Good morning class.

This past academic year, we have studied the many causes of the financial crisis. We’ve looked at how this stock market collapse compared to others, the impact of bank bailouts on competition, and of course, the Great Recession. There are lots of moving parts in this saga, and understanding them all is our goal.

Your final examination is in essay form. Answer each of the following 10 questions, using specific data and facts to buttress your arguments. Note you will be penalized for unsupported assumptions and unproven theories. Ideological arguments that lack a factual basis will also penalize you.

You have 3 hours (~15 minutes per question).

Good luck.

>

Final Examination

1. Following the dotcom implosion and 2000 market crash, the Federal Reserve lowered rates to 2% for 3 years, including a then unprecedented level of 1% for more than a year. Discuss the impact this had on various asset classes, including Real Estate, Fixed Income, Oil and Gold. What difference might a more traditional interest rate regime have made for these assets?

Bonus Question: Imagine you were FOMC Chair. Where would you have set rates in the 1990s? After the 2000 crash? Today?

2. The rating agencies — Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings — originally had business that were  funded by bond investors, who paid for the NRSRO’s research. This changed in the 1990s to a Syndicators & Underwriter purchased ratings model. How did this business model change impact a) the performance of ratings agencies; b) the underwriting quality of syndicators?

Bonus question: Does finance still require NRSROs to evaluate complex financial products? What alternatives could replace these entities?

3. The Commodity Futures Modernization Act of 2000 was an unusual piece of deregulatory legislation, creating a new world of uniquely self-regulated financial instruments — the derivative. What was the impact of this on risk management, leverage, and mortgage underwriting?

Bonus: What did a lack of reserve requirements for underwriting derivatives mean for AIG, Bear Stearns and Lehman Brothers?

4. More than 50% of subprime loans were made by nonbank mortgage underwriters not subject to comprehensive federal supervision; another 30% were made by thrifts also not subject to routine supervision or examinations. What did this do to the supply/demand curve in the housing and mortgage markets?

Bonus: What was the role of changing credit standards in prior bubbles and financial crises?

5. In 2004, the SEC issued the “Bear Stearns exemption” — replacing Net Capitalization Rule’s 12 to 1 leverage limit  to with essentially unlimited leverage for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. Given that none of these companies exist today in the same structure as prior to the rule change, discuss the impact of this rule change on these companies.

Bonus: Changing broad legislation for only 5 companies is very unusual. What does this say about regulatory capture, democracy and the impact of lobbying on American society?

6A. Mortgage underwriting standards changed rapidly in the 2000s .Many lenders stopped verifying income, payment history, and credit scores.

6B. Traditional loan metrics also changed: Loan to value (LTV) went from 80% (20% down payment) to 100% (No Money Down) to even 120% (Piggyback mortgages).

6C. The loans themselves changed: “Innovative” new mortgage products were developed and marketed in the 2000s: 2/28 ARMs, I/O s, Neg Ams

Q: Discuss the correlation this had on a) home prices; b) new inventory build; and c) foreclosures.

7.  Banks developed automated underwriting (AU) systems that emphasized speed rather than accuracy in order to process the greatest number of mortgage apps as quickly as possible. What was the impact of this on the RE market? How did this impact default ratios and foreclosures?

Bonus: Real estate agents and mortgage brokers were known to repeatedly use the same corrupt appraisers to facilitate loans approval. Did this correlate with AU? Discuss how and why.

8. Collateralized debt obligation (CDO/CMOs) managers who created trillions of dollars in mortgage backed securities and the institutional investors (pensions, insurance firms, banks, etc.) who purchased these appear to have failed to engage in effective due diligence prior to underwriting or purchasing of these products. Reconcile this in terms of the Efficient Market Hypothesis

Bonus: What does this mean for self regulation of the financial industry? Is it desirable? Even possible?

9. The Depression era Glass Steagall legislation was repealed in 1998. What impact did this have on the size of banking institutions? What did this do to the competitive landscape of financial services industry? Did this impact bank risk taking? Discuss.

10. Numerous states had anti-predatory lending laws which in 2005 were “Federally Pre-empted” by order of John Dugan, head of the Office of the Comptroller of the Currency (OCC). What impact did this have on states with anti-predatory lending laws default and foreclosure levels, pre- and post- pre-emption?

