This is the fourth of four posts explaining how the economic crisis of 2008 came about. Make sure to read Part 1 on housing bubbles, Part 2 on financial derivatives and deregulation, and Part 3 on financial players, subprime mortgages and leverage if you haven’t already done so.
In 2001, following various issues (like the dot.com bust), the chairman of the Federal Reserve, Alan Greenspan, lowered interest rates down to 1% in an attempt to boost the economy. Big investors traditionally liked buying government bonds, as they were seen as a very safe return on investment, but 1% was such a low return rate that they started looking elsewhere. At the same time, 1% was very little to repay, so many banks borrowed more money, assuming they could make a higher return than 1% and so turn a profit.
As the housing market was booming, the banks and investors decided that this would be a good place for them to get involved and make a lot of money. For a while, many families were given easy access to credit to buy their own homes, and the mortgage brokers sold their mortgages on to investors, and they were lumped together by their thousands into Collateralised Debt Obligations (see Part 2), and a lot of people got very rich.
After a while, the market of financially prudent people looking for mortgages dried up, as they had all been given one. In order to keep making money, the mortgage lenders started looking more into the subprime market (see Part 3). Although they knew that occasionally some people wouldn’t pay back their mortgage, it wasn’t seen as overly problematic, as it just meant the investor would get their home instead, and homes were good to have since property values were rising so much.
The problem was that houses and their prices do not exist in isolation, but in relation to other ones.
Let’s imagine America street, with 20 houses. When the first house on the street goes up for sale, it’s no big deal, and no one else is affected. However, if three months later it isn’t sold, and two more houses on the street also default and go on sale, this starts to have two effects. Firstly, the simple rules of supply and demand mean that if two families are wanting to move to the street, and one house is available, the price might go up and the richer family gets it. However, if those two families are competing for three houses, then there will be no price rise, and potentially even a price drop to try and sell the house. Secondly, if a few months later there are five empty houses, not only do the occupied houses lose value from an abundance of supply, but the street starts to look empty and unappealing for new families, and demand drops too. The Smiths at 1 America Street were paying a mortgage for when their house was worth $400,000, but now their house is valued at only $100,000. It is now financially better for them to simply abandon their house and move on.
This problem started happening all over America. Banks and investors once had a collection of mortgages that paid in money, but now just own homes. Not only was their revenue stream cut off, but also the homes they now own in their thousands are constantly losing value. Various financial players try to sell off these useless assets, but everyone knows there is no more money to be made so no one is buying.
This would not have been such a huge problem if everyone had been investing their own money, as they simply would have owned a useless selection of properties, but nothing that actually harmed them. But they weren’t investing their own money. Remember the principle of leverage (see Part 3), which meant that to make these investments, the banks had borrowed huge sums of money, at an average of 33 times more than they actually had in reserve. So when it came to paying back their money, not only did they bankrupt themselves, but lost money for any institutions they were borrowing from. The whole sector was so connected that the collapse of one led to everyone losing money.
So why did the problem not just affect banks? When bank X lost all their money, it also meant that they had to tell every ordinary working person who had kept their money in that bank that their savings were gone. Moreover, the interconnectedness of the banks was not kept in America, but was spread throughout the world. For example, when Lehman Brothers collapsed on Monday 15th September, 2008, the effects meant that by Friday factories had permanently closed in China.