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Notes for Main Reading for ECON 255 Presentation.docx

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ECON 255
Ashok Kotwal

Notes for Main Reading for ECON 255 Presentation: The 2008 Financial Crisis − 2008 Financial Crisis  occurred in the States  Solution: used a huge amount of taxpayer’s money to bail out the Lehman Brothers with the intention to prevent collapse of the world’s financial system − Effect to Europe: developed into Euro crisis − 5-year hindsight: showed that the crisis has multiple causes  1) Financiers: those who claim to find ways to eliminate risks and the central bankers who tolerated with the bankers, 2) The Great Moderation: Low inflation and stable growth which leads to people borrowing recklessly and having too much confidence  More on the Great Moderation: 1) European bankers were making a lot of borrowing in the form of the USD currency and buying unreliable security  2) Saving in Asian countries led to interest rate being low − Cause #1: Folly financiers  they loaned money to people with poor credit history. Also called irresponsible mortgage lending  this kind of subprime is supposed to pose a great risk as the lenders are poor people  but the risk was reduced by pooling the total of loans made by the poor. Hence, subprime market appears to be safe.  Assumption: pooling works if the risks are unassociated to one another, but this was proven to be false  Further on subprime pooling  it is used to back securities known as Collateralized Debt Obligation s (CDOs)  the CDOs are ‘sliced’ into tranches by degree of exposure to default. Investors bought the safer tranches because received triple A credit ratings  But: the rating is a hoax because rating agencies are paid by the banks  it appears to provide high returns by only facing low interest rates  The Blame Game: not sure whether the fluctuations of interest rate are caused by the Central Bankers or the Asian countries that were accumulating capital bonds (so, it drives down the interest rate)  Incentives from the low interest rates: leads to banks to look for riskier assets that offered high returns  if the interest rate is low and the asset is stable, investors will take the risk of borrowing in the money market to buy longer- dated, higher-yielding securities [From houses to money mar
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