why and how the 2008 economic crisis happen?
In: Economics
The movie The Big Short will explain it to you in a fun way (like youre 5), hope this answer is allowed?
Imagine you and your friends want to have some bicycles. I decide to give you money for it on the condition that you will keep paying me some little money every day and return the money eventually. I’ll actually own the bikes. I give out $1000 in total to buy the bikes and kids are riding happily. The mayor of town loves me cause I’ve done something great.
Then I go to uncle Richard, and say, “hey I’ve got 10 kids who are paying me interest of $50 every year and will eventually return $1000. Do you want to buy *that* for $1050?” and he buys that. He then sells it on, and the entire neighbourhood is trying to squeeze some money out of this.
But all of a sudden, some of the kids stop paying the money back. So Uncle Richard technically has some bikes now, but can’t get money, bikes aren’t worth that much…
All of a sudden, the neighbourhood has sunk their money into something that’s not worth that much. Their money has practically vanished. Kids can’t ride bikes, they have no money to get new stuff. The mayor needs to pump some money into the system to get things started again.
You see, everyone’s worse off…
Except me!!! but I’m nowhere to be found. Bye!!!
For years leading up to 2008, Banks were intentionally giving out mortgages to people they shouldn’t have been in an effort to try to make more money. They were gambling that they would be fine. That gamble lost, big time, and worldwide governments were left with a decision: Bail them out from their gamble and have inflation go through the roof, or let them fail and have the public lose their money (savings, pensions, investments). They chose the bail out option.
(Theres actually a bit more too it than even that. As someone else said, The Big Short goes into details on it. But the output is the same: The Banks fucked around, and found out, and now were all poorer for it.)
Banks gave lots of loans for houses to people who couldn’t pay them back, or could but just barely.
They then “packaged up” these loans. You can take a ton of loans, put them together, then sell *that* to investors. They’ll make money as long as enough people in the package pay back the loans with interest.
Then investors took those packages and sold bets on them, that would pay out in certain conditions. This was supposed to hedge them in case the packages failed.
This whole system only worked if enough people in the packages could pay off their loans.
They couldn’t. The math didn’t work out. Too many people in the packages weren’t able to pay off the loans, causing them to fail, which caused a domino reaction that led banks to fail.
Here are the two most important facts to understand about the 2008 financial crisis:
1) It was fueled The Federal Reserve printing money that was feeding directly into the financial markets.
2) The government was pushing lower lending standards onto banks because, at the time, it was politically desirable in the name of making it easier for low-income people to get home loans.
Pretty much everything else followed from those two things, but the official narrative that was crafted afterward was designed to exonerate the people in power in favor of pushing the blame entirely on the financial sector. Banks were pressured into giving loans without any evidence that the people they were giving them to would pay them back, so they packaged the mortgages and sold them off. Both the money to give out in the loans and the money to buy the mortgages from them were abundant in supply because of cheap credit from the Federal Reserve. Artificially low interest rates further encouraged this behavior by pushing down the return on investment for less risky investments like AAA bonds.
The regulatory environment did everything it could to encourage the system of giving out and selling off loans because- again- politicians wanted to brag about making home ownership easier. Fannie Mae and Freddie Mac were created specifically for that purpose, and in the lead-up to the financial crisis they were directly encourage to loosen standards and misrepresent the risk of the mortgage packages they were selling to private investors.
It’s complicated.
Broad strokes:
1. In the mid-1990s, there was a push to encourage low-income families to be able to buy houses. The government mortgage lenders (Fannie Mae/Freddie Mac), in coordination with congressional law, had policies in place where, effectively, a certain % of loans had to be made to low-income families. The methods changed, but it was a combination of several tools–one of which was higher interest rates (sometimes known as a “balloon mortgage” where the initial payments were low, then the interest rate jumped up–the idea being that a low-income family would have time to get better credit and then refinance.)
2. In the 90s and 2000s, the Federal Reserve effectively had the interest rate as low as it could possibly go. Aside from a few blips during the early 2000 recession, it was near zero. This had the effect of basically flooding the economy with money. Generally speaking, this was to encourage economic growth since it appeared that inflation was not going to be a problem.
