In layman’s terms, what caused the 2008 financial crisis?

If two things are to be blamed for 2008 financial crisis, then they are:

1. The assumption that “Housing prices will always rise and will never fall.”
2. And Gramm–Leach–Bliley Financial Modernization Act year 1999.(Remember the year)

What this act did was, it broke the boundaries between the Commercial bank, Investment bank, and Insurance company. And ideally, all these three entities should be in isolation.

Let’s assume a situation that there’s a family of four members, husband-wife, and two children. Such a family has a regular source of income; good health, and basic necessities to maintain a decent living standard. Let’s name such families in America as Prime families.

Now, Prime families want a house. Unless you’re a rock-star, businessman or big cat rich you can’t own up a house without “house loan”.

So, Prime families approach the broker for getting their loan sanctioned from a commercial bank. Since they’re Prime families, therefore, their loan gets sanctioned very easily.

The loan is sanctioned, possession is achieved and Mortgage papers (i.e. legal documents of the house) are taken by the bank as collateral.

This cycle is perfect to run the economy.

A family wants a loan; it went to a bank via. the broker gets the loan, owns up a house, the bank retains mortgage paper. That’s how the system works. Till now there’s no problem and everything is fine in the economy.

But unfortunately Gramm-Leach-Bliley Act got passed and it said that we must run the system faster. And therefore Investment Bank comes into the play.

Investment bank’s job is to invest such people’s money who want high returns and bank gets the commission for this. Investment bank’s investors were China, Japan and later US federal reserves also started investing.

There are other investment banks as well in the other countries which share the goal with American Investment bank.

Because of Dot-com bubble crash, there was less swiftness in the market and hence American government asked US central bank i.e. US Federal reserves to lower their interest rate to 1% p.a., so that market should start borrowing the loan and asked them to invest in Investment bank also.

Now countries like China and Japan who use to invest in US Investment banks and use to earn great profits can’t do the same now because Federal reserve has lowered their interest rate. Hence, such countries are now looking for other such similar avenues.

By this time Gramm-Leach-Bliley financial modernization act was already passed which permitted Investment bank to deal with the Commercial bank.

Now the big game begins.

Now that Investment bank and the Commercial bank can deal with each other. Therefore, Investment bank tells the Commercial bank that “Mortgage paper of houses of Prime families you have are pretty good, why don’t we start dealing?” To which commercial bank agreed and flow of mortgage papers from the commercial bank to investment bank started.

And Investment bank compiled mortgage papers and made a CDO i.e. Collateralized debt obligation out of them.

Investment banks divided CDO’s into three slices.

• AAA grading (safe papers of extremely prime families)
• BBB grading (Okay papers of moderately prime families)
• CCC grading (little doubtful)

This rating was done by rating agency which was third-party neutral hence it raises the worth of papers. But to make papers more worthy Investment banks asked big insurance company like American International Group to put the insurance on the top of the paper.

Now these CDO’s can be sold to return hungry countries like China, Japan, and other countries who had the possession of pension funds, mutual funds and hedge funds, who earlier couldn’t invest in US Investment banks because of lower interest rates.

Now, CDO’s have been sold worldwide and have become very popular among global investor because big insurance companies like AIG has granted insurance to them.

But still, there isn’t any problem since everything is running legally and ethically.

Now countries like China, Japan and others who had invested in CDO are overwhelmed by the kind of returns they’re getting and now they want even more. They want more of such mortgage papers.

So they pressurized Investment banks for more such CDO’s of mortgage papers.

Investment bank pressurized Commercial bank for mortgage papers.

Commercial banks pressurized broker to look for more such families who are looking for house loans. Brokers all over America did what was asked of them.

But there’s a threshold to everything. At one point all the Prime families got the loans and the houses. And there were no more Prime families left without a house.

But the pressure still persists. Hence, commercial banks introduced a new phenomenon called Teaser loans.

