DERIVATIVES (FIN402) 2020

ASSIGNMENT: ESSAY
Module Leader: Hiep Luu
FPT University
Email: HiepLN4@fe.edu.vn

“The 2007-08 Financial Crisis”

The financial crisis of 2007-08,also known as the Global Financial crisis and 2008 financial crisis,is
considered by many economists the worst crisis since the Great Depression of the 1930s.It resulted in the
threat of total collapse of large financial institutions,the bailout of banks by national governments,and
downturns in stock markets around the world.In many areas,the housing market also suffered,resulting in
evictions,forclosures and prolonged unemployment.The crisis played a significant role in the failure of
key businesses,declines in consumer wealth estimated in trillions of dollars,and a downturn in economic
activity leading to the 2008-2012 global recession and contributing to the European debt sovereign-debt
crisis.

So what caused the financial crisis of 2008? I think we can sum up the cause of our current economic
crisis in one word, GREED! The American economy is built on credit. Credit is a great tool when used
wisely. For instance, credit can be used to start or expand a business, which can create jobs. Although the
exact causes of the financial crisis are a matter of dispute among economists, there is general agreement
regarding the factors that played a role (experts disagree about their relative importance).

First, the Federal Reserve (Fed), the central bank of the United States, having anticipated a mild recession
that began in 2001, reduced the federal funds rate (the interest rate that banks charge each other for
overnight loans of federal funds—i.e., balances held at a Federal Reserve bank) 11 times between May
2000 and December 2001, from 6.5 percent to 1.75 percent. That significant decrease enabled banks to
extend consumer credit at a lower prime rate (the interest rate that banks charge to their “prime,” or low-
risk, customers, generally three percentage points above the federal funds rate) and encouraged them to
lend even to “subprime,” or high-risk, customers, though at higher interest rates (see subprime lending).
Consumers took advantage of the cheap credit to purchase durable goods such as appliances, automobiles,
and especially houses. The result was the creation in the late 1990s of a “housing bubble” (a rapid
increase in home prices to levels well beyond their fundamental, or intrinsic, value, driven by excessive
speculation).

Second, owing to changes in banking laws beginning in the 1980s, banks were able to offer to subprime
customers mortgage loans that were structured with balloon payments (unusually large payments that are
due at or near the end of a loan period) or adjustable interest rates (rates that remain fixed at relatively
low levels for an initial period and float, generally with the federal funds rate, thereafter). As long as
home prices continued to increase, subprime borrowers could protect themselves against high mortgage
payments by refinancing, borrowing against the increased value of their homes, or selling their homes at a
profit and paying off their mortgages. In the case of default, banks could repossess the property and sell it
for more than the amount of the original loan. Subprime lending thus represented a lucrative investment
for many banks. Accordingly, many banks aggressively marketed subprime loans to customers with poor
credit or few assets, knowing that those borrowers could not afford to repay the loans and often
misleading them about the risks involved. As a result, the share of subprime mortgages among all home
loans increased from about 2.5 percent to nearly 15 percent per year from the late 1990s to 2004–07.

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Third, contributing to the growth of subprime lending was the widespread practice of securitization,
whereby banks bundled together hundreds or even thousands of subprime mortgages and other, less-risky
forms of consumer debt and sold them (or pieces of them) in capital markets as securities (bonds) to other
banks and investors, including hedge funds and pension funds. Bonds consisting primarily of mortgages
became known as mortgage-backed securities, or MBSs, which entitled their purchasers to a share of the
interest and principal payments on the underlying loans. Selling subprime mortgages as MBSs was
considered a good way for banks to increase their liquidity and reduce their exposure to risky loans, while
purchasing MBSs was viewed as a good way for banks and investors to diversify their portfolios and earn
money. As home prices continued their meteoric rise through the early 2000s, MBSs became widely
popular, and their prices in capital markets increased accordingly.