3. Mortgages, when held by a bank or mortgage holder, often get bought and sold. These are often done in packages. Your local bank might actually give you a loan, but after it’s established, they “sell” that loan to another company. Your local bank would rather have the money *now* than deal with processing the payments for the next 30 years. The terms don’t change when this happens, so you, as a consumer, probably don’t even know it’s happening (aside from a new mailing address).
4. These “packages” are made up of a mix of different mortgages. Mortgages, in general and historically, are a safe bet. Even if they somehow fail (which they rarely do–people prioritize their home payments), the banks still have the property. Even with the “new” mortgages that are higher-risk, it’s still within the range of acceptable risk for most investors.
5. This was done, partly, by making these “packages” balanced. You stick 70% “safe” mortgages and, say, 30% “risky” mortgages and sell it. Or 80/20 or 50/50. Investors can pick their level of risk and these packages (mortgage-backed securities) at whatever price point makes sense.
6. So far, so good–none of this is particularly controversial. It’s pretty standard finance.
7. Until: these packages? Turns out it wasn’t 70/30, it was 20/80. These mortgage-backed securities were stuffed *full* of high-risk mortgages. And many of them were on balloon payments, so they *looked* safe now, but after a few years those interest rates were going to skyrocket. If a small % of your package has those, no big deal, but if that’s *all* they have, you’ve got a problem–especially if you bought the package assuming it was the 70/30 split.
8. Those balloon payments started to come to fruition, and people started to not pay their mortgages at the higher rate. As time went on, more and more of these high-risk mortgages were failing. And when they fail, the institution who owns the mortgage gets the house–except when *everyone* is failing, those houses are worth less. This has a ripple effect across everything, making it even harder for existing holders to pay *their* mortgages…and so on. Eventually, the dam burst and the mortgage-backed securities collapsed when people realize how many risky mortgages were not getting repaid.
9. Like most things in finance, *some* of this can be absorbed into the economy, but not if it all happens at once. The problem is is that *everyone* was getting into mortgage-backed securities–they’re supposed to be a “safe” bet, remember?–so when mortgages started failing left and right, *everyone* was left holding the bag. Pretty much all major financial institutions in the US were hit hard, and some nearly centuries-old houses, like Bear Stearns and Leheman Brothers, collapsed. The government of Iceland nearly toppled.
Who is to blame for all this? You can take your pick–financiers who didn’t want to look too closely at the securities they were buying, and entities who deliberately downplayed the risk. Government policies that made money basically free to borrow and fueled a housing bubble. Government policies that encourages people who couldn’t afford houses to get houses. My own opinion is the credit ratings agencies (Standard and Poor’s, Moody’s, and Fitch) whose *entire purpose* was to investigate and examine the risk of these securities, and they just fucking didn’t. But there’s lot of blame to go around.
A lot of people will try to pin the crash on one thing but it was a multi-layer
– Back then there somewhat loose regulation on lending, people can easily lie about their income and lenders can give loans to people that shouldn’t qualify. Banks get money from the interest on the loan and if the buyer defaults they get the house which has been increasing in value.
– There were investment banks that saw this and decided they want in so they bought a pool of mortgages from lenders so they get to collect on the interest on the mortgage payments and get the house if the buyer defaults. This seemed lucrative to retail investors (say someone like you and I) so the Investment Bank sells Mortgage-Backed Securities to them. The lender gets their money back (with some interest) and can re-lend the money again. So long as they can buy mortgages off lenders they can keep making money.
– There were insurance companies seeing this and saw the potential to make more money, they can sell Credit Default Swaps which they payout when buyers can’t make payments. This seemed lucrative and other investors want in, so they would sell multiple insurance policies on a single mortgage. So long as people made their payments they can keep making money.
Now banks can lend money to anybody and pass the risk off to investors who pass the risk off to insurance. If there’s little risk, why not sell mortgages to everyone whether they can pay it off or not?
– Now there are sub-prime mortgages. These are targeted to people with bad credit and low income. They seem low at first but can increase the interest to ridiculous amounts making the payments unaffordable, unfortunately since the buyer isn’t the most finance savvy person that doesn’t read the contracts, they buy it anyway.
