Since the Great Depression of the 1930s, many economists claimed that the financial crisis of 2008 created the most serious economic recession that affected not only America but the global financial system. It is hard to pinpoint the only one reason, however, the housing price boom in 2007-2008 period was the starting point of the following events that led to this disaster.
During this period, the housing price rose dramatically with the plummeted interest rate that made people considered their houses as a piggy bank, with the belief that they will gain more money from the real estate speculation. Therefore, the number of mortgage loans increased as a result of the demand of house owning. The big investors wanted to invest their money in the rising housing market, but they did not want to deal with each individual because it was too risky for them.
Hence, the large financial institutions such as mutual funds, insurance companies, etc. jumped in and securitized the mortgage loans. They bought thousands of individual mortgages, pooled them together, and sold the mortgage-backed securities to the investors. With the guarantee of credit and default risk, the investors had no doubt about these pass-throughs because if the homeowners couldn’t pay and made it a default, they got the house and could sell it for more money. Also, credit ratings agency gave the mortgage-backed securities AAA ratings meaning they were good investments, and investors were desperate to buy more.
When the qualified borrowers already had their mortgages, the lenders created a new product called nonconforming subprime loans by adding more default risk. It required no proof of income documents and no down payment, in other words, the subprime borrowers could purchase a house by borrowing a lump sum price. Investment bankers even made the pool became riskier by creating collateralized debt obligations (CDOs), one slide of pool that included the most credit risk to protect the remaining. Still, it’s a part of these mortgage loan pool, so some of them were given AAA ratings even though they made up incredibly risk. Along with the CDO market, credit default swaps appeared as an insurance contract to the purchasers. While the investors believed in the credit ratings agency and kept pouring their money in the housing market, the borrowers also maxed out their borrowing capacity based on the low adjustable rate mortgages (ARM).
The panic appeared by the time the housing bubble exploded in September 2007 to 2008, when the value of the house went down and was a lower than the mortgage loans because the ARM went up. As more houses turned to default and went back for sale, the prices dropped further. Everyone was in the same boat of this crisis. The big financial institutions stopped buying subprime loans, so the investment bank couldn’t sell their CDOs to anyone and stuck with the bad debt, some of them had to declare bankruptcy like Lehman Brothers and Merrill Lynch. The investors lost their money in these mortgage-backed securities, and the homeowners lost their house. Besides that, the banks couldn’t extend credits to households and small businesses, which affected the normal operations.
The consequences were huge: the financial system was frozen, the stock market crashed, the unemployment rate rose rapidly, and the whole economy was in a recession. To deal with this financial crisis caused by the deregulation in the financial industry, the government stepped in and bailed out the big banks from bankruptcy by lending them money. They also enacted new law to response to this crisis, such as Dodd-Frank Reform Act to mitigate the systemic risk.
