Comsats University Islamabad

Names:
Syed Wajih Salman SP23-BAF-097

Subject : FIM
Class: BAF, 4B
Instructor : Sir Muhammad Ali Raza

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The 2008 financial crisis was one of the most devastating economic events in modern
history, unraveling decades of unchecked greed, deregulation, and reckless financial
practices. It began with the bursting of the U.S. housing bubble but quickly spiraled into a
global meltdown, leaving millions unemployed, homeless, and financially ruined. The crisis
exposed deep flaws in the financial system, from predatory lending to unregulated
derivatives, and highlighted the unchecked power of major banks and corporations. This
summary breaks down the causes, mechanisms, and lasting impacts of the crisis, as
explained in the documentary ‘Inside Job’.

1. Pre-Crisis Environment: Foundations of Instability

The seeds of the 2008 global financial crisis were sown over decades, as policies, practices, and
deregulation gradually eroded the financial system's stability.

Mechanisms:

Deregulation Initiatives: Beginning in the 1980s under President Ronald Reagan, financial
deregulation dismantled protections established after the Great Depression. The Glass-Steagall
Act, which had separated commercial and investment banking to prevent speculative risks with
consumer deposits, was systematically weakened and ultimately repealed in 1999. This allowed
banks to engage in highly speculative activities that had been prohibited for decades.

Expansion of Financial Power: Financial institutions underwent significant transformations

during this era. Investment banks, which had traditionally been small, privately owned
partnerships, went public. This gave them access to vast pools of capital and shifted their
priorities from long-term stability to short-term profit maximization for shareholders. This
structural change encouraged reckless risk-taking.

Globalization and Complexity: As financial systems became more interconnected, global

markets relied increasingly on the U.S. financial system. The growing complexity of financial
instruments, including derivatives, created an opaque and fragile system that policymakers and
regulators failed to fully understand or address.

Complicity of Credit Rating Agencies: Agencies like Moody’s, Standard & Poor’s (S&P), and
Fitch played a pivotal role in enabling risky financial behavior. They gave AAA ratings ‘the

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highest safety designation’ to complex and often toxic financial instruments, helping to
perpetuate the illusion of stability and safety in an increasingly volatile market.

Impact:

The environment of deregulation and financial expansion enabled institutions to pursue profit
through increasingly risky ventures without sufficient oversight. This created an unstable
foundation upon which future crises could—and eventually did—develop.

2. The Securitization Boom: The Rise of Risky Practices

In the 1990s and early 2000s, the financial system underwent a transformation driven by the
process of securitization, which fundamentally altered the relationship between borrowers,
lenders, and investors.

Mechanisms:

The Securitization Food Chain: The securitization process allowed banks to bundle loans, such
as mortgages, into financial products called collateralized debt obligations (CDOs). These CDOs
were sold to investors worldwide. In the traditional lending model, banks bore the risk of loan
defaults, incentivizing them to lend prudently. In the securitization model, banks transferred the
risk to investors, weakening their motivation to ensure the creditworthiness of borrowers.

Subprime Mortgages: To maximize profits, lenders increasingly issued high-risk loans to

borrowers with poor credit histories. Known as subprime mortgages, these loans were often
structured with low initial payments that ballooned over time, making them difficult to repay.
Despite their high risk, subprime mortgages were bundled into CDOs and given AAA ratings.

Leverage Expansion: Financial institutions borrowed heavily to increase their investments and
profits. The ratio of borrowed funds to equity, known as leverage, skyrocketed. By 2004, firms
successfully lobbied the Securities and Exchange Commission (SEC) to relax leverage limits,
allowing them to operate at ratios as high as 33-to-1. This meant that even small declines in asset
values could render firms insolvent.

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Impact:

The securitization boom created a massive housing bubble as lending standards eroded and
homeownership expanded to unsustainable levels. Financial institutions prioritized profit over
prudence, relying on flawed ratings and the assumption that housing prices would continue to
rise indefinitely.

3. Derivatives and Regulatory Failures: A Systemic Time Bomb

The emergence and proliferation of complex financial derivatives further destabilized the
financial system, exacerbated by the lack of regulation and oversight.

Mechanisms:

Derivatives as Amplifiers of Risk: Derivatives such as credit default swaps (CDSs) were initially
designed as insurance-like tools to protect against losses on financial instruments. However, they
quickly became speculative tools, allowing institutions to bet on the performance of assets they
did not own. This practice created a cascading risk environment.

Unregulated Markets: Efforts to regulate derivatives markets were actively suppressed by

powerful financial institutions and policymakers. Brooksley Born, chair of the Commodity
Futures Trading Commission (CFTC) in the late 1990s, attempted to introduce regulations but
faced opposition from figures like Alan Greenspan, Larry Summers, and Robert Rubin, who
argued that market forces should prevail.

