Top Ten Causes of the Financial Crisis

1. Understand that the financial crisis had more than one cause.
2. Identify some of the major causes of the financial crisis.
3. Analyze how various causes helped bring about the financial crisis.
4. Apply concepts from the principles of macroeconomics to a real-life example.

This exercise would be appropriate to use in a moderately-sized lecture course after students have been exposed to macroeconomic theory, including monetary policy and the financial system, and have learned about the recent financial crisis. The activity should take about half an hour with students working in ten groups of 2 to 5 students each, depending on the number of students in the class. It is appropriate for class sizes of 20 to 50 students. No special equipment is required. It is probably best done near the end of a semester-long introduction to macroeconomics.

This activity is based on a presentation given by Wally Young at the Federal Reserve Bank of San Francisco, outlining the top 10 causes of the recent financial crisis. (Note that these are Wally Young's personal views, and do not necessarily represent the official views of the Federal Reserve Bank of San Francisco.)

The class should be divided into ten groups of nearly equal size. Groups of two to five students each work best, and since there need to be ten groups, this activity is designed for classes of 20 to 50 students.

Each group is given a brief description of one of the top ten causes of the financial crisis. Working in a group, they develop an outline of why this cause contributed to the financial crisis. For example, did it contribute to the housing bubble, and if so, how? Or did it contribute by encouraging financial speculation? Why did this factor help result in a crisis?

The attached file contains the top ten causes of the crisis, according to Young, along with a brief explanation to help the students understand what the terms are referring to. Each group will be given one sheet. They then work as a group for 10 to 15 minutes to discuss how this cause contributed to the crisis and to prepare a brief summary of their discussion to present to the rest of the class.

Each group will then present their results to the rest of the class in a one to two minute presentation.
Group Handouts for Top Ten Causes of the Financial Crisis Exercise (Microsoft Word 2007 (.docx) 20kB Dec8 13)

It might be best to form groups rather than letting the students choose their own groups. This could be done by assigning groups of students sitting near each other, or by having them count off from one to ten. The counting off process will give more random groupings and will be more likely to have students work with new people, but will also take more time due to the need for the students to move around the room and rearrange desks. If time is short, having students sitting close together in the same group will be more efficient. It is better to choose the groups for the students rather than letting them choose their own groups in order to make sure that each group is close to the same size and that every student joins a group without embarrassment.

Make enough copies of each page so that each member of the group has a copy of the instructions and topic for their group. Each student only needs the one page for their own group—not all ten pages. Be careful not to make the copies double-sided.

I would recommend this as an ungraded, class participation project, but a grade could be assigned based on the quality of each group's analysis. Each member of a group should get credit for participating. You could also give extra credit for students who speak during the presentation. This will encourage the groups to have all members speak rather than just one person.

Each group should be asked one or two probing questions, either by other students in the class, or by the instructor, in order to push the members to consider other points they may not have thought of and to further their skills at analysis.

Key points to be sure are mentioned in the discussion for each group:

Group 1: Banking Regulations
- Incentives to take risks
- Differences between regulations on banks and shadow banks
- "Bank runs" on shadow banks
Group 2: Credit Rating Agencies
- Securitization and diversification
- Risks of investment
Group 3: Originate to Distribute Models
- Risks of investment
- Diversification
- Leverage
Group 4: "Spec" Developers
- Supply and demand
- Leverage
- Debt overhang and vicious cycle of deleveraging
Group 5: High Loan Concentrations
- Diversification and risk
- Securitization
- Debt overhang and vicious cycle of deleveraging
Group 6: The Highly Leveraged Home Buyer
- Risk of default
- Asset bubbles
- Debt overhang and vicious cycle of deleveraging
Group 7: Public Policy
- Encouragement of home ownership
- Loans to poorly qualified buyers
- Monetary policy
Group 8: Low Interest Rates
- Supply and demand for loanable funds
- Monetary policy
- Risk and reward
Group 9: Investor Demand for High Yields
- Supply and demand for loanable funds
- Risk and reward
- Securitization and diversification
Group 10: Accounting Rules
- Debt overhang
- Vicious cycle of deleveraging
- Risk and reward