank Failures
• Most SIVs are owned and operated by investment
banks, which had to absorb losses made by their SIV
subsidiaries.
• Bear Stern faced liquidity problem in March 2008 and
acquired by J.P. Morgan Chase with arrangement by
the Federal Reserves.
• Lehman Brothers went bankruptcy in September 2008,
seen as the federal government and the Federal
Reserves' punishment to moral hazard behavior.
• Merrill Lynch was merged with Bank of America in
December 2009.
• Goldman Sacks and Morgan Stanley formed bank-
holding companies to become eligible for help from
the Federal Reserves in case of liquidity problem.

25. Commercial Bank Failures
• Many large and medium commercial banks (e.g.
IndyMac Bank in CA, Washington Mutual Bank –
Wamu in WA) which invested in CDOs and CMOs also
became insolvent and bankrupted.
• Megabanks acquired failing mortgage firms (e.g.
Countrywide acquired by Bank of America, and Golden
West Financial by Wachovia Bank). Subsequently,
Bank of America and Wachovia became insolvent as
their mortgage units faced too many default of
mortgage loans, but they were “too big to fail.”
• Many medium and small local and community banks
(e.g. Colonial Bank in AL) suffered massive default of
commercial real estate loans due to the recession and,
subsequently, went bankruptcy.

26. Money Market Crisis
• Money market mutual funds were thought most liquid
and least risky money market instrument, since they
primarily purchase Treasury bills and short-maturity
Treasury bonds.
• Without proper supervision and regulation, Reserve
management purchased and held commercial papers
issued by Lehman Brothers.
• After Lehman Brother’s failure, Primary fund by Reserve
management, money market mutual funds, became
insolvent.
• Investors got in panic, and attempted to withdraw funds
from money market mutual funds, which might lead to
liquidity crisis to all money market mutual funds and
their management firms (financial institutions such as
Merrill Lynch, T. Rowe Price, Fidelity).

27. Hedge Funds Failures
• Many hedge funds bet on commodities, real
estates, stocks, and derivatives.
• When prices of commodities such as oil and
corn, prices of financial assets, and prices of
real estates fell in 2008, many hedge funds
suffered huge losses and many of them went
under (in 2008, 1,471 hedge funds went
bankruptcy).

28. Recession
• Insolvent banks became very conservative in
assets management to avoid bankruptcy.
– They built up reserves to meet unexpected deposit
outflows.
– They turned down most loan requests from
businesses and households.
• Lack of access to bank loans created liquidity
problems to many business firms.
• Real estate market crash caused households to
cut back their spending (negative wealth effect).
• Many small and large business firms suffered
losses and laid off workers, causing downward
spiral of recession.

29. Collapse of Credit Default Swap Market
• Massive default of CDOs and CMOs as a result of default
of mortgage loans and bankruptcy of SVIs forced AIG to
honor its CDS contract – continue to pay Treasury interest
payments while not receiving interest payments from
CDOs and CMOs.
• Without holding enough Treasury securities, AIG found
itself making huge losses and its obligation exceeding its
assets.
• After the collapse of Lehman Brothers, it became
impossible for AIG to raise funds to honor its CDS
obligation.
• AIG was about to bankruptcy, but it was “too big to fail.”
• A failure of AIG would affect all other counter parties of
CDSs (mostly large financial institutions) and could bring
them insolvency and bankruptcy.

30. Worldwide Financial Crisis
• Major international banks in the world also invested into
CMOs and CDOs issued by American SIVs, and became
insolvent after massive default of CMOs and CDOs in the
U.S. (e.g. USB)
• Some countries also had real estate bubble like the U.S.
(e.g. U.K. and Spain) and suffered the real estate market
crash, and caused bank run (e.g. Northern Rock in U.K.)
• Global liquidity problem initiated by major banks spread
further.
• Worldwide volatility in financial (currency, derivative)
markets led further global financial and economic
problems. (e.g. Iceland’s currency crisis; $7.1 billion loss
of Société Générale, French financial service firm )

31. Stock Market Crash of 2008
• As the problem in financial institutions grew
and many of them became insolvent,
investors fled from stock markets and sought
safety in Treasury bonds.
• As the U.S. economy got into recession, the
stock market went down.
• DJIA fell from 14,000 in October 2007 to 6,500
in March 2009.

32. Financial Bailout
The federal government and the Federal
Reserves made joint efforts to prevent the U.S.
and global economy from full-scale financial
crisis spiral and another great depression.
•Fiscal stimulus
•Bailout of failing financial institutions
•Lenders of last resort to all financial institutions

33. Federal Government Actions
• The Congress passed $700 billion bailout bill
(Emergency Economic Stabilization Act of 2008)
on October 2008, which loaned to insolvent
financial institutions (e.g. Citibank, bank of
America, AIG) and GM and Chrysler.
• PPIP (Public-Private Investment Program) in 2009
was intended to encourage investors to purchase
CDOs and CMOs from banks.
• ARRA (American Recovery and Reinvestment Act)
in 2009 is a $789 billion stimulus bill that includes
tax cuts and spending on education, infrastructure
(e.g. road construction), energy (e.g. green energy
and smart grid), low-income aid, etc.

34. Federal Reserves Actions
• The Federal Reserves stood by to provide
emergency loans to any insolvent banks which
faced liquidity problem or potential bank run.
• The Federal Reserves initiated TALF (Temporary
Asset-Backed Securities Loan Facility) to make
loans to banks and bank-holding companies.
• CPFF (Commercial Paper Funding Facility)
provided liquidity in commercial paper markets.
• MMIEF (Money Market Investor Funding
Facility) helped restore liquidity in the money
market funds.

35. Actions by FDIC
• FDIC has arranged many mergers and acquisitions
of failed banks (e.g. IndyMac Bank in CA,
Washington Mutual Bank in WA, Colonial Bank in
AL, Cooperative Bank in NC).
• FDIC has paid tens of billion dollars of insured
deposits to depositors of hundred of failed banks.
• FDIC raised its deposit insurance cap to $250,000
per account from $100, 000 per account to
prevent large deposit outflows from insolvent
commercial banks and bank run.

36. Actions by SEC
• SEC allowed banks to switch from mark-to-market
accounting (all assets must be valued at current
market price) to hold-to-maturity accounting
(original purchase price). The mark-to-market
accounting forces banks to write down as market
prices of CDOs and CMOs fell, causing them
insolvent.
• SEC tightened its supervision and investigation of
Ponzi schemes (e.g. Bernard Madoff, Allen
Stanford) to protect investors.
• SEC put a temporary ban of short sales which put
downward pressure on stock prices.

37. Financial Regulatory Reform
• The financial crisis was a result of unregulated risk-
taking activities by financial firms, speculation by
investors, and moral hazard problems in the
financial system under weak supervision.
• The government’s financial regulatory reform is
intended to regulate those unregulated previously,
to reduce moral hazard problem through more
supervision, make financial institutions more prone
to liquidity and systematic risk, and reorganize
regulatory agencies to have more effective
supervision and clearer responsibilities.

38. Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University