Compensation Structures: Perverse incentives rewarded short-term profits without penalties for
long-term losses. Bankers, traders, and executives received massive bonuses for creating and
selling risky products, even if those products later led to catastrophic losses.

Impact:

The unregulated derivatives market became a ticking time bomb. By 2007, these instruments
linked financial institutions worldwide in an intricate web of obligations and risks. The lack of
regulatory oversight ensured that no safeguards were in place to contain the fallout when the
system began to unravel.

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4. The Collapse: Unraveling of the System

The bursting of the housing bubble in 2007 triggered a chain reaction that culminated in the
global financial crisis of 2008.

Mechanisms:

Housing Market Implosion: As housing prices peaked and began to decline, mortgage defaults
soared. Subprime loans were particularly affected, as borrowers with low credit scores and
adjustable-rate mortgages were unable to meet their obligations.

Collapse of Financial Institutions: Major financial firms, including Lehman Brothers, AIG, and
Bear Stearns, faced insolvency due to their exposure to toxic assets. Lehman Brothers’
bankruptcy in September 2008 marked the largest corporate failure in U.S. history and sent
shockwaves through global markets.

Freezing of Credit Markets: The interconnected nature of the financial system caused a
cascading effect. Credit markets froze as banks stopped lending to each other, fearing exposure
to bad debts. This freeze disrupted global commerce, as businesses could no longer access short-
term funding to cover payroll and other expenses.

Impact:

The crisis caused massive economic damage. Trillions of dollars in global wealth were wiped
out, and millions of jobs and homes were lost. The ripple effects included widespread
unemployment, a collapse in consumer confidence, and a deep global recession.

5. Responses and Accountability: Limited Justice

Governments and central banks around the world intervened to prevent total economic collapse.
However, the responses were widely criticized for their focus on rescuing financial institutions
rather than holding them accountable.

Mechanisms:

Massive Bailouts: In the U.S., the government launched the $700 billion Troubled Asset Relief
Program (TARP) to stabilize the financial system. Firms like AIG, Goldman Sachs, and

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Citigroup received billions in taxpayer funds. In many cases, these firms continued to pay
bonuses to executives even as they were being rescued.

Absence of Accountability: Despite clear evidence of fraud, misconduct, and negligence, no

senior executives were prosecuted. The government chose to prioritize systemic stability over
individual accountability, leading to widespread public anger.

Modest Reforms: Legislative responses, such as the Dodd-Frank Act, aimed to strengthen
financial regulations, but they fell short of addressing the root causes of the crisis. Key areas,
including the role of credit rating agencies and executive compensation, remained largely
unchanged.

Impact:

The lack of accountability undermined trust in both the financial system and government
institutions. Many saw the bailouts as a reward for reckless behavior, while ordinary citizens
bore the brunt of the economic fallout.

6. Long-Term Consequences: A Fragile Recovery

The crisis had profound and far-reaching consequences that continue to shape the global
economy and society.

Mechanisms:

Widening Inequality: The recovery disproportionately benefited the wealthiest individuals and
institutions. Financial firms returned to profitability, while the middle and lower classes faced
stagnant wages, high unemployment, and rising debt. The crisis accelerated income and wealth
inequality in the United States and globally.

Erosion of Public Trust: The crisis exposed systemic corruption and failures in oversight,
eroding public trust in financial institutions, government regulators, and policymakers. This
distrust fueled populist and anti-establishment political movements in subsequent years.

Concentration of Financial Power: The financial sector became even more concentrated, with
major institutions like JPMorgan Chase, Bank of America, and Wells Fargo acquiring smaller

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competitors during the crisis. This increased the systemic risk posed by "too big to fail"
institutions.

Impact:

The uneven recovery highlighted the fragility of the global financial system and the need for
significant reform. However, many of the structural issues that caused the crisis remain
unresolved, leaving the system vulnerable to future shocks.

7. Lessons and Unresolved Issues

The crisis revealed deep flaws in the global financial system, as well as the political and
intellectual frameworks that supported it.

Mechanisms:

The Role of Academia: Economists and academics played a significant role in legitimizing
deregulation and free-market policies. Many prominent figures had financial ties to the industry,
creating conflicts of interest that compromised their objectivity.

Structural Failures: The crisis exposed the dangers of short-term incentives, unregulated
financial innovation, and the concentration of economic and political power in the hands of a few
institutions.

Missed Opportunities for Reform: While the crisis provided a moment of clarity about systemic
risks, the responses were insufficient to address the underlying causes. Key reforms, such as
breaking up large financial institutions or imposing stricter limits on leverage, were not pursued.

