The 2008 Financial Crisis could have caused a worldwide financial and economic collapse with devastating consequences. Despite the fact that this did not occur, it nonetheless produced significant financial issues. Everyone should know the essentials of what happened and how the economy managed to survive.
It was a catastrophic economic and financial crash that caused a lot of everyday citizens to lose their jobs, their houses, their savings, and more. So what precisely occurred, and why did it occur? We will provide you with the most comprehensive explanation possible, so please continue reading.
Understanding The 2008 Financial Crisis
The Housing Market Bubble
To understand what happened, we must first understand what mortgages are. You may already be aware of this, but we will explain it nonetheless. Assume someone wants to buy a house and borrows a significant amount of money from a bank.
In exchange, the bank receives a mortgage, which requires the homeowner to repay a portion of the principal plus interest to the mortgage holder each month. If the homeowner fails to make payments, the mortgage holder takes possession of the property.
Typically, the bank is not the mortgage holder because it is sold to a third party. Back in the day, getting a mortgage was extremely difficult because you needed to have a steady job and good credit to avoid the risk of default. Simply put, lenders did not want to take the risk that you would default on your loan.
This began to change in the 2000s, when investors from the U.S. and abroad seeking a low-risk, high-return investment began to invest in the U.S. housing market. The idea was that the interest rates homeowners paid on mortgages would provide a better return than investing in other assets.
Furthermore, they did not purchase mortgages directly from customers. They decided to invest in mortgage-backed securities. When large financial institutions securitize mortgages, mortgage-backed securities are created. In layman’s terms, financial institutions buy a large number of individual mortgages, bundle them together, and sell a portion of that pool to investors.
Investors looking for a quick profit purchased a large number of mortgage-backed securities. They essentially paid a higher rate of return than they could get elsewhere. Home prices were rising at the time. So, even if the homeowner defaults on the mortgage, the lender can simply sell the house at a higher price and still make a profit.
At the same time, credit rating agencies assured investors that these mortgage-backed securities were safe investments. The ratings were generally high, with AAA ratings dominating.
This usually leads to investors wanting to buy more and more of these securities. As a result, lenders, in this case, banks, did everything they could to create as many of them as possible. However, in order to increase the number of them, lenders relaxed their standards, allowing more people to obtain a mortgage.
People with bad credit and low income could then get a mortgage, which is known as a sub-prime mortgage. Some even made loans without verifying income and offered absurd interest rate mortgages with payments that were initially affordable but quickly became more expensive as time passed.
Because these sub-prime mortgages were brand new, credit rating agencies could still rely on historical data indicating that mortgage debt was a safe investment. That was not the case at all.
Investments became less and less safe as time passed. However, investors trusted the ratings and continued to invest. Traders began selling a riskier product known as a collateralized debt obligation (CDO). And once again, these investments received the highest possible rating from the rating agencies.
The Market Collapse
Furthermore, as more investors poured money into the housing market in the United States, the cost of housing was skyrocketing. Prices rose as a result of new lax lending requirements and low-interest rates, making mortgage-backed securities look like an even better investment.
Because house prices were rising, people could no longer afford to pay their rising mortgage payments. Every day, more people default, putting more houses on the market for sale.
But because there were no buyers, supply increased while demand decreased, causing house prices to plummet. As prices fell, some people found themselves with a mortgage that was far greater than the value of their home. As a result, they stopped paying, which resulted in even more defaults, causing prices to fall even further.
As this was happening, large financial institutions stopped buying subprime mortgages, leaving subprime lenders with bad loans. Some of the largest lenders had declared bankruptcy by 2007.
The problem also spread to the large investors who had poured money into these mortgage-backed securities and collateralized debt obligations (CDOs). And they began to lose a lot of money on these investments.
Furthermore, financial institutions had another financial instrument on their books that could solve all of these problems: unregulated over-the-counter derivatives, such as credit default swaps, which were essentially sold as insurance against mortgage-backed securities.
AIG made tens of millions of dollars in profit from the sale of insurance policies but did not have the financial resources to honor them when problems occurred. Things went horribly wrong, as we now know. These credit default swaps were converted into other securities as well. This effectively allowed traders to bet large sums of money on whether the value of mortgage securities rose or fell.
