An Analysis of the Financial Crisis of 2008: Causes and Solutions

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An Analysis of the Financial Crisis of 2008: Causes and Solutions

By Austin Murphy*

________________________________________________________________________ *by Austin Murphy, Professor of Finance, Oakland University, SBA, Rochester, MI 48309-4493 (248-370-2125; jamurphy@oakland.edu).

Electronic copy available at: http://ssrn.com/abstract=1295344

Abstract
This research evaluates the fundamental causes of the current financial crisis. Close financial analysis indicates that theoretical modeling based on unrealistic assumptions led to serious problems in mispricing in the massive unregulated market for credit default swaps that exploded upon catalytic rises in residential mortgage defaults. Recent academic research implies solutions to the crisis that are appraised to be far less costly than a bailout of investors who made poor financial decisions with respect to credit analysis. JEL: G11, G12, G13, G14

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Electronic copy available at: http://ssrn.com/abstract=1295344

An Analysis of the Financial Crisis of 2008: Causes and Solutions

The financial crisis in 2008 is of such epic proportions that even astronomical amounts spent to address the problem have so far been insufficient to resolve the it. Besides the well-publicized $700 billion approved by Congress, the Federal Reserve has attempted to bail out institutions and markets with about $1.3 trillion in investments in various risky assets, including loans to otherwise bankrupt institutions and collateralized debt obligations like those backed by subprime mortgages that are defaulting at rapid rates (Morris, 2008). A further $900 billion is being proposed in lending to large corporations (Aversa, 2008), making a total of nearly $3 trillion in bailout money so far, without even counting the massive sum of corporate debts guaranteed by the U.S. government in the last year. An analysis of the fundamental causes of this “colossal failure” that has put “the entire financial system… at risk” (Woellert and Kopecki, 2008) is warranted in order to both solve the problem and avoid such events in the future.

Root Cause of the Crisis: Mispricing in the Massive Credit Default Swaps Market Many blame defaulting mortgages for the current financial crisis, but this massive tragedy is only a component and symptom of the deeper problem. The pricing of credit default swaps, whose principal amount has been estimated to be $55 trillion by the Securities and Exchange Commission (SEC) and may actually exceed $60 trillion (or over 4 times the publicly traded corporate and mortgage U.S. debt they are supposed to insure), are totally unregulated, and have often been contracted over the phone without 2

documentation (Simon, 2008), is the primary fundamental issue from which all the other problems of the crisis emanate.
Credit default swaps are actually rather simple instruments in concept, merely mandating that one party paying a periodic fee to another to insure the debts of some entity (such as a specified corporation) against default for a particular amount of time like 5 years. They are effectively debt insurance policies that are labeled otherwise to avoid the regulation that normally is imposed on insurance contracts. This unregulated market grew astronomically from $900 billion at the turn of the millennium to over $50 trillion in 2008 after Congress enacted a law exempting them from state gaming laws in 2000 (PIA Connection, 2008)..

Any investment in a debt requires compensation not only for the time value of money but also a premium for the credit risk of the debt. Compensation for the time value of money is usually provided by the debt promising, at a minimum, a yield equal to that of the rate available on default-free government securities like U.S. Treasury bonds. The credit risk premium above that rate must compensate investors for not only the expected value of default losses but also for the systematic risk relating to the debt, as well as for any...
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