Teaser loans are those type of loans where initial interest rate and initial installments are very low but they at one-point they start hiking up drastically.

Teaser Loan attracted such families who were sub-prime families to borrow house loans. Such families didn’t have regular earnings and had a large number of family members like 5-6 children.

Sub-prime families were granted loans in the name of Prime families only. Sub-prime families weren’t capable of paying installments regularly. Still, CDO’s were made the mix of Prime families and Sub-prime families, and no one knew which CDO had what number of Prime or Sub-prime families mortgage papers.

Here the de-stability begins.

Suddenly Investment bank realizes that mortgage papers are losing their due worth slightly because installments weren’t being paid by borrowers on time (mostly sub-prime families). To which commercial bank responded to Investment bank that it is happening because so and so lost his job, or died etc. hence he can’t pay now.

In such situation, commercial banks re-possess the house and put it for sale. Suddenly more such houses went on sale. The supply was more than the demand; hence prices came down.

Here, the popular assumption that “housing prices will always rise and will never come down” shattered badly.

(This chart clearly shows how house prices started hiking from the year 1999 and suddenly crashed in the period of 2006 to 2008.)

The problem started when Prime-families who too had borrowed the loan realized that price has come down so drastically that their loan is more than the worth of the house they’re living in.

Hence, now even Prime-families who could easily repay the loan stopped paying the installments and asked the bank to repossess the house if they want.

Now the primary source of credit stopped.

The whole big game of money was played just because the borrowers were paying their loan sincerely. But now that’s no more a case.

Biggest housing giants like Fannie Mae and Freddie Mac collapsed.

Market shattered drastically overnight because credit flow has stopped.

CDO’s which were sold across the world lost its worth. Because there’s no more trust in the market since no one knows who is having a CDO of sub-prime mortgage papers.

Trust deficit begins.

Normal banks who aren’t even part of this whole play had stopped lending loans to anyone. Banks aren’t even giving loans to established genuine companies like Google etc.

And big industrial giant’s whole mechanism stopped which led to the recession, people started losing jobs.

The government was in big dilemma to bail out such companies or not a bailout. The bailout is like a when a big industrial giant who has consumed a large number of population as the employee goes through a depression and banks refuses to give them funds, then the government gives them money to withstand, this phenomenon is called a bailout. If the government doesn’t bailout such companies large masses will lose their job and if it does, then ethically government can’t invest public’s money into a private firm, which can lead to mass protest. But the government chose to bailout which obviously led to the high price rise.

Now. People are still losing jobs.
The economy has crashed.
Prices are on record time rise.
Housing industries are losing worth.
There’s trust deficit, nobody is funding anyone.

Iceland as a country went bankrupt.

This led to the biggest recession.

This is the entire story of 2008 housing financial crisis.

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Indian ace economist Raghu Ram Rajan predicted this crisis well before the odds turn up.

I’ll conclude by quoting Mahatma Gandhi.

There’s enough for everyone’s need on this planet but not enough for single man’s greed.

Thanks for reading. :)

Picture credit: Google.

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Edit 1:
This is just to explain what happens when there’s trust deficit and also somebody has given loose or faulty documents.

Let’s have a hypothetical situation.

I have 1 crore and I decided to lend the money to some borrower at a reasonable rate of interest and in return, I’ve taken borrower’s property paper as a collateral.

The borrower has further lent the money to someone else on his risk but his borrower hasn’t given the right set of documents.

Now, in a case when an Auditor comes to me to audit my business. I’ll show him the record and papers of borrowers, watching them he calls my borrower and asks him to show his documents and papers which he has taken from his borrower. Now some those documents turn out to be faulty and Auditor labeled me as a “Defaulter.”

Now that I’m defaulter my investors have stopped funding me.

In the meantime, some car company came to me to take a loan for establishing another unit, which will provide jobs to many. But now I can’t give them money since I don’t have any investment.

This situation has not only created economy deadlock but also has nullified the chances of job creation. Trust deficit follows.

Thanks.