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Housing-price boom and bust
• From the late 1990s to 2006 U.S. home prices roughly doubled, outpacing incomes and rents.
• Drivers: low interest rates after the 2001 recession, capital inflows from export-surplus countries, federal tax incentives for home ownership, and an industry belief that nationwide housing prices “never fall.”
• When price growth slowed in 2006-07, highly leveraged borrowers began to default, starting a chain reaction through the financial system.
Explosion of subprime and other high-risk mortgages
• Lenders increasingly originated loans to borrowers with weak credit, little documentation (“Alt-A,” “liar loans”), or teaser rates that reset sharply higher.
• Underwriting standards deteriorated because lenders immediately sold the loans, shifting credit risk away from themselves.
• Predatory sales practices and borrower speculation added fuel.
Securitization and faulty credit ratings
• Banks pooled mortgages into mortgage-backed securities (MBS) and, in a second step, into collateralized debt obligations (CDOs).
• Rating agencies paid by issuers stamped many tranches AAA, underestimating the correlation of defaults and relying on limited historical data that did not include a nationwide price decline.
• Investors worldwide—pension funds, insurers, money-market funds—bought the securities believing they were nearly risk-free.
Excess leverage and the shadow-banking system
• Investment banks, hedge funds, structured investment vehicles (SIVs), and money-market funds funded long-term assets with cheap, short-term wholesale funding such as repurchase (repo) agreements and commercial paper.
• Leverage ratios at major broker-dealers exceeded 30:1; a small decline in asset values wiped out capital.
• Because these entities were outside traditional deposit insurance and capital regulations, they were prone to runs.
Derivatives and counterparty risk
• Credit-default swaps (CDS) allowed speculators and insurers (notably AIG) to sell protection on MBS and CDO tranches without setting aside capital.
• When defaults mounted, protection sellers faced huge collateral calls, creating systemic risk because the market was opaque and unregulated.
Regulatory and supervisory failures
• Key post-Depression firewalls had been weakened (e.g., the 1999 repeal of parts of Glass-Steagall).
• The SEC in 2004 let major broker-dealers choose their own risk models and cut required capital cushions.
• No federal agency oversaw mortgage brokers; the Fed did not use its authority to curb abusive lending under the Home Ownership and Equity Protection Act.
• Fragmented regulation left gaps between banking, securities, insurance, and derivatives oversight.
Incentive misalignment across the chain
• Mortgage brokers earned fees on volume, not loan performance.
• Structured-product desks earned bonuses on deal flow and modeled risk, not realized losses.
• Rating-agency analysts were paid by issuers.
• Senior managers relied on short-term stock options; shareholders benefited from upside but had limited liability on downside.
Global imbalances and the hunt for yield
• High-saving emerging markets (China, oil exporters) and Germany/Japan ran large current-account surpluses and invested in U.S. fixed-income assets, pushing down yields.
• Investors ventured into complex structured products to earn a few extra basis points, amplifying demand for risky mortgages.
Monetary policy backdrop
• The Federal Reserve kept the federal-funds rate very low (1% in 2003-04) to counter the 2001 tech-bust recession and deflation fears, encouraging borrowing.
• While not the sole cause, cheap money made credit-fueled asset bubbles easier to form.
Immediate trigger events (2007-08)
• Feb-Apr 2007: subprime lender New Century collapses; several hedge funds at Bear Stearns fail.
• Summer 2007: interbank lending strains appear; BNP Paribas freezes three funds, marking the “first freeze” of liquidity.
• Mar 2008: Bear Stearns rescued by JPMorgan with Fed support.
• Sept 2008:
– Sept 7: U.S. government takes Fannie Mae and Freddie Mac into conservatorship.
– Sept 15: Lehman Brothers files for bankruptcy, shattering confidence in all short-term funding markets.
– Sept 16: AIG rescued; Reserve Primary money-market fund “breaks the buck,” triggering wholesale runs.
• Without functioning credit markets, real-economy firms could not roll over working capital, forcing extraordinary central-bank and fiscal interventions.
Interaction of factors
— A housing bubble provided the combustible material.
— Securitization and derivatives spread that risk across highly leveraged institutions worldwide.
— Poor regulation, flawed models, and misaligned incentives let fragilities accumulate out of sight.
— Once house prices reversed, losses cascaded through interconnected balance sheets; liquidity evaporated, turning a credit correction into a systemic crisis.
In short, the 2008 financial crisis was not caused by a single event but by the convergence of a housing bubble, lax lending, complex and misunderstood financial engineering, excessive leverage, regulatory gaps, and macroeconomic forces that together produced a sudden loss of confidence and a worldwide credit freeze.