By: Larry Zhang, Senior Editor

The 2008 financial crisis is widely touted as the worst since the Great Depression. Stock markets plummeted, the housing market collapsed, and unemployment, foreclosures, and losses of trillions of consumer dollars ensued. But what, exactly, were the key causes of the crisis? Where did it begin?
With sky-high housing prices plummeting downwards in 2007, the housing bubble finally burst. This crisis in the American housing market threatened the collapse of the entire economy, starting with mortgage financiers who would sell “subprime” mortgages to borrowers, who simply couldn’t afford to buy them. Those who did often didn’t qualify for regular home loans, and thus shot themselves in the foot when they agreed to unfavorable loan conditions. These subprime mortgages were accompanied by unusually low interest rates, which inflated to the double-digits in later years. Worst hit were first-time homebuyers, those who had no previous experience in the housing market, and were thus beguiled by deals that were indeed too good to be true.
Besides receiving monthly payments for their services, mortgage lenders had the option of selling loans to banks or institutions such as Fannie Mae and Freddie Mac, which bought mortgages and supplied mortgage lenders with more money to lend. Investment banks would then buy these mortgages and then bundle them with hundreds or thousands of others (as “mortgage-backed securities”), later to be divided into a number of smaller shares and sold to investors as “low-risk” investments. The risks of each investment in a pool were thought to be uncorrelated, with Wall Street arguing that the housing markets were independent of each other. However, the housing market collapsed together. Additionally, credit default swaps, essentially insurance covering any losses due to mortgage defaults, contributed to speculative chaos. Banks sold and bought CDSs that they didn’t own, which amounted to $62 trillion in credit being ensured by the start of 2008.
Why, though, did the housing bubble continue for so long? The truth is, rising home prices meant that everyone won. Mortgage holders without a steady stream of income could borrow against home equities, and rating agencies rated mortgage-backed securities (knowing that they would fail) as safe, even though they were far from it. Interestingly enough, these rating agencies were being paid by the same banks that created these collateralized debt obligations. Investors continued to be duped because such pools appeared relatively safe and conducive to higher returns in a sea of low interest rates. When the housing bubble collapsed, however, mortgage holders defaulted on their loans, leading to massive instances of foreclosures and plummeting home prices.
With the onslaught of the bubble, major financial institutions crumbled as well. Countrywide Financial Corp., the largest American mortgage lender, failed and was acquired by Bank of America for next to nothing. Investment bank Bear Stearns, loaded with mortgage-based securities, collapsed as the value of these securities hit rock bottom, and was bought by JPMorgan Chase for chump change. The Treasury bailed out Fannie Mae and Freddie Mac as scores of subprime mortgages defaulted. Bank of America bought Merrill Lynch after its mortgage-backed securities threatened its demise, while Lehman Brothers declared bankruptcy because it couldn’t find a buyer. The losses didn’t stop. One last major player to lose was American International Group, which lost immensely from credit default swaps until it was rescued by the Fed and the Treasury.
Because of the chaos that resulted from subprime mortgages, the issuers of these bogus loans are considered by many to be the main culprits. With mortgage-backed securities at an all-time high, mortgage companies were eager to lend to anyone, regardless of how poor their credit histories were. Others claim that deregulation in the 1990s played a large role in the crisis as well. When Congress battered down the barriers between commercial and investment banking, it encouraged risky investments with borrowed money. Derivatives, or financial instruments that derive their value from underlying securities, were then neglected from federal regulation.
However, deregulators attribute the crisis not to predatory lenders, but to predatory borrowers, those who shopped for subprime mortgages even though they were unqualified to obtain a loan in the first place. It’s also critical to understand that central bankers and other financial regulators played a negligent role in the crisis, too. By letting Lehman Brothers go bankrupt, the markets panicked. These credit markets, where hundreds of billions of dollars are lent out, led banks to lose faith on borrowers. Then, all trust between lender and borrower was destroyed, and no one would lend. This caused non-financial companies to slash spending and hoard cash to pay suppliers and workers with money that would’ve been otherwise borrowed. Businesses halted everywhere. With Lehman Brothers bankrupt, the regulators had to bail out scores of other banks, ironically leading to more government intervention, not less.
Long before LB failed, though, central regulators were tolerating huge international current-account imbalances and housing bubbles. Moreover, America’s large deficit and the net capital flows from Asia’s excess savings were problems that overshadowed Europe’s role in the crisis’s origins. Northern Europe was basking in offsetting surpluses while Southern Europe wallowed in deep current-account deficits during the first decade of the euro. These imbalances grew as money moved to the inflated housing markets of countries like Ireland and Spain. The European Central Bank neglected the credit flow from Europe’s core to its outer markets, assuming that current-account imbalances wouldn’t matter in an euro alliance.
What could the Central Bank have done? To attempt to prevent such chaos, the Fed should’ve made a greater effort to curb the housing bubble. If higher interest rates proved to be ineffective against the housing and credit booms, other regulatory measures could have been used, such as lowering maximum loan-to-value ratios for mortgages, or requiring banks to set aside more capital. Stay tuned for Part II, an analysis on the aftermath of the crisis.