11. In 2006, more than 84% of subprime mortgages were issued by private lending institutions not covered by government regulations (McClatchy). Discuss what this means in terms of profit motive, government policy, and GSEs.

12. The Bank Bailouts “rescued” the system, but may have created additional issues int he future. Discuss the Moral Hazard of bailouts, what they mean in terms of competitive landscape and concentration of assets in the financial services industry.

Bonus: What impact might the Consumer Financial Protection Bureau on lending and future credit bubbles?

~~~


Economics 301, Professor Ritholtz
Causes and Elements, Financial Crises and Depressions
Office hours Tu-Thu 3-5

Category: Bailouts, Politics, Real Estate, Really, really bad calls, Regulation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

53 Responses to “Financial Crisis: Final Essay Exam”

  1. Chief Tomahawk says:

    Methinks this should’ve been Econ 401. Nevertheless, I have been auditing under the universities’ “Life-long Learner” program.

    Might this test make for one heck-of-a Wa Post column???

    13. Substantiate the claim the Community Reinvestment Act caused the 2008 financial crisis.

    14. Why did lending bubbles occur simultaneously in many countries beyond the U.S.? Bonus if you tie this into 13.

  2. rootless says:

    Ideological arguments that lack a factual basis will also penalize you.

    What is the factual basis for the believe, which is pushed by you again and again, that the Fed under Greenspan was able to control interest rates in a markets for debt that amounts to a total volume of many trillion dollars, just by tuning one little parameter, the Fed Funds target rate, the interest rate for which depository institutions lent each other a few billion dollars of excess reserves over night?

  3. [...] The Big Picture’s Barry Ritholz delivers the final exam from the class we’ve all been in for the last thirteen years: Causes and Elements of Financial Crises and Depressions. [...]

  4. louis says:

    Holy Shit, I didn’t know I actually had to pay attention in your class.

  5. Niskyboy says:

    Excellent, Barry, just excellent.

    This afternoon we have another exam, for our Ethics course. Only one question on this one: Given widespread, indisputable evidence that personal, legal and perhaps even moral integrity has broken down among leaders in government, education, finance and in other key areas of society, what are the likely implications for the health and welfare of our country over the next 50 years?

  6. Bokolis says:

    I would use my writing skills to effectively mask the fact that I didn’t put in the work (I only tried hard enough to be a B student, which is to say that I didn’t try at all) necessary to learn their ass-backwards theories, which pissed off the professors to no end.

    As someone who ditched a few 300-level Economics courses, I’ll say that they wish they had this level of pertinence. They assumed that none of this could happen.

    Answering these questions after the fact is what accountants do. The bottom line is that these things happened because no one was calling out the perpetrators as they were doing it. Instead of a vigilant media corps, we have the media playing Big Brother. Forget executing these criminals, we can’t even get a shaving cream pie to the face because the gold-diggin’ DreamKiller decided to over-deliver…he’s definitely going to have to rework the pre-nup after that. Like a driver who can kill, an old lady who blocks cream pies is invaluable.

  7. ali says:

    “This is the most humble day of my life.”

  8. Frances_Coppola says:

    Further questions from a non-US perspective:

    1. To what extent did the global financial crisis stem from the US practice of securitizing everything except the kitchen sink, exporting toxic debt and excessive risk to the rest of the world? As it is still doing this, can we expect further global financial collapses from other forms of lending such as student loans?

    2. Expectation of bailout contributed to the mispricing of CDOs and failure to do due diligence when purchasing these instruments. Since the banks that expected to be bailed out were indeed bailed out, and the EU is currently disguising further bailout of European banks as “country rescue”, can we believe anything politicians say about not bailing out banks in future?

    3. Since banks’ credit ratings depend on the expectation of bailout, which is being withdrawn apparently, we can expect these ratings to drop to a more realistic level. At the same time banks are being asked to obtain more capital to enable them to take losses themselves. However, major bank shareholders are pension funds – which need a prudent attitude to risk as they invest people’s life savings. What would be the effect on banks’ cost of capital if risk weightings are reduced? What would be the likely behaviour of institutional investors regarding the proportion of bank equity in their portfolios?

