Financial Crisis: Final Essay Exam

Good morning class.

This past academic year, we have studied the many causes of the financial crisis. We’ve looked at how this stock market collapse compared to others, the impact of bank bailouts on competition, and of course, the Great Recession. There are lots of moving parts in this saga, and understanding them all is our goal.

Your final examination is in essay form. Answer each of the following 10 questions, using specific data and facts to buttress your arguments. Note you will be penalized for unsupported assumptions and unproven theories. Ideological arguments that lack a factual basis will also penalize you.

You have 3 hours (~15 minutes per question).

Good luck.


Final Examination

1. Following the dotcom implosion and 2000 market crash, the Federal Reserve lowered rates to 2% for 3 years, including a then unprecedented level of 1% for more than a year. Discuss the impact this had on various asset classes, including Real Estate, Fixed Income, Oil and Gold. What difference might a more traditional interest rate regime have made for these assets?

Bonus Question: Imagine you were FOMC Chair. Where would you have set rates in the 1990s? After the 2000 crash? Today?

2. The rating agencies — Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings — originally had business that were  funded by bond investors, who paid for the NRSRO’s research. This changed in the 1990s to a Syndicators & Underwriter purchased ratings model. How did this business model change impact a) the performance of ratings agencies; b) the underwriting quality of syndicators?

Bonus question: Does finance still require NRSROs to evaluate complex financial products? What alternatives could replace these entities?

3. The Commodity Futures Modernization Act of 2000 was an unusual piece of deregulatory legislation, creating a new world of uniquely self-regulated financial instruments — the derivative. What was the impact of this on risk management, leverage, and mortgage underwriting?

Bonus: What did a lack of reserve requirements for underwriting derivatives mean for AIG, Bear Stearns and Lehman Brothers?

4. More than 50% of subprime loans were made by nonbank mortgage underwriters not subject to comprehensive federal supervision; another 30% were made by thrifts also not subject to routine supervision or examinations. What did this do to the supply/demand curve in the housing and mortgage markets?

Bonus: What was the role of changing credit standards in prior bubbles and financial crises?

5. In 2004, the SEC issued the “Bear Stearns exemption” — replacing Net Capitalization Rule’s 12 to 1 leverage limit  to with essentially unlimited leverage for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. Given that none of these companies exist today in the same structure as prior to the rule change, discuss the impact of this rule change on these companies.

Bonus: Changing broad legislation for only 5 companies is very unusual. What does this say about regulatory capture, democracy and the impact of lobbying on American society?

6A. Mortgage underwriting standards changed rapidly in the 2000s .Many lenders stopped verifying income, payment history, and credit scores.

6B. Traditional loan metrics also changed: Loan to value (LTV) went from 80% (20% down payment) to 100% (No Money Down) to even 120% (Piggyback mortgages).

6C. The loans themselves changed: “Innovative” new mortgage products were developed and marketed in the 2000s: 2/28 ARMs, I/O s, Neg Ams

Q: Discuss the correlation this had on a) home prices; b) new inventory build; and c) foreclosures.

7.  Banks developed automated underwriting (AU) systems that emphasized speed rather than accuracy in order to process the greatest number of mortgage apps as quickly as possible. What was the impact of this on the RE market? How did this impact default ratios and foreclosures?

Bonus: Real estate agents and mortgage brokers were known to repeatedly use the same corrupt appraisers to facilitate loans approval. Did this correlate with AU? Discuss how and why.

8. Collateralized debt obligation (CDO/CMOs) managers who created trillions of dollars in mortgage backed securities and the institutional investors (pensions, insurance firms, banks, etc.) who purchased these appear to have failed to engage in effective due diligence prior to underwriting or purchasing of these products. Reconcile this in terms of the Efficient Market Hypothesis

Bonus: What does this mean for self regulation of the financial industry? Is it desirable? Even possible?

9. The Depression era Glass Steagall legislation was repealed in 1998. What impact did this have on the size of banking institutions? What did this do to the competitive landscape of financial services industry? Did this impact bank risk taking? Discuss.

10. Numerous states had anti-predatory lending laws which in 2005 were “Federally Pre-empted” by order of John Dugan, head of the Office of the Comptroller of the Currency (OCC). What impact did this have on states with anti-predatory lending laws default and foreclosure levels, pre- and post- pre-emption?

11. In 2006, more than 84% of subprime mortgages were issued by private lending institutions not covered by government regulations (McClatchy). Discuss what this means in terms of profit motive, government policy, and GSEs.

12. The Bank Bailouts “rescued” the system, but may have created additional issues int he future. Discuss the Moral Hazard of bailouts, what they mean in terms of competitive landscape and concentration of assets in the financial services industry.

Bonus: What impact might the Consumer Financial Protection Bureau on lending and future credit bubbles?


Economics 301, Professor Ritholtz
Causes and Elements, Financial Crises and Depressions
Office hours Tu-Thu 3-5

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