Impact:

The crisis remains a cautionary tale about the dangers of unregulated capitalism and the
concentration of power within the financial sector. Without addressing these structural flaws, the
global financial system is vulnerable to repeating the same mistakes, with potentially even more
severe consequences.

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8. Post-Crisis Realities: The Persistence of Power and Influence

The aftermath of the financial crisis saw the financial sector regaining its strength, wielding even
more influence over policy and politics while largely avoiding accountability for its role in the
meltdown.

Mechanisms:

Lobbying and Political Power: The financial industry ramped up its lobbying efforts in the years
following the crisis. Between 1998 and 2008, the industry spent over $5 billion on lobbying and
campaign contributions, a trend that only increased in the post-crisis years. Financial firms
successfully pushed back against regulatory reforms that threatened their interests.

Revolving Door Between Wall Street and Government: Many key figures in the government’s
response to the crisis, such as Treasury Secretary Henry Paulson and Federal Reserve Chair Ben
Bernanke, had close ties to the financial sector. Paulson, a former Goldman Sachs CEO, played a
central role in designing bailout packages that disproportionately benefited his former firm and
other major banks.

Weak Enforcement and Legal Settlements: While financial institutions faced civil penalties and
fines, these settlements were often a fraction of the profits they earned during the bubble.
Moreover, these penalties were typically paid by shareholders, not the executives responsible for
the misconduct.

Impact:

The post-crisis period reinforced the perception that the financial elite operate under a different
set of rules, shielded from the consequences of their actions. This lack of accountability further
undermined public trust and fueled resentment toward both the government and financial
institutions.

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9. Broader Social and Economic Implications

The ripple effects of the financial crisis extended far beyond the financial sector, reshaping
societies and economies around the world.

Mechanisms:

Global Recession: The crisis triggered a severe global recession, with widespread job losses,
reduced economic output, and increased poverty. Developing countries, which had relied on
exports to the U.S. and other major markets, were particularly hard hit.

Rise of Populism: Economic dislocation and growing inequality contributed to the rise of
populist political movements in the U.S., Europe, and beyond. These movements often framed
the financial crisis as a failure of globalization and elite governance.

Housing and Community Impact: The foreclosure crisis devastated families and communities,
particularly in low-income and minority neighborhoods. Entire neighborhoods were hollowed
out as homeowners were forced to abandon properties, leading to declines in property values and
tax revenues.

Impact:

The social and economic fallout of the crisis highlighted the interconnectedness of global
markets and the disproportionate burden borne by the most vulnerable populations. The crisis
also raised important questions about the sustainability of current economic and financial
systems.

10. Looking Forward: Avoiding the Next Crisis

The financial crisis of 2008 underscored the urgent need for reforms to prevent future crises.
However, the lack of decisive action in its aftermath leaves significant vulnerabilities
unaddressed.

Proposed Reforms:

Stronger Regulation: Experts have called for reinstating key protections, such as the separation
of commercial and investment banking under a modernized Glass-Steagall Act. Other

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recommendations include stricter capital requirements, limits on leverage, and greater oversight
of derivatives markets.

Accountability Measures: Holding executives and institutions accountable for misconduct is

essential to deterring future abuses. This includes criminal prosecutions for fraud and clawbacks
of ill-gotten gains.

Economic Diversification: Reducing reliance on the financial sector and investing in industries
that create sustainable, long-term growth—such as manufacturing, technology, and renewable
energy—could help stabilize the economy.

Challenges:

Despite widespread recognition of these needs, meaningful reform has been hindered by the
financial industry’s entrenched political power. The influence of lobbying, combined with a
regulatory culture often sympathetic to industry interests, has stalled many reform efforts.

Conclusion

The 2008 financial crisis was not an isolated event but the culmination of decades of systemic
failures, including deregulation, unchecked greed, and a lack of accountability. It exposed the
fragility of global financial systems and the immense human and economic costs of prioritizing
profit over stability.

While governments and central banks managed to prevent a total collapse, the crisis left deep
scars on the global economy and society. Millions of people lost their jobs, homes, and savings,
while the financial institutions and executives responsible largely escaped consequences. The
post-crisis period has seen growing inequality, erosion of trust in institutions, and an alarming
concentration of economic and political power.

To avoid repeating the mistakes of the past, comprehensive reforms are needed to create a more
resilient and equitable financial system. However, as long as the financial sector wields
disproportionate influence over policy and regulation, achieving these goals will remain a
significant challenge. The lessons of the crisis must not be forgotten, as the cost of inaction could
be even greater in the future.

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