    4. The calculation of capital for adequacy purposes depends on the Basel II risk weighting of assets. Under this accord banks can set their own rules for assessing the riskiness of certain assets, and other assets such as sovereign debt attract uniform low risk weightings (in this case, zero). Given this, how realistic are bank capital adequacy calculations, and will the increases in bank capital proposed by Basel, the Fed and the Bank of England really equip banks to absorb losses arising from asset toxicity?

    I could go on and on, but that will do for now. Answers on a postcard please.

  9. Blissex says:

    «the Federal Reserve lower rates to then unprecedented levels to 2% for 3 years, including 1% for a year. Discuss the impact this has on various asset classes, including Real Estate, Fixed Income, Oil and Gold. »

    You leave out the big yellow elephant in the room, the carry trade from Japan. To some extent the Fed was just competing with the bank of Japan to ensure demand for yen did not balloon driving down the yen (a bit of industrial policy).

    But what really mattered was not the price of credit, the interest rate, but its quantity: there was credit available from both the Fed and (more) private banks in near unlimited amounts, and this also happened in other countries (which related to point 14 in a comment above).

    Credit availability was a political decision to goose returns in the financial sector (another bit of industrial policy), and the explosion began in 1995 in the USA when certain popular types of lending had capital requirements essentially removed, fro example those collateralized by AAA securities, which meant that a credit fueled insatiable demand for those loans was created. In other countries credit explosions were fueled by the Japanese carry trade and similar measures by local government that relaxed credit creation standards to let the good times roll.

    You also don’t mention that the USA needed has needed to fund a few expensive wars entirely on credit, following a “butter and guns” policy.

    When

  10. ruetheday says:

    One more question – Discuss the role of the shadow banking systems (specifically, the nexus of the repo market, money market mutual funds, the commercial paper market, and SIVs) in the financial crisis. Should non-banks that collectively engage in a form of banking (borrowing short and liquid to lend long and illiquid) be regulated as banks?

  11. carleric says:

    Great quiz….much is self-explanatory but terrific commentary

  12. AHodge says:

    nice
    we make you king of all academic departments that used to be called economists
    that brand irretrievably tarnished. Ph D in ritholtzomics
    ive got my list to add like everybody else
    but dam good framework

  13. Moss says:

    Extra Extra bonus:

    Explain the consequences of not prosecuting illegal behavior.

  14. Petey Wheatstraw says:

    13. Was the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 a signal that the banks and government;

    a) knew that credit had already been extremely overextended, and/or;

    b) a clear indication that Corporate entities were now firmly in control of the Legislature, and were dictating the laws they wanted enacted?

  15. James says:

    > Good luck.

    Ha, thank god it’s open book!

    FYI, I have an idea a class w/you would be a riot (which is not to say there’d be a riot!).

  16. maddog2020 says:

    I would encourage every congress-critter and presidential candidate to take the exam and post their answers.

  17. Bob is still unemployed   says:

    Among those who have not learned their lessons from the financial crisis are the banks who are still robo-signing documents.

    They get a FAIL.

  18. beaufou says:

    Is this your next Washington Post column BR?

  19. farfetched says:

    It is so tempting to actually answer all of the questions. Imagine where we would be now if the elderly, retired, savers and the owners of capital could demand actual risk adjusted returns for their capital.
    If everyone removed their cash from the banks it would be a nice way of voting and weeding out the ‘too weak to exist’.

    Rather than taking the exam, let me just say that I am so disappointed that we have been reduced to shaving cream pies rather than fists, brass knuckles or lead. In the use of more advanced weaponry than shaving cream, old ladies make lousy shields. Even baseball bats ala ‘The Untouchables’ would be an improvement.

    I received a political email inviting me to a brown bag lunch sit in in front of my senator or congressperson’s office. When we have a flaming brown bag of dog excrement throw-ins or a pitchforks and torch days, give me a call. We are not nearly mad enough…..yet. BTW, I’ll supply the dog waste.

  20. How DARE you accuse us of having class!

    @beaufou,

    He’s crowd sourcing for his next book. Now he expects us to write it!

  21. Julia Chestnut says:

    Do you have extra blue books? I’m going to need extra blue books.

    This is fantastic, by the way.

  22. Greg0658 says:

    LOL .. a couple days ago filling out an application for a Farm&Fleet rival that is setting up its 52nd store .. a pre-screen pop quiz .. 18 very intriguing (I wonder how my spelling was without Google) questions.. like 8. “What are the clues you have come to recognize you are under to much stress?”

