Jesse Shaffer
Final Paper
Since the Great Recession many governments and economies have been looking toward
further regulating financial institutions with higher capital requirements. Limiting these financial
institutions’ ability to invest in securities and other investments means that these financial
institutions won’t be able to invest in as risky assets that were investing in during and up to the
Great Recession.
Prior to the Great Recession, these financial institutions had experienced years of
deregulation, that allowed these financial institutions to engage in more risky investments in
order to gain profits. These financial institutions were losing competitiveness and needed to
make higher profits, therefore through the process of financial innovation they were able to
create financial derivatives, namely CDOs (Collateralized Debt Obligations) that were structured
to be diversified assets of hundreds of subprime mortgages. After the collapse of the housing
bubble, and due to the widespread nature of these CDOs, many financial institutions, including
banks, suffered decreased asset value that caused many financial institutions to become insolvent
and threatened a collapse of the global financial markets. These financial institutions packaged
mortgages that to people who shouldn’t have been able to receive these mortgages (subprime), in
order to gain profits by packaging these mortgages into a security and selling the proceeds of the
investment. This is a problem of moral hazard, mortgage brokers did not do due diligence to
make sure that mortgages that they were giving out were secured and going to people who could
afford to pay the mortgages, they had to meet quotas for having a certain number of mortgages
that could be packaged into one of these CDOs.
The results of the financial crisis have created many financial frictions that have kept
many investors and firms from investing further into the financial markets. Financial frictions
result during periods of uncertainty about the future of financial markets, and lead to decreases in
real output and if these frictions are long-term, then real output may fall during the long-term.
The Great Recession caused much uncertainty about the financial markets as much information
was revealed about the validity of the assets and securities which were being traded within the
financial markets, the Great Recession questioned whether these financial markets were stable
and therefore has decreased activity within these markets.
These major players in the securitization of these subprime mortgages and other risky
investments were systemic financial institutions. These systemic financial institutions collapse
would threaten the global economy and the global financial markets, therefore these financial
