I have an easy way to explain what the mortgage market was doing to once the Clinton administration nixed the of Glass-Steagall Act (the video below explains that concept in 5 minutes, if you need help).
I name one side of the room my borrowers, and give each student a different colored slip of paper that represents a mortgage. Each of these mortgages is risky (the borrower has bad or no credit so they receive a sub-prime mortgage. The borrower can't afford a traditional mortgage, so they take out an interest-only mortgage, etc.) Loan officers are not compensated for the quality of loans, but for the quantity of loans. Students recognize that loan officers will start cutting corners.
Since this is risky business for the bank underwriting the loans, the banks start to hedge their risk. To demonstrate this, I collect the slips of paper and turn to the other side of the classroom with scissors in hand. I explain that I want to offer the other side, my investors, a deal. They can buy little parcels that contain snipets of the loans. As I do this, I cut the stacked colored paper into strips. Each investment parcel is built up of parts of loans, which allows a few loans to default without losing too much value. But the idea is most of the mortgages will prosper. Each investor is now making the average of all the rates of return, a rate which is well above inflation. Investors prosper, and so their retirement funds grow. As the bank, I have now insured my investment. In turn, i offer to insure the investments of my investors... an extra couple percentage points that will eat into their returns.
Banks are sitting pretty, until we realize that there are so many of these CDOs out there, and the mortgage market is about to pop. These bad loans bought starter homes the borrower would be out of in five years, which is enough time for the property value to create some equity. If enough borrowers are out there, leveraging the market, we just need the cost of something else that is totally essential to rise quickly and force borrowers to chose between their mortgage and that item. And in this case, it was gas. So the whole system collapses as properties default and CDOs devalue and insurance plans are cashed in... and now suddenly those big banks that lack a cash reserve have no cash on hand. Word gets out on the street and you have a run on the bank.
We quickly outline various quirks of Iceland's history: the relatively small and isolated culture, the limited industries (namely fishing, geo-thermal, and aluminum smelting), the lack of experience in economics and banking, and the school boy idoltry of David Oddsson for Milton Friedman.
Students found Lewis's characterization of Icelandic culture humorous. We had to really discuss how horrid Lewis is of their culture. He alleges that Icelanders are all inbred, neanderthal, and animalistic. It is important to note that inbred are more prone to a vast multitude of health issues, including mental deficiencies. These assertions question if there is any mental capacity at all to understand complex international banking. Long story short: if the data is not there to back the assertion, we are looking at bias and we have to be careful. Furthermore, there are many indicators of brutish behavior in America... our love of physically violent sports, for one.
We quickly transition into the roles of the central banks. It seems fitting to explore what central banks are, who runs them, and what they have learned in their collective history. In order to facilitate this discussion, we created a prezi that is a loose adaptation from Neil Irwin's The Alchemists.