  23. Greg0658 says:

    shaving cream or lead :-| some factions just gotta turn the other cheek .. its in their dna :-( alas some not

  24. tidervan says:

    @maddog; encourge hell….mandatory; especially before any public debate ;>

  25. jerryork says:

    This could have been summarized as a single question.

    Will people in positions of power and responsibility act in their own short term best interests to the detriment of their client(s), constituent(s) and customers, assuming little or no down-side risk?

  26. krice2001 says:

    Agree with Chief Tomahawk, Beaufou (maybe others). This would be an excellent WashPo piece.

  27. wally says:

    It is very clever to put things in the form of questions… it might get around the knee-jerk responses that simply stating facts often provokes.
    Unfortunately, the persons who would most benefit from thinking about these things have long ago made decisions based on self-interest and they do not intend to begin any sort of open-minded thinking foolishness. They come first, their country comes second.

  28. EDF says:

    @Niskyboy: Well said

    @Chief Tomahawk (and others): If it appeared in the WaPo, there’s a decent chance that ‘the right people’ might read this and learn. Hope springs eternal.

  29. Long term says:

    Methinks BR would like to see 12 graphs and NO words for a good grade here.

  30. willid3 says:

    2. I am thinking the funding model change destroyed their creditability, its the same as payolla scandals the music industry went through in the 20th century. while we may not need the NRSROS as they are today, a need is still needed for some body to do evaluation, who isn’t corrupted by being beholden to seller or the buyer. sellers became the equivalent of the used car salesman, no product was bad, all were good as gold. and buyers were only interested in those good as gold products only because a lot of them were required to have high grade assets. consider that todays banks are still carrying mortgages at full value, not marking other assets as market values, because they can and they have to. are there others in a similar situation? pensions, 401k funds, etc all need a high quality ‘asset’, and they will buy them and retain them, even if they aren’t.

  31. willid3 says:

    Frances_Coppola, I doubt seriously that the banks and wall street ever expected to need a bailout, after all, they were doing nothing wrong as far as they were concerned.

  32. kenny powers says:

    Come on, Barry. This would never be on an economics exam.
    I vividly remember the subject matter of one graduate economics class in the fall of ’09 being ” why didn’t anyone see the crisis coming?” I raised my hand and said plenty of private sector players and economists saw it coming, but the professor hadn’t heard any of the names I listed, so he dismissed the notion that anyone was ahead of the curve and instead spent 60 minutes praising Paul Krugman for some shit article he wrote after the fact. Ironically, he thus fully answered his own question.

  33. socaljoe says:

    I don’t have 3 hours, so here’s my short answer:

    When you allow 40:1 leverage and make money available for free… shit happens.

    Always did… always will.

  34. Lukey says:

    Okay Barry – I concede – the (evil and corrupt) bankers were mostly responsible for the housing collapse and the subsequent banking crisis. But I’m glad to see you started with the Fed’s role because I believe that was the fuel for this fire. And as for the role of (de)regulation, I think the vast regulatory regime which continued to exist in the banking space is what provided the incentive to get as big as possible as fast as possible. Maybe the existence of regulations designed to thwart that incentive may have helped with this problem but may also have created other problems. I think a goal of breaking up these mega banks (both commercial and investment) would be worthwhile and may well be facilitated by looking at all the (still existing) regulations for ways to lighten its load while maintaining basic oversight that discourages fraud. Make the littler banks more competitive with the bigger banks and maybe some of these toxic behemoths would start breaking up on their own. As for the rating agencies – I would do away with them. Make the investment brokers that sell these bonds do the due diligence and put their name on the line for recommending them. If it blows up in their faces they go away. Again, if we have enough competition in this market they won’t take chances on selling crap (maybe). But your points are well taken!!!

  35. CSN says:

    Do we get a certificate if we pass?

  36. gordo365 says:

    @maddog2020 “I would encourage every congress-critter and presidential candidate to take the exam and post their answers.”

    You are kidding right? Remember when one of the more innumerate congress-critters claimed — with sincere conviction — that President Obama’s trip to India was costing $300,000,000 per day? Right. $300M per day.

