This paper was written for a lecture in 2005 preceding the financial Crisis of 07-08. The Paper captures important elements of the Crisis and acts on a predictory note with the help of data. This report is a short exposition of the paper.

How did he realize the potential risks and the extent of dangers the risks posed. What evidences were used to indicate such outcomes and faults in the financial world?

I would talk about investment managers and their incentives and how interest rates were critical in influencing their decisions.

How these incentives provided a collapsing spiral and led to the collapse of Big Banks like Bear Stearns , Lehman Brothers and brought others on their knees.

Investment Managers are the people who largely control investor (your) money. They are the people sitting in the big banks, hedge fund offices, pension and insurance funds.

There were two associated behaviours:

Tail Risks- Investment Managers for greater compensation took risks which had low probability to bore fruit but far damaging consequences if materialized. These investments were in the Credit Default Swaps (abbreviated as CDS in the above graph). They would insure other parties’ loans for a fee and promise to pay back if the party defaults. Since rates of defaults are pretty low so they were off with easy money and payments were to be made only in case the party defaults.

Trivia- The American International Group(insurance company) lost 30 billion dollars in bad credit swaps during the crisis. It had to be ultimately bailed out by the US Government

Herding- The investment managers tend to group together and follow each other’s positions to make sure that they do not relatively underperform. This has the potential to change market prices and drive prices away from fundamentals increasing market volatility and giving rise to a bubble. This was partly responsible to surge in mortgage backed securities. Everyone was investing in them because everyone else was investing in them.

A Relatively high level of interest rates in the end of the century followed by low rates in the beginning. How did rates provide such an impetus?

High Rates followed by steeply falling Low rates induce managers’ want to increase their yield and make the most out of the period of low interests. This has the potential to overburden existing capacities pushing the system towards a high but volatile state. Mutual and Investment Funds face an existential crisis in times of low rates and have to invest their money in risky assets. High rates tend to keep them conservative and avoid unnecessary risk. While these risks are not bad in themselves these funds provide the leverage(money) for greater damage if things go wrong.

References: Has Financial Developments made the world riskier? By Raghuram Rajan Investopedia To read more on AIG, https://insight.kellogg.northwestern.edu/article/what-went-wrong-at-aig