(The AIG headquarters in New York. Source: CNBC)
All of these bets and financial instruments combined to form a complex structure that included assets, liabilities, and risks. This meant that if things went wrong, the entire financial system would collapse.
Some major financial players, such as Lehman Brothers, declared bankruptcy. Others were forced to merge, or the government simply bailed them out. The issue was that no one knew how bad things had gotten. Some financial institutions had complex, unregulated assets, making it difficult to tell.
The Financial Panic
People at this time began to experience a widespread feeling of panic. Trading, as well as the credit markets, came to a complete halt. The collapse of the stock market was ultimately followed by a painful great recession in the United States.
During this time, the government did a lot to try to stop it. The Federal Reserve acted swiftly and provided financial institutions with access to emergency loans. The goal was to keep fundamentally sound banks from collapsing simply because their lenders were scared. The government initiated the TARP (Troubled Assets Relief Program), also known as the bank bailout.
Initially, $700 billion was set aside to shore up the banks. Despite the fact that it later spent $250 billion bailing out the banks, it was later expanded to help other institutions such as AIG and even homeowners. This, combined with Fed lending, aided in putting a stop to the financial industry’s panic.
The Treasury also put the largest Wall Street banks through stress tests. Government accountants swarmed over bank balance sheets, publicly declaring which ones were safe and which needed more capital.
This removed some uncertainties that had prevented institutions from lending. At the beginning of 2009, Congress also passed a massive stimulus package. This injected more than $800 billion into the economy in the form of new spending and tax cuts. This assisted in preventing the spending, productivity, and employment numbers from plummeting without control.
The Aftermath
The Dodd-Frank Act was passed by Congress in 2010. It was decided to take action in order to prevent banks from taking on excessive risk and to raise the level of transparency.
This created a consumer protection bureau to combat predatory lending. Additionally, it mandated that the trading of financial derivatives take place on exchanges that were open to the inspection of all market participants.
Furthermore, it established mechanisms to allow large banks to fail in a controlled and predictable manner. Despite the fact that no one is certain that this will be enough to prevent future financial crises.
The perverse incentives that were in place in 2008 were the single most important contributor to the financial crisis that year. When a policy ends up having the opposite effect of what was intended, this is an example of “perverse incentives.”
(Development of industrial production during the 2008 Financial Crisis. Source: Eurostat)
For instance, mortgage brokers received bonuses for lending out more money; however, because of this, they made riskier loans, which ultimately hurt their profits. When one person takes on more risk because another person is responsible for bearing the burden of that risk, this creates a situation known as moral hazard.
Because they intended to resell the mortgage to another buyer, banks and other lenders were willing to lend money to borrowers with subprime credit ratings. This sets off a chain of risks that will eventually result in failure.
If banking firms are aware that they will be saved by the government in the event of a crisis, they will have an incentive to place wagers that are reckless or risky. Who exactly is to blame, though? The United States economy as a whole is to blame for this situation.
The government did not sufficiently supervise or regulate the financial system. Deregulation in the financial industry over a period of years is also held partially responsible for the crisis. Everyone in the system, from the largest financial institutions to individual borrowers, was borrowing an excessive amount of money and taking on an excessive amount of risk.
Takeaways
- The 2008 Financial Crisis could have caused a worldwide financial and economic collapse with devastating consequences.
- This began to change in the 2000s, when investors from the US and abroad seeking a low-risk, high-return investment began to invest in the US housing market.
- The idea was that the interest rates homeowners paid on mortgages would provide a better return than investing in other assets.
- Financial institutions began to loosen up their mortgage standards in order to increase the number of mortgages and therefore increase profits.
- Simply put, as more investors poured money into the housing market in the United States, the cost of housing was skyrocketing.
- Because house prices were rising, people could no longer afford to pay their rising mortgage payments.
- AIG sold tens of millions of dollars in insurance policies with no money to back them up when things went wrong.
- To avoid the total collapse of the economy, the government initiated the TARP (Troubled Assets Relief Program), also known as the bank bailout.
