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P1.T1.20.17. Anatomy of the Great Financial Crisis (GFC) of 2007-2009

Nicole Seaman

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Learning objectives: Describe the historical background and provide an overview of the 2007-2009 financial crisis. Describe the build-up to the financial crisis and the factors that played an important role. Explain the role of subprime mortgages and collateralized debt obligations (CDOs) in the crisis. Compare the roles of different types of institutions in the financial crisis, including banks, financial intermediaries, mortgage brokers and lenders and rating agencies. Describe trends in the short-term wholesale funding markets that contributed to the financial crisis, including their impact on systemic risk. Describe responses taken by central banks in response to the crisis.


20.17.1. According to GARP, each of the following was a causal factor in the 2007-2009 global financial crisis (GFC) EXCEPT which is not a causal factor?

a. Low interest rates
b. The originate-to-distribute (OTD) business model and securitization, especially CDOs
c. An unexpected spike in prepayments due to an acceleration in repeat refinancing
d. Dubious lending practices and risky mortgage loan products (e.g., NINJA) and loan features (e.g., teaser rates)

20.17.2. According to GARP, "a wave of uncertainty over the valuation of asset-backed structured products exacerbated the [global financial] crisis" as counterparty risk suddenly became priced expensively by counterparties. Consequently, the valuation of these illiquid assets became problematic due to their inherent opacity (until mid-2007 counterparty risk was a factor that effectively had NOT even been priced by the market!). Coincidently, with these VALUATION and TRANSPARENCY issues, which of the following is TRUE about the ensuing liquidity crunch?

a. A solvency crisis led to a liquidity crisis
b. The OIS-swap spread narrowed to almost zero
c. Short-term wholesale funding markets started to freeze
d. Systemic reduction in collateral haircuts led to a liquidity crunch

20.17.3. According to GARP, each of the following is an important feature (or lesson) of the global financial crisis (GFC) EXCEPT which is false?

a. Perceptions about collateral quality translated into systemic risk, which exacerbated the impact of the crisis
b. Central banks came to the rescue in large part by introducing innovative liquidity injection facilities such as TAF, PDCF, and TARP
c. Many of the initial securitization ratings, in particular AAA-rated senior tranches, were faulty from the onset and provided by rating agencies who were conflicted
d. The unduly complex mechanics of commercial paper (CP) and the inclusion (i.e., automatic stay) of repurchase agreements (aka, repos) led to valuation and transparency issues

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