The 2008 financial crisis
“September and October of 2008 was the worst financial crisis in global history, including the great depression.” - Ben Bernanke.
The financial crisis caused the stock market to plummet. Nearly eight trillion dollars were wiped out. The unemployment rate had risen to 13.2%. The cause of this economic catastrophe began with Investors looking for low-risk and high-return investments.
The housing market caught the eye of these investors. They believed that they could get a better return from the mortgage interest rates that homeowners paid than they could get on US treasury bonds. A mortgage is a secured loan usually given by banks to finance properties. Here the homeowner will borrow a certain amount of money from the bank, and every month the homeowner must pay back a portion of the principal plus interest.
What these investors sought to purchase were Mortgage-backed securities (MBS). These MBSs were created by financial institutions to securitize mortgages. The financial institutions handle the loans, and then they proceed to sell a large sum of these loans at a discount to be packaged as MBSs to investors as a type of collateralized bond. Although real estate prices were increasing, investors thought in the worst-case scenario, the homeowner defaults, and they get to sell the house for more money. Credit agencies kept telling investors these MBSs were safe investments. The investors started getting greedy and desperate to buy more MBSs, so lenders did their best job to find them.
For lenders to create more MBSs investments for desperate investors, they started handing out subprime mortgages. A subprime mortgage is a loan granted to individuals with a poor credit history. This later came back to bite the economy. Some banks ignored the verification of income completely and offered adjustable mortgages with payments people could afford at first, but quickly ballooned beyond their means. The risk of these investments grew, but investors blindly trusted the ratings and continued to pour in their money. As this went on, traders began selling a product called Collateralized Debt Obligations (CDO). A collateralized debt obligation is a complex structured finance product that is backed by a pool of loans and other assets. Investors took on those risky investments as well. The cause of the increased housing prices were the new lax lending requirements and low interest rates. This only made the MBSs and CDOs seem like an even better investment because even if the borrower defaulted, the bank still had a valuable home, but they were wrong. Thus the housing bubble was formed.
In short, a housing bubble is an increase in housing prices. This bubble quickly burst. People could no longer pay for their expensive homes or keep up with their ballooning mortgage payments. Homeowners had to default, and the homes went back on the market, but there was a shortage of buyers. This continued to occur, and the supply of housing increased while the demand maintained low.
As this occurred, the big financial institutions stopped buying subprime mortgages, and subprime lenders were getting stuck with bad loans; by 2007, some massive lenders had declared bankruptcy. This problem spread to investors who continued to pour their money into MBSs and CDOs. They started losing a myriad of money on their investments.
Financial institutions began selling credit default swaps. Credit default swaps were sold as insurance against Mortgage-backed securities. The insurance company AIG sold millions of dollars worth of default credit swap policies without any money to back them up when things went wrong. All of these financial instruments resulted in an incredibly complicated web of assets, liabilities, and risk. Major financial players had to declare bankruptcy, like the Lehman brothers. Others were forced into mergers or needed to be bailed out by the government. Trading and the credit markets froze. The stock market crashed and the US economy suffered a disastrous recession.