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Causes of the 2008 Financial Crisis

Sebencapital

Published
19/01/24
Causes of the 2008 Financial Crisis

The 2008 financial crisis happened because of problems in the finance industry and the broader economy.

The main issue was the financial industry being less regulated. This allowed banks to do risky hedge fund trading using derivatives. Banks wanted more mortgages to support selling these derivatives at a profit, so they came up with affordable interest-only loans for subprime borrowers.

In 2004, the Federal Reserve increased the fed funds rate just as the interest rates on these new mortgages changed. Housing prices started going down in 2007 because there were more houses than people wanted to buy. This left homeowners unable to afford their payments and unable to sell their houses. When the values of the derivatives dropped, banks stopped lending to each other. This caused the financial crisis that led to the Great Recession.

Key Takeaways

  • New rules for banks allowed them to use customers' money to invest in derivatives.
  • Derivatives were made using risky home loans, and the demand for homes went way up.
  • When the Federal Reserve increased interest rates, people with risky mortgages couldn't afford to pay them anymore.
  • There were too many houses, not enough people wanted to buy them, and those who borrowed money for homes couldn't make their payments. This caused the derivatives and other investments linked to them to lose value.
  • The financial crisis happened because some investment banks and insurance companies acted dishonestly, shifting all the risks to investors.

Deregulation

In 1999, the Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act, did away with the Glass-Steagall Act of 1933. This change allowed banks to use customer deposits to invest in derivatives. Lobbyists for banks argued that this was necessary for them to compete with foreign companies. They assured everyone that they would only invest in low-risk options to keep their customers safe.

The next year, the Commodity Futures Modernization Act came into play. This federal law made sure that credit default swaps and other derivatives were not bound by regulations. It overruled state laws that used to prevent this kind of financial activity, considering it a form of gambling. The act even made an exception for trading in energy derivatives.

The key figures pushing for both of these bills were Texas Senator Phil Gramm, who chaired the Senate Committee on Banking, Housing, and Urban Affairs. Senator Gramm had a keen ear for lobbyists from the energy giant Enron. Interestingly, Senator Gramm's wife, who had previously led the Commodities Future Trading Commission, served on Enron's board. Enron was a major supporter of Senator Gramm's political campaigns. Alongside them, heavyweights like Federal Reserve Chairman Alan Greenspan and former Treasury Secretary Larry Summers also worked hard to ensure the bills were passed.

Enron was particularly interested in diving into derivatives trading using online futures exchanges. They argued that foreign exchanges gave an unfair advantage to overseas companies. This legislative shift had a profound impact, opening doors for more risk-taking in the financial world.

Note

Large banks, having plenty of money, became skilled at using complex financial products like derivatives. The more intricate the products, the more money these banks could make. This success allowed them to acquire smaller, safer banks. By 2008, many of these big banks had grown so much that they were considered "too big to fail."

Securitization

Securitization worked like this: Hedge funds and others sold financial products called mortgage-backed securities, collateralized debt obligations, and other derivatives. When you get a mortgage from a bank, the bank sells that loan to others in the secondary market.

Next, a hedge fund groups your mortgage with many similar ones. Using computer models, they determine the bundle's value based on factors like monthly payments, total owed, likelihood of repayment, and future home prices. The hedge fund then sells these mortgage-backed securities to investors.

The bank, having sold your mortgage, can make new loans with the money it got. While it may still collect your payments, it sends them to the hedge fund, which, in turn, passes them on to its investors. Along the way, everyone takes a share, making this process popular as it seemed low-risk for both the bank and the hedge fund.

Investors, who took the risk of default, weren't too concerned because they had insurance called credit default swaps. These were sold by reputable companies like the American International Group. With this insurance, investors eagerly bought these derivatives. Over time, everyone, from pension funds to large banks and individual investors, owned them, with major players being Bear Stearns, Citibank, and Lehman Brothers.

