FINANCIAL CRISIS TEST

1. Explain in great detail how a stripper buying an investment homes in Florida and a
pension fund manager in Iceland could be connected to each other. Describe the parts
of the chain connecting them and how the parts interacted with each other. You can
draw a picture.

2. In detail explain the reasoning behind giving someone like a stripper or a poor
immigrant or a dead person a $500,000 loan to buy a house. If you already did it in the
question above, indicate where you answered it by highlighting it.

They could be connected to each other by both ending up broke haha. But on a serious
note. The stripper takes out a bunch of NINA/NINJA loans from a mortgage broker – loans
where they don’t really run a background check on you and give the loan to just about
anyone. These loans were created because there was a high demand for mortgage-backed
securities but not enough actual mortgages to meet the demand. So, the mortgage broker
gave the stripper the loans, despite her not normally qualifying to receive a classic loan,
because he wanted as many mortgages as possible. He had perverse incentives – he
received more money by giving out a lot of sub-prime mortgages and then selling them off
to someone who bundles them up for an MBS, than if he had responsible clients who
reliably payed their mortgages.
This shady mortgage broker would sell mortgages to people who bundle them up. Those
people then sold the bundles off to Wall Street.
There were also people on the side, who created CDOs out of “junk” mortgages that were in
bad tranches (BB, BBB) of MBS’s and didn’t get sold off. These people than also sold these
CDO’s off to Wall Street.

Icelandic banks bought MBSs and CDOs from Wall Street

In Iceland banks started giving out really good interest rates to people putting their money
into pension funds – the money doesn’t just lay around in the bank, it’s used to invest so
that the banks can make some profit. At the time the US housing market was booming and
Icelandic banks wanted to invest, therefore they were trying to get people to put their
money into savings. This is where our pension fund manager comes into play, his job was to
wisely invest the money. And it seemed that he did. At first the banks were extremely
successful, growing their assets to 9x that of Iceland’s GDP. However, then the crash came.
For Iceland it was devastating. Unlike the U.S., which treated major financial institutions as
being “too big to fail,” Iceland treated its banks as being “too big to save.” and 3 of their
major banks collapsed. All the people who put their money into savings got scared and
wanted their money back but the banks simply didn’t have it and the whole country ended
up having to declare bankruptcy. The country had to be bailed out by the IMF.
 3. When the stripper stopped paying her mortgage, how did this contribute to a
worldwide financial crisis?

Her and other sub-prime mortgages started defaulting. There are two reasons why this is really
bad. For one, people at Wall Street were looking at data that was based on stats prior to loans
being so easy to come by. The data looked really good because pretty much all the people who
were cleared for a loan reliably payed their mortgage. By people such as the stripper not paying
their mortgages and being at high risk of defaulting, the data was no longer accurate. Secondly,
under normal circumstances it would’ve been alright if a mortgage defaulted – the bank would
just get the house/property. However, since so many mortgages were defaulting, there ended
up being too many houses on the market and not enough people that could afford them.
Supply surpassed demand and the price of housing started going down. This was a really big
“oh no” that pretty much no investor anticipated.

4. What was the financial product that allowed some people to profit from the crisis?
How did it work?

Credit default swaps. Simply put it’s a kind of like an insurance. In this case it protects buyers
from the risk of things such as defaults, bankruptcies, etc. Just like with regular insurance, the
buyer has to pay a monthly/annual fee. Then if let’s say a mortgage defaults, the person with a
CDS gets a set amount of money from whoever they made CDS contract with.
To be specific, Michael Burry realized the market was going to crash so he went to the big banks
on Wall Street, bought a bunch of subprime deals and simultaneously got them to sell him CDSs
on them. He was confident the subprime mortgages would fail so it was a pretty much
guaranteed profit.

5. Explain the connection of Neoliberalism and globalization to this crisis.

Neoliberalism is all for the market regulating itself and the government keeping its nose out of
it. It’s a proponent of privatization, deregulation of financial and labor markets, deregulation of
business activities and free trade. It was the leading rightist ideology in the years leading up to
the crisis however with the great recession and the financial crash, it marked the end of
neoliberalism (for now). After the crash, the government realized just how few regulations
there were and in order to prevent another crash they stepped in.

Globalization plays a role, since the whole world was affected by the crisis despite it pertaining
to the US housing market. Head banks of foreign countries had investments in the housing
market and countries such as Iceland and Ireland were crushed by the crash. Many countries
had to implement fiscal policies - the government lowering tax rates/increasing spending to
encourage demand and spur economic activity.
 6. How was Greece able to get into massive debt and why did it threaten the whole EU

In 1999 the euro was established. At the time the Greek government was seriously
overspending in order to boost social benefits and wages. This led to their debt-to-GDP being
108% - in order to adopt the euro, it must be lower than 60%. With the help of the US
investment bank Goldman Sachs, Greece was able to cheat the system by concealing some of
its debt through currency swaps. This way it could adopt the euro and not have to cut it’s
spendings or introduce any reforms.

After adopting the euro, the economy was steadily growing, but so was their debt. However,
that didn’t seem to concern them because EU money was constantly flowing in…until it wasn’t.
Due to the US housing market crash pretty much the whole world went into a recession. It
became much more expensive to borrow money and it was also revealed that Greece had been
cooking the books and was in much more debt than the EU had thought. It seemed like Greece
was going to default on its loans but in the end, it was bailed out by the European Commission,
the European Central Bank and the IMF who lent them heck of a lot of money (110 billion
euros). They urged Greece to put in place austerity measures (higher taxes, less spending) but
somehow Greece’s debt-to-GDP still kept rising. In the end, the EU and the IMF had to lend
them a further 130 billion euros and had them increase their austerity measures. This worked

and Greece was finally able to be in a surplus. However, the citizens of Greece are unhappy🙄
and start to protest against the austerity measures. Later, negotiations with the EU + IMF are
attempted but it results in them cutting their support of Greece. Greece’s economy is in
shambles and in 2015 they default, missing a 1,6 billion payment to the IMF. The EU proposes a
bailout but the Greek citizens protest against it. In the end they accept it because they honestly
don’t have any other good option.

7. What roles did governments play in repairing the US financial crisis and European debt
crisis? Why were these measures controversial? This is a multi-part answer.

In the US the collapse of Lehman Brothers caused so much damage, the government realized
they couldn’t let another massive investment bank go under. So, they bailed out the rest of
them. Eventually the banks repaid the government. It was controversial, because the banks
messed up BIG time but (other than Lehman Brothers) hardly suffered any consequences. Many
of the employees were still receiving sizable bonuses while the rest of the economy was in the
trenches.
They also had the TARP program which was created to help stabilize the U.S. financial system,
restart economic growth, and prevent avoidable foreclosures
As I already mentioned, the government also increased market regulations as a preventive
measure.
In the EU it was just classic recession stuff with a couple country bailouts. Tax increases,
decrease in spending, cutting wages etc. Weirdly in Greece it was controversial that the EU was
bailing them out. The citizens were so unhappy with the austerity measures put in place that
they’d rather leave the EU, be in debt and very possibly go bankrupt then accept a bailout.
Weird lol