– Investment Banks still want MORE mortgages and keep the gravy train going so they also buy these subprime mortgages. This made those mortgage-backed securities into ticking time bombs. They rolled these subprime mortgages into those securities, lie to investors about the risk, sell “riskier” securities, and new investments.
All this made a red hot real estate market and thus made the “bubble”hinged on people making their mortgage payments on time. You have lender that doesn’t care who they lend to, investment banks that doesn’t care about how risky those loans are and insurance companies that are backing these, all pretending not to see if people make their mortgage payments on time.
Then a recession happens and people start to miss their payments. People start to lose their homes.
Then those mortgage-backed securities become real estate. Investment Banks now have more homes than it could possibly handle.
Then there is a MASSIVE wave of foreclosed houses flooding the real estate market meaning there are way more houses than buyers. This plummeted house prices.
Now the domino effect begins.
Those investments default, they stopped buying mortgages from banks. Insurance companies now have impossible amounts payouts. Banks, investment companies and insurance companies start shutting down.
Now the government has to step in to save two of the largest insurance companies.
This causes a massive shockwave in investing and effects citizens and companies who invested in the USA, the global economic engine stalls. This took YEARS to recover and new regulation and lending practice took place.
Years ago, if a bank gave you a mortgage loan, they would hold the note and hopefully (usually) get paid back. Eventually other financial houses started buying them from the originating banks. It became very profitable for the banks to keep creating loans, and selling them.
They institutions that kept buy them had to accept that the originating bank had done due diligence, but the banks felt less and less need to do that. Somewhere along the way the outfits holding all these bags realized the risk had gotten unwieldy, so they started dicing all the loans into what they called “tranches” of verying risk, and selling them as “Mortgage Backed Securities”. Safer tranches would earn less, be be more likely to pay off (and be paid first, in case of a collapse). Riskier tranches offered a higher return. The riskier market was called “Sub Prime.”
This whole mess turned into a trillion dollar market. The whole concept of “collateralized debt” exploded.
Then, people who had gotten into balloon mortgage deals (nice rates to start, then eventually the payments would go up) started to see that their homes were not worth what they were becoming obligated to. Too many of these people simply walked away. This combined with the higher than you would want Subprime failures. They were largely blamed in the press, but they were never the main problem. The problem mortgages were the heavier balloon mortages, but they both yanked the bottom out of the whole collateralized debt mess.
When a couple large financial companies declared bankruptcy, the shit hit the fan.
The major cause of it was collapse of the housing bubble in the United States.
Basically in the years leading up to it, banks and other major financial institutions began to lend a lot of money (house mortgages) to people that couldn’t really pay it back. Why did they do this? Because they would bundle up these loans (bundling them up made them look less risky than they actually were) and sell it to other people, who thought that these loan bundles were really secure investments.
The banks made tons of money off of this, and so they basically would give out massive loans to people that might not even have jobs since they could just sell the loans to someone else and then they didn’t worry about what happened when the borrower couldn’t pay the loan back. Since anyone could get a loan, this drove housing prices up, which created a really big housing bubble. Importantly, secondary markets began to develop around these loans – that is, they became assets that were passed around the financial market and could be used as things like collateral for *other* loans. On paper, these bundles seemed great since even if the borrower defaulted on the loan (not super common generally), the owner of the loan could sell the house to offset the loss. So these loan bundles were very desirable.
Anyway, eventually the borrowers *weren’t* able to pay back their loans and started defaulting. Well, that’s fine right? The owners of the loans could just sell the houses, which were theoretically worth a lot since the mortgages were big. Well, this is when the housing bubble popped. Suddenly there were tons of houses on the market (nobody was paying their loans so the banks tried selling them) and nobody wanted to buy it. The prices cratered. It turns out that house bought by somebody with no job wasn’t worth $500K, after all. So that means companies with a ton of these loan bundles had a bunch of literally worthless items on their balance sheet – and maybe these loan bundles were what kept them solvent on paper. So companies start collapsing and *trillions* of dollars of theoretical wealth has evaporated practically overnight. This economic mayhem spreads to other places in the world.
Too many people with too few securities could get credits and the banks could get away insuring against default by having rating companies tell everyone “those are fine, trust us, bro™”
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