Fourth, in 1999 the Depression-era Glass-Steagall Act (1933) was partially repealed, allowing banks,
securities firms, and insurance companies to enter each other’s markets and to merge, resulting in the
formation of banks that were “too big to fail” (i.e., so big that their failure would threaten to undermine
the entire financial system). In addition, in 2004 the Securities and Exchange Commission (SEC)
weakened the net-capital requirement (the ratio of capital, or assets, to debt, or liabilities, that banks are
required to maintain as a safeguard against insolvency), which encouraged banks to invest even more
money into MBSs. Although the SEC’s decision resulted in enormous profits for banks, it also exposed
their portfolios to significant risk, because the asset value of MBSs was implicitly premised on the
continuation of the housing bubble.

Fifth, and finally, the long period of global economic stability and growth that immediately preceded the
crisis, beginning in the mid- to late 1980s and since known as the “Great Moderation,” had convinced
many U.S. banking executives, government officials, and economists that extreme economic volatility
was a thing of the past. That confident attitude—together with an ideological climate emphasizing
deregulation and the ability of financial firms to police themselves—led almost all of them to ignore or
discount clear signs of an impending crisis and, in the case of bankers, to continue reckless lending,
borrowing, and securitization practices.

Beginning in 2004 a series of developments portended the coming crisis, though very few economists
anticipated its vast scale. Over a two-year period (June 2004 to June 2006) the Fed raised the federal
funds rate from 1.25 to 5.25 percent, inevitably resulting in more defaults from subprime borrowers
holding adjustable-rate mortgages (ARMs). Partly because of the rate increase, but also because the
housing market had reached a saturation point, home sales, and thus home prices, began to fall in 2005.
Many subprime mortgage holders were unable to rescue themselves by borrowing, refinancing, or selling
their homes, because there were fewer buyers and because many mortgage holders now owed more on
their loans than their homes were worth (they were “underwater”)—an increasingly common
phenomenon as the crisis developed. As more and more subprime borrowers defaulted and as home prices
continued to slide, MBSs based on subprime mortgages lost value, with dire consequences for the
portfolios of many banks and investment firms. Indeed, because MBSs generated from the U.S. housing
market had also been bought and sold in other countries (notably in western Europe), many of which had
experienced their own housing bubbles, it quickly became apparent that the trouble in the United States
would have global implications, though most experts insisted that the problems were not as serious as
they appeared and that damage to financial markets could be contained.

In 2012 the St. Louis Federal Reserve Bank estimated that during the financial crisis the net worth of
American households had declined by about $17 trillion in inflation-adjusted terms, a loss of 26 percent.
In a 2018 study, the Federal Reserve Bank of San Francisco found that, 10 years after the start of the
financial crisis, the country’s gross domestic product was approximately 7 percent lower than it would
have been had the crisis not occurred, representing a loss of $70,000 in lifetime income for every
American. Approximately 7.5 million jobs were lost between 2007 and 2009, representing a doubling of

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the unemployment rate, which stood at nearly 10 percent in 2010. Although the economy slowly added
jobs after the start of the recovery in 2009, reducing the unemployment rate to 3.9 percent in 2018, many
of the added jobs were lower paying and less secure than the ones that had been lost.

For most Americans, recovery from the financial crisis and the Great Recession was exceedingly slow.
Those who had suffered the most—the millions of families who lost their homes, businesses, or savings;
the millions of workers who lost their jobs and faced long-term unemployment; the millions of people
who fell into poverty—continued to struggle years after the worst of the turmoil had passed. Their
situation contrasted markedly with that of the bankers who had helped to create the crisis. Some of those
executives lost their jobs when the extent of their mismanagement had become apparent to shareholders
and the public, but those who resigned often did so with lavish bonuses (“golden parachutes”). Moreover,
no American CEO or other senior executive went to jail or was even prosecuted on criminal charges—in
stark contrast with earlier financial scandals, such as the savings and loan crisis of the 1980s and the
bankruptcy of Enron in 2001. In general, the key leaders of financial firms, as well as other very wealthy
Americans, had not lost as much in proportional terms as members of the lower and middle classes had,
and by 2010 they had largely recovered their losses, while many ordinary Americans never did.

That visible disparity naturally engendered a great deal of public resentment, which coalesced in 2011 in
the Occupy Wall Street movement. Taking aim at economic elites and at a political and economic system
that seemed designed to serve the interests of the very wealthy—the “1 percent,” as opposed to the “99
percent”—the movement raised awareness of economic inequality in the United States, a potent issue that
soon became a theme of Democratic political rhetoric at both the federal and the state levels. However, in
part because the movement had no organized leadership or any concrete goals, it did not result in any
specific reforms, much less in the complete transformation of “the system” that some of its members had
hoped for.

