The 2007/2008 recession is one of the biggest financial hits the world and real estate industry have witnessed. It suppressed local markets, caused the foreclosure of many homes in the USA, and led to the highest rates of unemployment globally. Following the 2008 housing crisis, many government operations got disrupted, with several jurisdictions having to bail out their banks. The once proclaimed “too big to fail” banks started filing for bankruptcy one after the other, with some seeking funding from their local governments.
In the light of the occurrences, the question that still lingers in the minds of everyone is what caused the 2008 housing crisis. Most researchers have cited financial deregulation as the main culprit behind the massive housing crisis. As the world keeps fighting to equilibrate the economy after the decade-long occurrence, the 2008 recession taught the world how risky it is to leave the financial markets unregulated.
Here’s a complete guide to the causes of the 2008 financial recession.
Deregulation: How Did It Happen?
After the repeal of the Glass-Steagall Act of 1999, banks received permission to invest their deposits in derivatives. According to bank lobbyists, this change was necessary to compete with foreign firms. However, these activists promised to limit their ventures to low-risk investments.
A year later, the Commodity Futures Modernization Act was passed to exempt derivatives (including credit default swaps) from regulation. This law overruled any state law prohibiting the activities. The then-Texas Senator, Phil Gramm, wrote and advocated for passing the laws. Senator Gramm was the chairman of the Senate Committee on Banking, Housing, and Urban Affairs. His wife, then the chairperson of the Commodities Future Trading Commission, was also a member of the Enron Energy Company’s board.
The company contributed sizeably to the senator’s campaigns. Since it wanted to trade derivatives through its online futures exchanges, the company sent its banking experts to lobby for the passing of these laws.
Banks Coming Into the Picture
The passing of these laws wasn’t only relief and opportunity for the energy company, as big banks joined the bandwagon, all thanks to the available resources. That spiked the use of these complex derivatives.
The markets became a sea of survival of the fittest, with the banks that had the most intricate financial products profiting the most. After some time, the big banks began to buy the smaller, safer ones, making the major players “too big to fail” by 2008.
The derivatives market grew, with traders selling collateralized debt obligations (CDOs) and mortgage-backed securities (MBSs). The MBSs refer to financial derivatives with values that rely on mortgage prices, which act as collateral.
The MBSs traders depended on home buyers for collateral. After getting a mortgage, the bank will sell the home loan to hedge funds. Depending on the buyer’s potential to pay the loan, future home prices, monthly rates, and other factors, the hedge fund will group the mortgages with similar loans and sell them as MBSs to investors.
Thus, banks had money to loan out to more people purchasing houses. All the proceeds from the already sold mortgages went through the hedge funds to the investors who bought them, although the banks still collected the funds.
The business grew popular since every stop along the channel (bank, hedge fund, and investor) made profits. Banks had less to worry about since the risk of default was a burden for investors to bear. Big insurance companies like the American International Group sold credit default swap policies to investors to cover their backs. Due to the availability of the insurance policy and high profitability, these derivatives were snapped up by different investors, with almost all large banks, pension funds, and individual investors owning them. Lehman Brothers, Bear Stearns, and Citibank were among the most popular participants in the business.
The Rise in Subprime Mortgages
The demand grew, and the banks’ thirst for more mortgages to secure the investments multiplied. Due to the trends and the reinforcement of the Community Reinvestment Act in 1989, most mortgage brokers offered these loans without considering the borrower’s creditworthiness or ability to repay.
Subprime mortgages grew. These mortgages refer to the home loans banks issued to borrowers with poor credit scores that wouldn’t qualify for conventional home loans.
Since everyone could afford a home, the markets became saturated. The demand soon rose higher than demand.
The Rapid Rise in Interest Rates for Subprime Mortgages
The housing markets bubbled up pretty fast. However, the investors never thought that the mortgage rates could increase fast enough to overwhelm the subprime borrowers. By the end of 2004, the mortgage rate was at 2.25%. A year later, the rate got to 4.25%, while 2006 saw it rise to 5.25%.
The mortgage payments got so high that most subprime borrowers couldn’t keep up with the payments. As a result, the home prices faced a deep dive, dropping by 33% between April 2006 and March 2011.
The falling market prices meant home buyers couldn’t sell their homes and couldn’t raise enough funds to cover their mortgage loans. The investor’s inability to pay their mortgages caused the rising housing bubble to burst, leading to one of the biggest financial crises in history.
The Peak of the 2008 Housing Crisis: Conclusion
The world saw the peak of the massive housing crisis in 2007 when one of the subprime lenders filed for bankruptcy. A few months later, other similar lenders followed suit. In 2008, one of the “too big to fail” banks, Lehman Brothers, filed for bankruptcy, causing a wavering in the financial markets. While it’s unclear what damage the 2008 housing crisis caused the world, research indicates that many funds got lost in the activities. The US alone used up to $500 billion for bailouts.