The housing bubble and the financial crisis of 2008

Table of Contents

Overview
What Caused the 2008 Financial Crisis?
The lending standards and the housing bubble
After effects of the burst of the housing bubble
Reading material
Book recommendations
Tags

Wall Street greed sank the global economy for years.

3.8 million

Number of Americans who lost their homes due to foreclosure as a result of the 2007–08 collapse in the housing market, according to the Federal Reserve Bank of Cleveland.

Overview

The financial crisis of 2007-2008 was years in the making, and due to a complex interweaving of causes.

The crisis had relatively little to do with traditional bank lending or, indeed, with bankrupcies. Its prime cause was the rise and fall of securitized lending.

What Caused the 2008 Financial Crisis?

https://www.investopedia.com/articles/investing/020115/big-short-explained.asp

The financial crisis of 2007-2008 was years in the making, and due to a complex interweaving of causes. Its seeds were sown early in the decade, with cheap credit and lax lending standards fueled a housing bubble - an upward spiral in home prices as borrowers took advantage of low mortgage rates. Many of these loans were subprime - that is, the borrowers really couldn’t afford them, putting the loans at high risk of default.

Lenders then sold those loans on to Wall Street investment banks, which packaged them into mortgage-backed securities and collateralized debt obligations. Rescinded regulations freed up banks and other institutions to borrow heavily to invest in these securities, which they then repackaged and sold to other investors.

By mid-decade, interest rates started to rise and homeownership reached a saturation point. Real estate prices started to drop, and people began to default on their mortgages. When the bubble burst in 2007, financial institutions were left holding trillions of dollars worth of near-worthless investments in subprime mortgages.

The interbank market that keeps money circulating around the globe froze—no one knew how widespread the losses were or who owed what, so they stopped lending completely.

By the summer of 2008, the carnage was spreading across the financial sector. Many venerable firms, like Bear Stearns and Lehman Brothers, went under. Lehman’s collapse spooked the stock market, which went into free fall starting in late September.

The lending standards and the housing bubble

The seeds for the crisis were sown early in the decade, with cheap credit and lax lending standards fueled a housing bubble - an upward spiral in home prices as borrowers took advantage of low mortgage rates.
Relatively poor families from across all the states in America had been able to buy or mortgage their homes with often complex loans that (unbeknown to them) were then bundled together with other, similar loans, repackaged as collateralized debt obligations (CDOs) and sold by banks in New York and London to (among others) German regional banks and Norwegian municipal authorities, who thereby became the effective mortgage lenders.
Many of these loans were subprime - that is, the borrowers really couldn’t afford them, putting the loans at high risk of default.
Securitized lending allowed banks to originate loans but then repackage and sell them on. Lenders then sold those loans on to Wall Street investment banks, which packaged them into mortgage-backed securities and collateralized debt obligations. These are poorly structured, high-risk packages of loan securities.
Rescinded regulations freed up banks and other institutions to borrow heavily to invest in these securities, which they then repackaged and sold to other investors.
These packages of loans received AAA ratings from credit rating agencies - implying a degree of safety they don’t deserve - and are furthermore repackaged and resold in highly questionable ways. These CDOs had been so sliced and diced that it was possible to claim that a tier of the interest payments from the original borrowers was as dependable a stream of income as the interest on a ten-year US Treasury bond, and therefore worthy of a coveted triple-A rating. This took financial alchemy to a new level of sophistication, apparently turning lead into gold.
As the banks took over the securities, the ratios between their capital and their assets lurched down towards their regulatory minima.
It is the financial institutions’ appetite for these securities that fueled much of real estate’s rise - out of all proportion to the industry’s fundamentals.
By mid-decade, interest rates started to rise and homeownership reached a saturation point. Real estate prices started to drop, and people began to default on their mortgages.
1. When the original mortgages reset at higher interest rates after their one- or two-year “teaser” periods expired, the borrowers began to default on their payments.
2. These defaults signalled that the bubble in US real estate was bursting, triggering the sharpest fall in house prices since the 1930s.
3. Some banks made subprime mortgages their entire business, and in early 2008 they began to see late payments and defaults in such high numbers that many banks collapsed.
4. Mounting defaults on subprime mortgages caused a spasm in the credit markets.
Meanwhile, the increased foreclosures began to bring down values of nearby homes, and the chain reaction spread across the country from 2008 to 2010.

After effects of the burst of the housing bubble

The burst of the housing bubble created a slow but ultimately devastating chain reaction.
The global financial system has become so intricate.
When the housing bubble burst in 2007, financial institutions were left holding trillions of dollars worth of near-worthless investments in subprime mortgages.
All kinds of asset-backed securities, including many instruments not in fact backed with subprime mortgages, slumped in value. Institutions like conduits and structured investment vehicles, which had been set up by banks to hold these securities off the banks’ balance sheets, found themselves in severe difficulties.
The interbank market that keeps money circulating around the globe froze - no one knew how widespread the losses were or who owed what, so they stopped lending completely.
Central banks in the US and Europe sought to alleviate the pressure on the banks with interest rate cuts and offers of funds through special term auction facilities. Yet, in May 2008, the rates at which banks could borrow money, whether by issuing commercial paper, selling bonds or borrowing from each other, remained substantially above the official Federal funds target rate, the minimum lending rate in the US economy.
Loans that were originally intended to finance purchases or corporations by private equity partnerships were also only saleable at significant discounts.
By the summer of 2008, the carnage was spreading across the financial sector.
1. Heavy subprime portfolios quickly brought down insurance companies such as AIG that had insured these mortgages.
2. Pools of mortgages used for investments were defaulting, and institutions such as Lehman Brothers and Bear Sterns that underwrote, owned and sold many such investments saw drops in value so great they not only had to shut their doors but also brought down others.
3. Many venerable firms, like Bear Stearns and Lehman Brothers, went under.
4. Lehman’s collapse spooked the stock market, which went into free fall starting in late September.
Having suffered enormous losses, many of the best-known American and European banks had to turn not only to Western central banks for short-term assistance to rebuild their reserves but also to Asian and Middle Eastern sovereign wealth funds for equity injections to rebuild their capital bases.

Reading material

Book recommendations

Andrew Ross Sorkin’s crisis tell-all Too Big To Fail
The Big Short: Inside the Doomsday Machine by Michael Lewis
1. The Big Short employs vivid, colloquial, and even humorous ways to illustrate and define the complex financial instruments and tools, from collateralized debt obligations (CDOs) and tranches to credit-default swaps and mortgage-backed securities, that helped sink the global economy.
Aftershock: The Next Economy and America’s Future by Robert B. Reich
1. https://www.goodreads.com/book/show/7845023-aftershock