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3. LITERATURE
The relevant literature on this subject is very large. What follows is an indicative list of articles of this
literature. Students should use additional (or different) references depending on the specific topic of each
essay.

1. Acharya, Viral, Thomas Philippon, Matthew Richardson and Nouriel Roubini. 2009. “The Financial
Crisis of 2007-2009: Causes and Remedies”, Financial Markets, Institutions & Instruments 18 (2):
89–137.
2. Keys, BenjaminJ. Tanmoy Mukherjee, Amit Seru and Vikrant Vig. 2010. “Did Securitization Lead
to Lax Screening? Evidence from Subprime Loans”, The Quarterly Journal of Economics 125 (1):
307-362.
3. Diamond, Douglas W., and Raghuram G. Rajan. 2009. "The Credit Crisis: Conjectures about Causes
and Remedies." American Economic Review, 99(2): 606-10.
4. Duffie, Darrell. 2010. "The Failure Mechanics of Dealer Banks." Journal of Economic Perspectives
24(1): 5172.
5. Gorton, Gary. 2009. "The Subprime Panic," European Financial Management 15 (1): 10-46.
6. Gorton, Gary, and Andrew Metrick. 2012. “Securitized banking and the run on repo”, Journal of
Financial Economics 104: 425–451.
7. Hull, John and Alan White. 2012. “Ratings Arbitrage and Structured Products”, Journal of
Derivatives 20 (1): 80-86.
8. Krinsman, Allan N. 2007. “Subprime Mortgage Meltdown: How Did It Happen and How Will It
End?” The Journal of Structured Finance 13(2):13-19.
9. Kroszner, Randall S., and Philip E. Strahan. 2011. "Financial Regulatory Reform: Challenges
Ahead." American Economic Review, 101(3): 242-46.
10. Mian, Atif and Amir Sufi. 2009. “The Consequences of Mortgage Credit Expansion: Evidence from
the U.S. Mortgage Default Crisis”, The Quarterly Journal of Economics 124 (4): 1449-1496.
11. Rajan, Raghuram G. 2005. "Has financial development made the world riskier?," Proceedings
-Economic Policy Symposium -Jackson Hole, Federal Reserve Bank of Kansas City, issue Aug,
pages 313-369.
12. Stout, Lynn A. 2011. “Derivatives and the Legal Origin of the 2008 Credit Crisis”, Harvard Business
Law Review 1: 1-38.
13. Stulz, René M. 2004. “Should We Fear Derivatives?” Journal of Economic Perspectives 18 (3): 173–
192.
14. Stulz, René M. 2009. “Financial Derivatives. Lessons From the Subprime Crisis”, The Milken
Institute Review, First Quarter: 58-70.
15. Stulz, René M. 2010. “Credit Default Swaps and the Credit Crisis”, Journal of Economic Perspectives
24 (1): 73–92.3

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4. SOME TIPS TO IMPROVE YOUR ACADEMIC WRITINGS AND ESSAYS
a) It is crucial to cite and include references correctly:
i) In the main text, references must be included at the end of the sentence and before the punctuation
mark.
ii) Textual quotations must appear between quotation marks, and the page number of the article/book
must be indicated.
iii) The style of the reference list must be consistent and well written. This is very important in an
academic work.
b) Figures and tables must be self-contained. That is, the reader should be able to fully
understand the figures without reading the text. Therefore, you have to include the description of the
variables, year, source, etc.
c) Provide a structure to your text. It is frequent to find essays that are not divided in sections,
subsections, etc. It is very important to give a structure to your text, which makes it easier to read.
d) The writing style is crucial:
i) Try to avoid long sentences and very long paragraphs. The language in academic texts is very simple.
Avoid also an extensive use of subordinate clauses.
ii) Try to structure your text so that each paragraph transmits just one idea.
iii) Read several times your text before submission.
e) Provide a critical discussion of the issue, that is, your critical and informed view. Your essay should
not be just a literature review.
f) Last but not least, make your writing interesting to the reader.