The combination of real estate and insurance in these derivatives proved very profitable. As the demand for them increased, banks wanted more mortgages to back these securities. To meet this demand, banks and mortgage brokers started offering home loans to almost anyone.

Note

Banks provided subprime mortgages because they could earn more money from the derivatives linked to these mortgages, rather than from the loans directly.

The Growth of Subprime Mortgages

In 1989, the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) made sure that banks followed the Community Reinvestment Act more strictly. This law aimed to stop banks from avoiding poor neighborhoods, a practice known as "redlining," which had led to the growth of disadvantaged areas in the 1970s. Now, regulators publicly rated banks on how well they supported neighborhoods, known as "greenlining." Fannie Mae and Freddie Mac encouraged banks by promising to turn these subprime loans into securities. This reassurance from Fannie Mae and Freddie Mac added to the encouragement from the Community Reinvestment Act. It created both a "push" and a "pull" effect, pushing banks to lend in these neighborhoods while also pulling them in with the promise of turning those loans into investments.

The Fed Raised Rates on Subprime Borrowers

Banks, struggling after the 2001 recession, were happy about new financial products. In December 2001, the Federal Reserve Chairman, Alan Greenspan, lowered the interest rate to 1.75%. In November 2002, it dropped again to 1.25%.

This move made adjustable-rate mortgage payments more affordable because they depended on short-term Treasury bill yields, linked to the lowered interest rates. However, it also reduced the income banks earned from loan interest rates.

Many people who couldn't afford regular mortgages were excited to get approved for interest-only loans. This led to a sharp increase in subprime mortgages, reaching 14% by 2007. The creation of mortgage-backed securities and the secondary market helped end the 2001 recession but also caused a real estate bubble in 2005.

The high demand for mortgages increased the need for homes, and builders tried to keep up. With low-cost loans, many people bought houses as investments, hoping to sell them at higher prices.

Unfortunately, some homeowners with adjustable-rate loans didn't realize their rates would increase in three to five years. In 2004, the Fed began raising rates, reaching 5.25% by June 2006. This sudden increase in rates caught homeowners off guard, making their payments unaffordable. The rates rose much faster than in the past, leading to financial difficulties for many.

Historical Fed Funds Rate

Causes of the 2008 Financial Crisis
Chart: The Balance  Source: Federal Reserve

The Bottom Line

The 2008 financial crash happened mainly because rules in the financial industry were relaxed, allowing risky bets on derivatives linked to easily given, low-cost mortgages, even for those with not-so-great credit.

As property values went up, many people jumped at the chance to get home loans. This created a bubble in the housing market. When the Federal Reserve increased interest rates in 2004, it made mortgage payments higher, making it tough for people to afford. This led to the bubble bursting in 2007.

Because home loans were connected to hedge funds, derivatives, and credit default swaps, the housing crash hit the U.S. financial industry hard. With its global impact, the U.S. banking industry almost caused financial systems worldwide to collapse. To prevent this, the U.S. government had to put in massive bailout programs for big financial institutions deemed "too big to fail."

The 2008 financial crisis shares similarities with the 1929 stock market crash. Both involved risky bets, easy credit, and too much debt in key markets – housing in 2008 and stocks in 1929.

1. How long did the financial crisis of 2008 last?

The U.S. economy hit its lowest point in 2009, and getting back on track took a while, not just in the U.S. but worldwide. It wasn't until 2017 that the U.S. reached full employment levels again.

2. How much did the 2008 financial crisis cost?

The 2008 financial crisis had a big impact, and there are various ways to see how much it cost. Some experts say just the bailouts in the U.S. cost around $500 billion. Others believe that the prolonged recession and slow recovery meant each American lost an estimated $70,000 in lifetime earnings.

3. What ended the great recession?

The tough economic times got better in 2009 because of different actions taken by Congress and the Federal Reserve. It's hard to say exactly which actions helped the most, and some experts think the government could have done more. However, studies suggest that without these interventions, the recession could have been much more severe.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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