PAPER CASTLES, THE COLLAPSE OF A FINANCIAL EMPIRE

This paper investigates the systemic failures that culminated in the 2008 financial crisis, focusing on the interaction between deregulation, regulatory inaction, and misaligned risk incentives. Drawing on historical policy shifts, it traces how financial deregulation in the 1980s—beginning with the Garn–St. Germain Act and culminating in the repeal of Glass–Steagall—encouraged excessive leverage and speculative practices. The securitization boom, fueled by subprime mortgages and collateralized debt obligations (CDOs), was legitimized by rating agencies assigning inflated AAA ratings, while credit default swaps (CDS) magnified systemic vulnerability. Case studies of Lehman Brothers, AIG, and the Icelandic banking collapse demonstrate how mispriced risk and liquidity freezes triggered global contagion. The paper also highlights overlooked early indicators, such as durable goods order declines, which signaled internal economic stress before the collapse. The findings argue that the crisis was not inevitable; regulatory bodies like the Federal Reserve and the SEC failed to exercise their oversight powers despite warning signals. Misinterpreting the crisis as a liquidity shortage rather than an insolvency event, the Federal Reserve deployed flawed interventions, including low-interest-rate bailouts, which worsened moral hazard. The analysis concludes by recommending stricter leverage controls, rating agency accountability, and real-time economic stress indicators to strengthen systemic resilience.