    Dare I say that same person is considered as a leading Republican candidate for one of the white house positions?

  37. lunartop says:

    Me thinks there’s some clues in these questions.

  38. blackjaquekerouac says:

    http://www.youtube.com/watch?v=PfAk8ljuEcQ&feature=player_detailpage
    I leave it to all of you to determine “who’s the SEC” here, “who’s Wall Street,” which Banker is driving the train through the “train block” and the how each sequence represents a particular aspect of the collapse starting in say…2008. to present of course…

  39. DeDude says:

    willid3;

    I think the solution is CDS prices determined on an open competitive exchange. The more it costs to insure against default of a paper on an exchange, the worse the rating. Those rating the security would basically be someone who had to put their money where their mouth is. Nothing like having to put your own skin in the game to keep the ratings honest and as close to reality as the available information allows. Would also easily allow a determination of how much leverage you could use. A paper would have to be backed by a specific multiple of the CDS cost (with minimums for each category) or if CDS was actually purchased just an amount corresponding to the cost of that CDS. For institutions required to “stay safe” a similar rule could be used. No holding a paper if its CDS cost is above X and if you do you must actually purchase CDS for them, that should keep the risk down. For rare papers that did not have a large enough circulation to be traded on an open CDS exchange other ways of determining ratings and allowable leverage could be used.

  40. Wyatt_Earl says:

    Uh, on question #4:

    “another 30% were made by banks or thrifts also not subject to routine supervision or examinations. ”

    There are banks not regularly examined? Not in my experience.

    If you would let ne know what you’re referring to here, I’d appreacite it.

  41. That should be thrifts — not banks

    I”ll fix above, thanks!

  42. I despair as far too many not only don’t know these answers, they don’t even understand the questions. The entire problem for them is Fannie and Freddie, and nothing else. Oh unless they toss in the Carter era Fair Housing regulation.

  43. Rouleur says:

    “Petey Wheatstraw Says:
    July 20th, 2011 at 11:44 am
    13. Was the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 a signal that the banks and government;

    a) knew that credit had already been extremely overextended, and/or;

    b) a clear indication that Corporate entities were now firmly in control of the Legislature, and were dictating the laws they wanted enacted?”

    …yes, Marcus, yes…I had the same thought at that time…WTF, they know this is goin’ down, just like so many did…

  44. [...] Take Barry Ritholtz’s final essay exam on the financial crisis! [...]

  45. ywsimw says:

    Excellent, really excellent. Thanks.

    I personally enjoyed the “Reconcile this in terms of the Efficient Market Hypothesis”

  46. DeDude says:

    I think we all should know whether our candidates for the house, the senate and the presidency next year can produce fact-based answers to these questions. After all they will be the ones that either prevent or precipitate the next big crisis. If you elect people who live in lalaland how can they govern in the US.

  47. [...] morning, we posted the Financial Crisis: Final Essay Exam. I have yet to score the various essays and give out final grades for the semester. But I can tell [...]

  48. OK Avenger says:

    Excellent work, BR. Top Notch.

  49. m111ark says:

    Like a moth to a flame, I cannot resist demonstrating my own “ignorance, unfamiliarity with empirical data…”, etc. Sure that my irrelevancies, while appreciated, will be quickly and irrefutably refuted.

    1.Lowering interest rates is a well used instrument of Fed policy, one should not be surprised it was used after 2001. The pool of worldwide capital, used to more substantial returns, went looking for greater yield. Securitzation, broached in the ’90s, looked like a good place for excess capital – oh those unintended consequences. I’m going to have to punt on fixed income – except that could have driven capital to the corporate bond market. Oil and gold, hey, easy money meant hard assets got only one way to go.

    Bonus – After the end of the cold war, back off the monetary policy, let the market, which won, set the rates. After 2000, well, the only answer, according to the Fed, of excess is more excess.

    2.Getting the easy ones out of the way, eh? The rating agencies did the bidding of their benefactors. What quality?
    Bonus – No. Remove the rating agencies completely – buyer beware.

    3.Deregulating for what end? Probably sold to congress as a competitive advantage, but, simply threw everything up in the air. There was always a way to “manage” risk, until everyone was so well managed that the slightest quiver would send everyone into collection mode. Disaster waiting to happen. Leverage to the moon. What underwriting, it’s going to be sold.
    Bonus – Too big to fail meant you’re going to meet those you pissed off on the way up while your on the way down.

