why and how the 2008 economic crisis happen?
In: Economics
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.
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