The Global Financial Crisis - put simply
BLOGECONOMICS
The Global Financial Crisis. The cause of one of the most severe economic downturns in modern history; and a crisis whose effects reshaped the financial system for years to come. But it can be quite difficult to understand. Want to learn about it without the extra fuss? Gotcha.
It essentially comes down to one thing, mortgages.
The Housing Boom
How did millions of people struggling to pay their mortgages end up threatening the entire global financial system? The issue lies with the sheer number of mortgages being issued, and who it was being issued to.
Interest rates were relatively low in the years preceding the crisis; the Federal Funds Rate fell from 6.5% in 2000 to just 1% by 2003, making borrowing significantly cheaper. Interest rates essentially represent the cost of borrowing, so when rates fall, taking out loans becomes more affordable and attractive. This encouraged consumers to borrow more and banks to lend more, particularly as rising house prices created the perception that property was a safe and increasingly profitable investment. US house prices more than doubled between 1998 and 2006.
As demand for housing grew, prices climbed, creating a cycle in which rising property values encouraged further borrowing, which in turn pushed prices even higher.
The Financial Machine - what were Mortgage-Backed Securities?
Once made, mortgages could be sold to a third party from banks- which in this case were investors looking for sources of low-risk high return investments. They saw mortgages. However, buying individual mortgages is a lengthy and highly unfeasible process. So in comes Mortgage-Backed Securities.
These are created when banks or other financial institutions buy thousands of individual mortgages, group them, then sell them to investors. To investors, they were getting a higher return rate (they received money from the mortgage payments) for what seemed like a stable and safe bet. The housing market was booming, and investors increasingly viewed these securities as relatively safe, partly because they believed rising property prices would protect them from widespread losses.
There were mainly three types of mortgages at play here:
Prime: Mortgages given to borrowers with strong credit and reliable finances.
Alt-A: Mortgages sitting between prime and subprime, often involving weaker documentation or other increased risks.
Subprime: Mortgages given to higher-risk borrowers with weaker credit histories or less reliable finances.
As demand for MBSs grew, so did the incentive for banks to create more mortgages to package and sell. This encouraged lenders to lower their standards, increasing the number of subprime and Alt-A mortgages entering the system. More subprime and alt-A mortgages were being lent, often even predatory lending practices were used. Banks started to give these loans without verifying income, even adjusting the rates to be more affordable initially but eventually became higher than what they could pay.
The risk no one thought would matter
At first, risky mortgages seemed manageable. As long as house prices continued rising, lenders could recover their money by selling properties if borrowers defaulted. Financial institutions had also leveraged themselves heavily, using borrowed money to invest in vast quantities of mortgage-backed securities. This meant that even a relatively small increase in mortgage defaults could create disproportionately large losses. More importantly, because these securities had been sold to banks and investors around the world, the risk was no longer confined to the original lenders. What started as risky mortgages had become a problem embedded throughout the global financial system.
The Bubble Bursts:
But the housing boom could not last forever. As borrowers began struggling to meet their mortgage payments, defaults rose and the supply of homes on the market increased. With demand falling, US house prices began to decline in 2007. Homeowners who had borrowed heavily found themselves owing more than their properties were worth. As homeowners stopped making payments, the mortgage-backed securities built from these loans rapidly lost value, leaving banks and investors facing enormous losses. The problem quickly spread through the financial system as banks became increasingly unwilling to lend to one another.
The collapse of Lehman Brothers in September 2008 marked a major turning point. One of the world's largest investment banks, Lehman had significant exposure to mortgages and mortgage-backed securities and had borrowed heavily to finance its investments. As these assets lost value, Lehman struggled to meet its obligations and ultimately filed for bankruptcy.
But why did one bank collapsing affect everyone?
Banks don't operate independently. They lend to each other, trade with each other, and hold each other's financial obligations. So when Lehman collapsed, other financial institutions suddenly had to ask: “If Lehman couldn't pay what it owed, which other banks might be next?”
And that's when the financial crisis started spilling into the real economy. As banks faced mounting losses, they became more cautious about lending, making it harder for businesses and households to access credit. Businesses cut investment and jobs, unemployment rose, and falling consumer spending further weakened economic activity. A problem that began with mortgages had now become a global recession.
The Global Financial Crisis wasn't simply caused by people taking out mortgages they couldn't afford. It was the result of a financial system that had taken those mortgages, repackaged and leveraged them, and spread the associated risk across the world. When the housing bubble burst, the consequences didn't stay in the housing market—they travelled through banks, businesses, and households around the globe.
The mortgages may have been American. The consequences were global.
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