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What caused the 2008 financial crisis?
The 2008 financial crisis was not caused by a single event but by a complex interplay of factors that built up over years, culminating in the collapse of the U.S. housing market and the subsequent freezing of the global financial system. The primary causes can be broken down into several key areas.
1. The Housing Bubble and Subprime Mortgages
This was the epicenter of the crisis. Several elements contributed to an unsustainable boom in U.S. housing prices.
- Low Interest Rates: Following the dot-com bubble burst and the 9/11 attacks, the U.S. Federal Reserve, led by Alan Greenspan, lowered the federal funds rate to a historic low of 1% by 2003. This made borrowing extremely cheap, encouraging individuals and businesses to take on more debt, much of which flowed into the real estate market.
- Subprime Lending: As the demand for mortgages grew, lenders began to relax their standards to attract new customers. They increasingly offered subprime mortgages to borrowers with poor credit histories and a higher risk of default. These loans often featured predatory terms, such as low initial “teaser” rates that would later reset to much higher adjustable rates, making them unaffordable for the borrower down the line.
- Belief in Ever-Rising House Prices: A widespread belief took hold that housing prices would continue to rise indefinitely. This created a speculative frenzy, where people bought homes not just to live in but as investments. This belief also gave lenders a false sense of security; if a borrower defaulted, the bank could simply foreclose and sell the house for a profit.
2. Financial Innovation and Securitization
A U.S. housing problem became a global crisis because of how these mortgages were packaged and sold throughout the financial system.
- Securitization and Mortgage-Backed Securities (MBS): Instead of holding mortgages on their books, lenders bundled thousands of them together—including the risky subprime ones—into complex financial products called Mortgage-Backed Securities (MBS). They then sold these securities to investors (pension funds, investment banks, other countries). This process, known as securitization, transferred the risk from the original lender to the investors. It also created a massive incentive for lenders to generate more and more mortgages, regardless of their quality, because they could immediately sell them off and book a profit.
- Collateralized Debt Obligations (CDOs): The process became even more complex and opaque. The riskiest, lowest-rated parts of MBS were often bundled together again to create a new security called a Collateralized Debt Obligation (CDO). Through financial engineering, these CDOs were often given high credit ratings, masking the poor quality of the underlying assets. Investors bought them believing they were safe, high-yield investments.
3. Regulatory Failures and Deregulation
Key institutions that were supposed to provide oversight failed to manage the escalating risk.
- Failure of Credit Rating Agencies: Agencies like Moody’s, Standard & Poor’s, and Fitch were paid by the very banks that created the MBS and CDOs. This created a major conflict of interest. These agencies gave investment-grade (often AAA, the highest possible rating) ratings to securities that were packed with risky subprime loans. These high ratings gave investors a false sense of security and fueled demand for the toxic assets.
- Lack of Regulation in the “Shadow Banking System”: Much of this risky activity occurred outside the traditional, highly regulated commercial banking system. Investment banks (like Lehman Brothers and Bear Stearns), hedge funds, and insurance companies (like AIG) operated with far less regulatory oversight and were allowed to take on enormous amounts of debt (leverage).
- Deregulation of Derivatives: The Commodity Futures Modernization Act of 2000 exempted derivatives like Credit Default Swaps (CDS) from regulation. A CDS is essentially an insurance policy on a debt product (like an MBS). AIG, a massive insurance company, sold tens of billions of dollars’ worth of CDSs, insuring investors against defaults on CDOs. However, AIG was not required to hold enough capital in reserve to actually pay out on these policies if a large number of CDOs failed simultaneously.
4. The Collapse and Contagion
When the housing bubble inevitably burst, the dominoes began to fall.
- The Bubble Pops (2006-2007): By 2006, housing prices peaked and began to decline. As interest rates on adjustable-rate mortgages reset, homeowners found they could no longer afford their payments. Because their homes were now worth less than their mortgages (underwater), they couldn’t refinance or sell. Defaults and foreclosures skyrocketed.
- Financial Contagion (2007-2008): As mortgages defaulted, the MBS and CDOs built upon them became worthless, or “toxic.” Financial institutions around the world were holding trillions of dollars of these now-toxic assets. Panic ensued because no one knew which banks were solvent and which were not.
- The Credit Freeze: Trust evaporated. Banks stopped lending to each other and to businesses, fearing they wouldn’t be paid back. This freezing of the interbank lending market (where rates like LIBOR are set) is the “credit crunch.” It choked off the flow of money that is the lifeblood of the modern economy.
- Key Failures of 2008:
- March: Bear Stearns, a major investment bank, collapsed and was sold to JPMorgan Chase in a fire sale brokered by the Federal Reserve.
- September: The U.S. government took over mortgage giants Fannie Mae and Freddie Mac.
- September 15: Lehman Brothers, the fourth-largest U.S. investment bank, declared bankruptcy. The government’s decision not to bail it out sent a shockwave of panic through the global system, signaling that no institution was safe.
- September 16: The government was forced to bail out AIG with an $85 billion loan because its collapse would have triggered a chain reaction of defaults throughout the system due to the massive number of CDSs it had sold.
In summary, the 2008 financial crisis was caused by a “perfect storm” of a U.S. housing bubble fueled by easy credit and subprime loans; the bundling of these bad loans into opaque, complex financial products that were sold globally; a profound failure by credit rating agencies and regulators to assess and control the risk; and a highly leveraged financial system that was unable to withstand the shock when the bubble finally burst.