Financial crisis of 2007–2008
The financial crisis of 2007–2008, also known as the global financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s. It was triggered by the subprime mortgage crisis in the US and transformed into an international banking crisis. In this article, I will try to explain in layman's terms why this crisis happened and what were the consequences of it.
Community Reinvestment Act
The main cause of the crisis is supposed to be the Community Reinvestment Act, which is a United States federal law designed to encourage commercial banks and savings associations to help meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods. In other words, this act encouraged banks to give subprime mortgages to borrowers with low credit ratings (usually subprime borrowers were defined as having FICO scores below 640). Because of high default risk associated with these mortgages, they have very high-interest rates. One form of subprime mortgages is an adjustable rate mortgage (ARM). It is a 30-year mortgage with a low-interest rate during the first few years (~5%), after which they reset to a higher rate (~7%).The monetary policy of the Federal Reserve Bank
Because of the attacks on the World Trade Center and dot-com bust on September 11, federal reserve chairman Alan Greenspan lowers interest rates to only 1% to keep the economy strong, which is an extremely low-interest rate.
This decision had one very unpleasant consequence: traditionally investors go to US Federal Reserve to buy treasury bills (T-Bills), believing that they are the safest investments, but after lowering the interest rates to only 1%, investors didn't want to invest their money with such a low return on their investments. So, they started to look for another investment opportunities.
On the other hand, it means that banks on Wall St. can borrow from the federal reserve for only 1%. So, there is an abundance of cheap credit. Banks came up with an idea how to use this cheap credit to their advantage: they would connect investors with home owners through mortgages. This causes banks to go crazy with leverage.
Leverage
Leverage is borrowing money to amplify the outcome of a deal. Here's a simple example of how it works.Let's imagine that a person has $10,000. In a normal deal, this person buys a product (let's assume for simplicity that it is a box) for $10,000, then sells this box to someone else for $11,000, which gives him $1,000 profit. But using leverage, the person with $10,000 would go borrow $990,000 with 1% interest (so, this person must return $999,900 (~$1,000,000) instead of $990,000). This borrowing plus initial $10,000 gives him $1,000,000 in hand. Then he buys 100 boxes with this $1,000,000 and sells them to someone else for $1,100,000. Then he pays back $990,000 + 1% interest, which leaves him with $90,000 profit. This is a major way how banks make their money.
Financial scheme
One day a lender gets a call from an investment banker, who wants to buy a mortgage. The lender sells it to him for a very nice fee. This investor borrows millions of dollars and buys thousands of these mortgages. He combines all these mortgages into one product — a box of mortgages. Every month he gets payments from home owners from all the mortgages in this box. After that this box is divided into 3 slices: safe, okay, risky. Then he puts these slices back into the box, which now is called a Collateralized debt obligation (CDO). The riskier the slice is, the higher rate of return it has: safe -- 4%, okay -- 7%, risky -- 10%. To make the safe slice even safer, the bank ensures it even more for a small fee, called Credit Default Swap. After that the return rate of the safe slice is 3%.
Investment banker can sell safe slice only to investors who want only safe investments, okay slices — to another investors, and risky slice to hedge funds and risk takers. The implicit guarantee by the US federal government, that these securities have a low risk, created a moral hazard and contributed to a glut of risky lending.
The Investment banker makes millions and investors have found a good investment for their money, much better than 1% treasury bills.
Greed
Because the scheme works perfectly, investors want more mortgage-backed securities. The investment banker calls up the lender, wanting more mortgages. The lender calls the broker wanting more home owners, but the broker can’t find anyone: everyone who is qualified for a mortgage already has one.And here comes the biggest mistake that lending institutions made: they decided that houses will always increase in their value. It led them to an idea that when a home owner defaults on his mortgage, the lender gets his house, which has increased in value. Since they are covered if home owners default, lenders can start adding risk to new mortgages: no down payment, no proof of income, etc.
So, instead of lending to responsible home owners, called prime mortgages, they started to lend to less responsible, which are sub-prime mortgages. This was the turning point.
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The percentage of low-quality subprime mortgages rose from 8% to approximately 20% from 2004 to 2006. Vast majority of these subprime mortgages, over 90% in 2006, were adjustable-rate mortgages. High mortgage approval rates led to a large pool of homebuyers, which drove up housing prices. Because of this appreciation in value, a lot of homeowners ought to borrow against their homes. Moderate lending standards and rising real estate prices led to the growth of the real estate bubble.
When U.S. home prices declined steeply after peaking in mid-2006, it became more difficult for borrowers to refinance their loans. And if a few persons default, there is nothing bad, the investment banker forecloses their houses and just puts them up for sale and fully returns his money and even more, because housing prices are rising. But because adjustable-rate mortgages began to reset at higher interest rates (causing higher monthly payments), the amount of delinquencies increased, and more and more of banker's monthly payments turn into houses and after a while there are so many houses for sale on the market, that there is more supply than demand which makes prices of houses plummet.
This creates an interesting problem for home owners who are still paying their mortgages. As all houses in their neighborhoods go up for sail, the value of their houses goes down and they start wondering why they are paying $300,000 for their mortgages when their houses are now worth only $90,000. They decide that it doesn’t make sense to continue paying and they forsake their houses stop paying for them.
Now, the investment banker holds a lot of worthless houses. Investors don’t buy this CDO anymore. But he is not the only one who is struggling, investors has already bought thousands of these CDOs.
Lending institutions don't give mortgages anymore, which makes brokers lose their jobs. At the same time, lenders can't sell mortgages which have already been given, because investment banker can't sell his CDOs. The whole financial system is frozen. Everybody starts going bankrupt, but that’s not all. The investor calls up the home owner and tells him that his investments are worthless. Now you can see, how the crisis flows in a cycle.
Consequences
Several banks and financial institutions merged with other institutions or were simply bought out. The collapse of large financial institutions was prevented by the bailout of banks by national governments, stock markets still dropped worldwide. The crisis played a significant role in the failure of key businesses, declines in consumer wealth estimated in trillions of US dollars, and a downturn in economic activity leading to the Great Recession of 2008-2012, with nearly 9 million jobs lost during 2008 and 2009, roughly 6% of the workforce, and contributing to the European sovereign-debt crisis. One estimate of lost output from the crisis comes to “at least 40% of 2007 gross domestic product”. U.S. housing prices fell nearly 30% on average and the U.S. stock market fell approximately 50% by early 2009.
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