Housing bubble of 2008 – Simplifying the Crash

The 2008 financial crisis still brings back horrific memories for many. It was regarded to be the greatest financial crisis since the 1929 depression. There was widespread panic, recession and it seemed the world would never be able to recover from it. Yet there are number of people who don’t exactly know what happened. Let’s revisit the crisis and understand what happened with the housing bubble of 2008.

The origin of it all

The origin of the crisis wasn’t in 2008 or 2007. It was in 2001. Following the tragic 9/11, the USA fell into recession. There was widespread pain and consumption was at miserable levels. To boost up the economy, the Federal Reserve(Fed) lowered interest rates. They hoped that with low interest rates, debt would be cheap and that would also boost consumption in the economy. Sure enough, it did start well with loans being taken by several individuals. With interest rates at an all-time low, Americans saw the perfect opportunity to purchase their own homes. It was an asset that everyone valued and it was possible to purchase it without worrying about the cost of debt.

What happened next

Bankers saw this opportunity and got to work. They securitized mortgages and also came up with mortgage-backed securities (MBS). They were a form of asset-backed securities and every MBS had a collection of diverse mortgages to diversify risk. These MBS were stacked together by investment banks to sell an investment instrument known as Collateralized Debt Obligation. These CDOs were given a rating from AAA to CCC. Based on the creditworthiness of the borrowers.

The investors of CDO would be paid as the borrower paid back the loan. In case there was a default, the banks would sell the house and pay the investors through that. It did seem a win-win right?

A rush for investments

This investment cycle did start well. The banks had found a way to make big money through CDOs as there was a frantic rush towards buying houses and hence there was a huge rise in the number of investors wanting to invest in CDOs. Since it was backed by a safe asset like a house, the investors felt it was a high reward low-risk investment. So where did it all turn upside down?

Housing bubble about to burst

Things started going downhill when almost all creditworthy borrowers had taken a house. Driven by this problem and their greed, banks now started lending to borrowers with higher chances of defaulting. Background checks and financial strength of the borrower were ignored and this led to the practice of subprime lending.A practice which is seen in some other areas today, as reported by The Wall Street Journal.The blasphemous part is that these mortgages weren’t only a part of the CCC-rated CDOs which would indicate high risk. Several triple A-rated CDOs too were full of subprime lending.

Housing bubble of 2008 finally bursts

And then the inevitable happened. The sub-prime borrowers started defaulting. The banks didn’t panic initially. As planned, they sold the houses of the defaulters. This is where the unplanned mess occurred. There were too many defaulters. A lot more than the banks anticipated. And hence there were a bit too many houses on the market now. The primary principle of economics came into play. The supply massively outstripped the demand for houses and hence the housing market crashed with prices of houses falling tremendously. The buyers and sellers of CDOs were left high and dry as the CDOs had lost all their value. It was a loop and there was no way out of it. The money market had been dismantled. From this here was no going back. The burst of the housing bubble of 2008 was a fact.

Global economic ripple effects

The housing market crash led to the stock market crash not only in the US which spilled over to other countries as well. The financial system of the world had come apart. There was debt all around, investments were worthless and investment banks were clueless. Almost all major economies around the globe entered a recession by the end of 2008. It was a dark time.

Eventually, the Fed did step in and rolled out a 700-billion-dollar relief plan. It bailed out several investment banks who got away scot-free. It was the common man, like always who suffered. The collapse of the markets led to immense layoffs and almost 2 million Americans lose their jobs.

Greatest financial crisis in modern era

The bottom line is that the intention behind low-interest rates and even securitizing mortgaging was a good one. But the onset of greed in the banks which led to unchecked lending brought the world to its knees. There is a very fine line in finance between a game-changing move and self-destruction. The bankers crossed that line, and thus led to the greatest financial crisis if the modern era via the housing bubble of 2008.