    4.To the moon. But what difference did it make whether you’re regulated or not if regulators are in your back pocket?
    Bonus – Have to take a pass here.

    5.Unlimited leverage and a government backing meant unlimited bonuses for executives. Dangle that carrot in front of money-hungry (is there any other kind)wall street and who’s surprised at what they do. The surprise is that the Dick let it all go.
    Bonus – It says corporatism is the new democracy.

    6A-C. Everyone can get a loan. Builders rushed to build, loan originators rushed to find new suckers(buyers) and when no one is left to buy, sellers appear as if by magic. So whose going to buy now?

    7.With the capital machine clamoring for more mortgage loans to bet on, loans being sold out the back door as soon as they come in the front (wiseguys got this down decades ago) who cares if the sucker can pay the mortgage. See #6.
    bounus – Hey, we got us a factory here – and it’s printing money.

    8.The efficient market goes out the window when uncle sugar backs all bets. See 6 and 7.
    bonus – Self-regulation must imply a cost as well as a profit. There is no cost when all bets are backed by TBTF. That is unless Wall Street develops a conscience – not likely any time soon.

    9.Only the biggest have the lobbying strength to get what they want – if you’re not big, your not playing the game. So banks consolidated. (I’ve had one bank account here in Chicago. First with First Chicago, then Bank One, then Chase – the big fish eat the smaller fish) If you’re TBTF then why not take outrageous risk, you get the bonus and lay off the losses to the sheeple – what’s so hard to understand about that?

    10.Got to take a guess here. This Dugan character has bounced between government “service” and a private law firm, perhaps the best connected in Washington. So knowing how theses people(had to really restrain myself there) act, he was doing the bidding of corporate masters with one goal in mind – greater power.

    11.Got to give it up here to those better informed than I am.

    12.Rescuing the banking system was the only goal. The biggest banks got bigger and the culture of TBTF continues. Executives know they’ve got us by the balls so the greedy game continues. If I knew how the next crisis was going to play out, I wouldn’t be writing here – so I’ll take a pass on what this means for the future.
    Bonus – None.

    Now some thoughts, purely imaginary, on the real problem facing the first democracy with a divinely inspired government of executive, legislative and judicial branch. We have squandered the greatest opportunity afforded us mortals in a very long time. Too much ease and love of wealth have made us collectively soft, immoral, unimaginative, corrupt, stupid, uncompetitive, immoral and, did I mention immoral. Still, we are, at least for the present, the best but not last hope for a truly advancing civilization. Pulling our collective heads out of our asses will require a tremendous act of will and courage and independent thinking, so far qualities not evident. Our salvation lies not in more legislation, more rules, bailouts, or no bailout, neither in tweaking our present monetary system, tea party, liberal or conservative – not nothing but in our collective upstepping of our cosmic mind. Well, I’d settle for at least 10% realizing what needs to be done.

    If anyone has read this far, here’s a book to get you started.

    There’s a Spiritual Solution to Every Problem.

  50. Clem Stone says:

    Oh God, i have no idea and don’t care enough to find out. This is why i read charts instead.

  51. Geert Van Parijs says:

    Dear Professor Ritholtz,

    I cannot participate to the exam and I’ll have to make it during a second session in September. Is it possible to prepare another exam specifically for the European crisis ?
    During my holiday and in order to prepare the exam “Financial crisis in America with worldwide impact”. I will read the “Bailout Nation” you gave me during my visit to New York.

    Thanks again for the interesting discussion we had in your office on Fifth Avenue.

    Best regards and greetings from the south of France,
    Your European pupil Geert

  52. Frances_Coppola says:

    willid3: No, indeed the banks and Wall Street didn’t think they were doing anything wrong. But they knew they had government backing. They therefore looked for higher and higher returns without paying much attention to the associated risks. Hence unrealistic assumptions in CDO pricing, misleading credit ratings and failure to do due diligence. I would add that in the UK, assumed government backing led auditors to give unqualified signoff to the accounts of banks that were already in serious financial trouble. Implicit government backing maintains banks’ high credit ratings and hence keeps their borrowing costs artificially low. Removal of this guarantee is fraught with problems. So (in answer to my own question) I would say: politicians will say whatever the electorate wants to hear, but in the end, large banks will always be bailed out because the alternative is much worse.