eli5 2008 Global economic crisis
In: Economics
This gets complicated very quickly.
In the early 2000’s there was a huge housing boom in the US. Banks were lending a lot of money (unwisely but that explanation is another long story) and taking on huge mortgage portfolios. So there was a great demand from banks to offload these risks. Some investment firms bought these loans from the retail banks and repackaged them into securities like credit default swaps (CDS) and collateralized debt options (CDO). These securities essentially tried to divide the risk for the loans into smaller bits which could be traded and sold off in smaller bits. AIG (an insurance company) underwrote many of these securities (meaning they insured against the risks) and MANY banks all over the world purchased these securities thinking that they were safe investments. (Details of CDO and CDS are technical)
Unfortunately there was a bit more risk than was understood in these investments and when the housing market cooled off slightly, AIG found out it couldn’t pay out and many banks realized that their investments were not as good as they thought and prices started to fall. According to bank accounting rules, the banks had to reserve (hold more money essentially) against these potential losses meaning they could no longer lend out money. This drove the global financial system into a liquidity crisis.
Bank loans are necessary for many businesses to operate. And businesses trade and do business with other businesses globally. As a result, many companies now ran the risk of bankruptcy when banks couldn’t supply them money even though the companies themselves were not directly involved.
Many governments had to step in and provide liquidity to the financial system by providing emergency loans to banks and forcing a restructuring of banks etc. Several large banks (notably Lehman Brothers) went out of business or were forced to merge. Although the immediate financial crisis was averted, the ramifications was a very real recession in many countries.
Your piggy bank isn’t just a normal piggy bank that holds your money until you need it. Instead the piggy uses your money to lend to other people and to make bets and investments.
The piggy thought it was making safe bets on something called mortgage backed securities. This is because these were supposed to be backed by people paying off the mortgages on their homes.
Unfortunately a lot of people were sold a lot of mortgages they shouldn’t have and didn’t have the means to ever pay off so a lot of the value of these mortgage backed securities was funny money. Eventually people realised and all the piggy banks realised they were about to lose a lot of money.
Because piggy banks are so vital to the global economy, the government had to step in and print pocket money for the piggys. But the result was it became harder to borrow money, lines of credit dried up (i.e. people got less pocket money) and the whole global economy got affected.
this is a very short question that requires a veeery long and detailed answer. what happened and why, was a result of a number of decisions and reasons, some of them being greed, gambling with other’s money and many more. i’d suggest to watch at least three movies – 2 are fiction and 1 is a documentary:
– [Margin Call (2011)](https://www.imdb.com/title/tt1615147/?ref_=nv_sr_srsg_0_tt_3_nm_5_q_margin%2520call) – tells a story of a big bank and people working there during the night before and the day when proverbial “shit hit the fan”. it explains how dangerous financial instruments, without proper supervision and fueled with greed generated so much debt that could collapse the whole US economy.
– [The Big Short (2015)](https://www.imdb.com/title/tt1596363/?ref_=nv_sr_srsg_0_tt_8_nm_0_q_the%2520big%2520short) – tells a story of three groups of people, who discover beforehand what is going to happen with the economy, separately of each other, and they try to make the best of it, given the circumstances. it explains in greater detail the mechanisms that led to the disaster than the former, and i’d say their explanations are better suited for the layman. one even could call them “fun” if it weren’t a really serious matter that affected a lot of people in a bad or even tragic way.
– [Inside Job (2010)](https://www.imdb.com/title/tt1645089/?ref_=nv_sr_srsg_3_tt_8_nm_0_q_inside%2520job) – this is the documentary, and it explains what happened in greatest detail among the other titles, but at the same time, the scope of knowledge is broad and it is the most difficult to take in. there are interviews with actual people involved (or at least attempts at them) and the whole affair is explained in greatest detail. some may say that it’s a boring movie, but it’s the most shocking out of these three. it clearly shows arrogance and impunity of people in power.
so, i didn’t actually explained how and why, but if you see these three you’ll know exactly what happened and what were the reasons why it happened.
The catalyst for the crisis was the collapse of housing bubble in the United States, which caused a large amount of banks and financial companies to collapse. Since the United States economy is so dominant and intertwined with the world economy, the problems spread throughout the world.
The housing bubble itself was caused by a massive amount of reckless lending by banks and lenders. Basically, lenders made it extremely easy to give people mortgages for housing – not even requiring proof of income or money from the applicant. So this meant that it was very likely for the mortgages to not be paid. The lenders would then sell bundles of garbage mortgages (called securities) to larger financial institutions while lying and saying that they were virtually risk free, as mortgages bundled up like a traditionally considered a very safe investment for banks. So safe, in fact, that there were a lot of secondary markets that were set up to trade these bundles and related financial instruments.
Eventually, the bad debt that a bunch of financial institutions had bought up starting going into default. It turns out that the mortgages were so worthless that they couldn’t cover the losses, and major financial institutions went bankrupt. All of the secondary markets also collapsed.
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