In 2008 there was a housing bubble burst which then caused a great recession to occur. A housing bubble is defined as “a run-up in housing prices fueled by demand”, and the burst indicated the housing prices dropped significantly. So naturally, this caused a huge issue in the economy and the real estate industry. This was one of the worst recessions since the early 1980s resulting in over 3 million foreclosures and the unemployment rate rising over 10 percent.
A Reckless Banking Industry
There were many reasons for the 2008 financial crisis. One of those reasons is the recklessness of the financiers. Lending institutions simply flooded the housing market with irresponsible mortgage loans to new homeowners and loan applicants who didn’t actually have the financial ability to repay these loans. Mortgages were given to applicants with poor credit history and income\expenses ratio also known as “subprime” borrowers. These mortgages were then passed on to big banks which sold them as low risks securities, even though they were actually high-risk securities.
Subprime Mortgages Integrated into CDO’s In An Attempt to “Reduce” Their Risk
Reducing the risks of these mortgages was made possible due to 2 main reasons. The first reason is that these mortgages were sold in CDOs. A collateralized debt obligation (CDO) is a bundle of mortgages with various risks and return on investment percentage. When the subprime mortgages that are risky were sold together with triple-A mortgages that are considered safe their risk was “reduced”. The only problem was that the risk of the CDO itself increased. Investors considered the CDO’s very safe and were exhilarated by the high return they allegedly yielded. In a world of low-interest rates, the CDO’s were one of the best investments money can buy.
The other reason “reducing the risk” of subprime mortgages was made possible was that agencies who rank the risk of mortgages and CDO’s like Moody’s and Standard & Poor’s were being paid by the same banks that created these CDO’s. Investors trusted the rankings of these agencies and invested in the CDO’s using their own money or in other cases other people’s money. One of these investors happened to be the 4th largest investment bank in the US – Lehman Brothers. The bank was involved in acquiring many of these CDO’s right before the crisis officially started.
When subprime borrowers started defaulting on their loans the bank simply didn’t get the retune on its huge investments and collapsed. The collapse of Lehman Brothers is associated more than anything like the beginning of the subprime crisis even though it began a lot earlier.
There were many other reasons for the 2008 financial crisis. It’s impossible to cover everything that has to do with one of the biggest events in the history of the American economy. There is however a wide consensus when it comes to the understanding that this was no accident. In this article 3 causes were mentioned as to how such a crisis occurred:
1. The recklessness of banks that lent money to applicants who couldn’t repay them (subprime borrowers)
2. Integrating these subprime mortgages in CDO’s and marketing them as safer than what they actually are.
3. Paying off agencies that determine the risk grades of mortgages and CDO’s so that such marketing could be done.
It’s easy to see just by looking at this chronological of “mistakes” that this was done by no mistake.
Credits: picture by Reuben Ingber