I) Causes of the Crisis
On September 15, 2008, the American bank Lehman Brothers, with holdings over 600 billion USD, filed bankruptcy. This was by far the biggest bankruptcy in U.S history and it marked the beginning and the largest financial crisis ever. How can one of the biggest banks in the world fail? How can a bankruptcy in US make someone on the other side of the world unemployed? The answer is Collateralized Debt Obligations (CDOs) and it all started by new innovations in the financial sector combined with deregulations on the financial market.
Many mathematicians and physicists started to work in the financial market and created new financial products called derivatives after the Cold War. These products made it possible for investment banks to speculate on stocks, currencies, commodities and even private debt and weather. History could have turned another way in 1998 when CFTC proposed to regulate the derivative market. Instead, in December 2000 the US government adopted the law “Commodity Futures Modernization Act” which forbidden regulations on the derivative market.
On September 11, 2001, the U.S. stock market crashed after the terrorist attack against World Trade Center, and the Federal Reserve decided to decrease the interest rate to feed the market. This action was made at the same moment as when the housing prices had increased over 50% in the last 15 years. The action could be argued as an event when the U.S. just pushed the crisis ahead and made it even worse.
People in the U.S. took out more loans and housing prices soared. Private loans were combined into so-called CDOs, which entail a positive cash flow as long as the debt holders pay off their interest rates. Investment banks divided the CDOs into “new” CDOs, which also were sold in the market. Since the CDOs were rated as safe investments (AAA) by the rating institutions, they acquired worldwide attraction for pension funds that are obligated to invest in “safe” securities. When the interest rates increased and the “subprime loan” was introduced, it only took a few years until people in the U.S. could not afford their loans anymore. Thus, they started to sell their houses. The housing prices went down and when the value of the houses were lower than the value of the initial loan, people left the houses to the banks. Instead of owning CDOs consisting with positive cash flows, the banks now owned CDOs consisting of houses with decreasing values (See appendix). The CDOs sold all over the world and combined in both banks and private peoples investments were now almost worthless. Lehman Brothers had an immense amount of investments in CDOs, and as they went bankrupt, one of the world’s worst financial meltdown had thus begun.
II) Critical Examination on How the Crisis Affected Iceland
Before the financial crisis in 2008, Iceland’s stock market had increased with over 900 percent since the middle of the 90th century (Graph 3). During 2000-2008,...