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What caused the 2008 financial crisis?

The 2008 financial crisis resulted from a complex web of interconnected factors that created a perfect storm in the global financial system. Here are the primary causes:

Housing Bubble and Subprime Mortgages

The crisis originated in the U.S. housing market, where a massive bubble had formed throughout the early 2000s. Financial institutions began issuing “subprime” mortgages to borrowers with poor credit histories or insufficient income documentation. These loans often featured adjustable rates that started low but increased significantly over time, making them unaffordable for many borrowers.

Deregulation and Regulatory Failures

Key regulatory changes contributed to the crisis:

The repeal of the Glass-Steagall Act in 1999 removed barriers between commercial and investment banking
Insufficient oversight of mortgage originators and financial institutions
Failure to regulate complex financial derivatives
Inadequate capital requirements for major banks

Securitization and Financial Engineering

Banks packaged mortgages into complex securities called mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). This process allowed banks to sell off mortgage risk to investors worldwide, but it also:

Obscured the true risk of underlying mortgages
Created incentives for banks to issue more loans regardless of quality
Spread toxic assets throughout the global financial system

Excessive Risk-Taking and Leverage

Financial institutions took on unprecedented levels of debt and risk:

Investment banks operated with leverage ratios exceeding 30:1
Banks held insufficient capital reserves relative to their risk exposure
A “too big to fail” mentality encouraged reckless behavior

Credit Rating Agencies’ Failures

Rating agencies like Moody’s, S&P, and Fitch gave top AAA ratings to mortgage securities that were actually highly risky. This occurred due to:

Conflicts of interest (agencies were paid by the issuers they rated)
Flawed risk assessment models
Competitive pressure to provide favorable ratings

Global Interconnectedness

The crisis spread rapidly due to:

International banks’ exposure to U.S. mortgage securities
Complex counterparty relationships between financial institutions
Frozen credit markets that affected lending worldwide

Government Policies

Certain government policies inadvertently contributed:

Low interest rates maintained by the Federal Reserve
Political pressure to increase homeownership rates
Government-sponsored enterprises (Fannie Mae and Freddie Mac) purchasing large quantities of subprime mortgages

The crisis began to unfold in 2007 when housing prices started declining and mortgage defaults increased dramatically. As the value of mortgage-backed securities plummeted, major financial institutions faced massive losses, leading to bank failures, frozen credit markets, and ultimately a severe global recession. The interconnected nature of these factors meant that problems in one area quickly cascaded throughout the entire financial system.