The 2008 Financial Crisis
Ever wondered what people meant when they talked about the dreaded crisis in 2008? Did you wonder why it was a big deal? I’ll give you a great understanding.
Back in 2002–2005, the housing market prices were up 14–15%, due diligence was taken in analyzing credit-worthiness of individuals before mortgages were given and all was well. Lenders gave individuals loans after due diligence to buy a house and the new house owner pays back in the form of principal plus interest in the form of monthly repayments. Investor around that time wanted more to invest in as the government bonds were not yielding as much as they wanted: the Dotcom bust cause federal reserve to reduce interest rate on treasury bills which was considered as very safe since it was backed by the government to 1% giving investors the headache of where to put their money and banks could also grab the opportunity to borrow money at a cheap rate.
Naturally, investment banks on wall street noticed this and went ahead to look for a solution. They met Lenders and asked to buy the mortgage debts off their hands so that the monthly payments come to them, a way of factoring, they buy the debt and create MBS (Mortgage Backed Securities) which they sell to investors. The banks borrow a ton of money to buy mortgages with and then lumps all these mortgages together before separating them into “the holy trinity”: “safe”, “Okay” and “Risky”. They called them “collateralized Debt Obligations” (CDOs), as homeowners make their monthly payments, money flows into the CDO and goes to the safe securities first before flowing to the okay and risky securities, so that if homeowners default, it affects the risky securities first. As normally understood, the risky securities held a higher interest rate compared to the rest.
Investment banks were now selling these securities called “Mortgage-Backed Securities” (MBS) to investors who wanted to get a piece of the action. This was a welcome development and everyone from the homeowners who were now able to buy expensive houses through mortgages, to lenders who could sell their risks off and to investment banks who served as the middle ground to investors who could finally earn a suitable return.
The problem began when the number of creditworthy people dropped and lenders started giving loans to individuals who did not have as great credit ratings just to keep the flow going, loans were given with shaky characteristics such as no income verification, variable interest rates and zero down payments. This is referred to as “Predatory Lending Practices”. Loans given to creditworthy individuals are called “prime loans” and the ones given to unrated individuals were called “sub-prime loans”. There was a metric to measure how safe loans were, the safest ones ranged from “AAA” pronounced “Triple-A” to “BB, the rest were risky.
As expected, people started defaulting on home payments but the banks thought it was ok as they would just sell those houses to new owners, but as more people defaulted, the banks had too many houses to sell and little demand for them so price started crashing and the houses started becoming worthless.

Credit rating agencies were still telling people that these securities were safe by giving them a favorable credit rating even though MBSs had become risky to invest in. As prices dropped, homeowners who had great credit ratings at the beginning started to lose faith as the value of their houses had dropped compared to the mortgage they were paying and so they stopped making payments making the default increase further.
And like that the housing bubble had popped, this had seemed very unlikely as it had never happened in the history of the united states. Homeowners now had no homes, lenders were trying to sell the mortgages they had to Investment banks who had stopped buying, investment banks were sitting on worthless properties and investors stopped investing.
The problem deepens when considering that banks had created and sold CDS (Credit Default Swaps) to investors to safeguard the securities on occasion of a bubble burst. In real terms, the banks didn’t have money to pay these CDOs, they just thought that the housing market was never going to crash and so they had that debt to pay coupled with the debt of the money borrowed from the government. The top Investment banks now owed a total of $4.1 Trillion which was 30% of the US nominal GDP in 2007, some of them announced bankruptcy in the wake of all the chaos.

This event shook the world economy as a result of something called “Financial Contagion” which is best described as a risk for countries who have integrated their financial system with the international financial market and institution.
One of the major reasons this event occurred is “moral hazard” which can be described as taking on too much risk because another person stands to bear the consequence as seen with lenders who gave loans without appropriate checks and banks.
The US government help solve this crisis by giving emergency loans through a program called ”TARP” (Troubled Asset Relief Program), stress testing banks to ensure they a high compliance level and ensuring that derivatives became exchange-traded so all could absolve them.
