The 2008 financial crisis is affecting millions of Americans and is one of the hottest topics in the Presidential campaigns. In the last few months we have seen several major financial institutions be absorbed by other financial institutions, receive government bailouts, or outright crash.
So what caused the financial crisis of 2008? This is actually the perfect storm which has been brewing for years now and finally reached its breaking point. Let’s look at it step by step.
This video explains the economic crisis:
The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.
Market instability
The recent market instability was caused by many factors, chief among them a dramatic change in the ability to create new lines of credit, which dried up the flow of money and slowed new economic growth and the buying and selling of assets. This hurt individuals, businesses, and financial institutions hard, and many financial institutions were left holding mortgage backed assets that had dropped precipitously in value and weren’t bringing in the amount of money needed to pay for the loans. This dried up their reserve cash and restricted their credit and ability to make new loans.
There were other factors as well, including the cheap credit which made it too easy for people to buy houses or make other investments based on pure speculation. Cheap credit created more money in the system and people wanted to spend that money. Unfortunately, people wanted to buy the same thing, which increased demand and caused inflation. Private equity firms leveraged billions of dollars of debt to purchase companies and created hundreds of billions of dollars in wealth by simply shuffling paper, but not creating anything of value. In more recent months speculation on oil prices and higher unemployment further increased inflation.
How did it get so bad?
Greed. The American economy is built on credit. Credit is a great tool when used wisely. For instance, credit can be used to start or expand a business, which can create jobs. It can also be used to purchase large ticket items such as houses or cars. Again, more jobs are created and people’s needs are satisfied. But in the last decade, credit went unchecked in our country, and it got out of control.
Mortgage brokers, acting only as middle men, determined who got loans, then passed on the responsibility for those loans on to others in the form of mortgage backed assets (after taking a fee for themselves originating the loan). Exotic and risky mortgages became commonplace and the brokers who approved these loans absolved themselves of responsibility by packaging these bad mortgages with other mortgages and reselling them as “investments.”
Thousands of people took out loans larger than they could afford in the hopes that they could either flip the house for profit or refinance later at a lower rate and with more equity in their home - which they would then leverage to purchase another “investment” house.
A lot of people got rich quickly and people wanted more. Before long, all you needed to buy a house was a pulse and your word that you could afford the mortgage. Brokers had no reason not to sell you a home. They made a cut on the sale, then packaged the mortgage with a group of other mortgages and erased all personal responsibility of the loan. But many of these mortgage backed assets were ticking time bombs. And they just went off.
The housing market declined
The housing slump set off a chain reaction in our economy. Individuals and investors could no longer flip their homes for a quick profit, adjustable rates mortgages adjusted skyward and mortgages no longer became affordable for many homeowners, and thousands of mortgages defaulted, leaving investors and financial institutions holding the bag.
This caused massive losses in mortgage backed securities and many banks and investment firms began bleeding money. This also caused a glut of homes on the market which depressed housing prices and slowed the growth of new home building, putting thousands of home builders and laborers out of business. Depressed housing prices caused further complications as it made many homes worth much less than the mortgage value and some owners chose to simply walk away instead of pay their mortgage.
The credit well dried up
These massive losses caused many banks to tighten their lending requirements, but it was already too late for many of them… the damage had already been done. Several banks and financial institutions merged with other institutions or were simply bought out. Others were lucky enough to receive a government bailout and are still functioning. The worst of the lot or the unlucky ones crashed.
The Economic Bailout is designed to increase the flow of credit
Many financial institutions that are saddled with risky mortgage backed securities can no longer afford to extend new credit. Unfortunately, making loans is how banks stay in business. If their current loans are not bringing in a positive cash flow and they cannot loan new money to individuals and businesses, that financial institution is not long for this world - as we have recently seen with the fall of Washington Mutual and other financial institutions.
The idea behind the economic bailout is to buy these risky mortgage backed securities from financial institutions, giving these banks the opportunity to lend more money to individuals and businesses, hopefully spurring on the economy.
What? Credit got us into this mess! Why give more?!?
Ironic isn’t it? Yes, it is true that credit got us into this mess, but it is also true that our economy is incredibly unstable right now, and being that it is built on credit, it needs an influx of cash or it could come crashing down. This is something no one wants to see as it would ripple through our economy and into the world markets in a matter of hours, potentially causing a worldwide meltdown.
As I previously mentioned, credit in and of itself is not a bad thing. Credit promotes growth and jobs. Poor use of credit, however, can be catastrophic, which is what we are on the verge of seeing now. So long as the bailout comes with changes to lending regulations and more oversight of the industry, along with other safeguards to protect taxpayer dollars and prevent thieves from not only getting of the hook, but profiting again, there is potential to stabilize the market, which is what everyone wants. Whether or not it works is to be seen, but as it has already been voted on and passed, we should all hope it does.
Want more opinions? Check out this article on the same topic:
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{ 38 comments… read them below or add one }
Patrick - I agree with your analysis but you left off one other factor. The government (starting with the Clinton administration) decided in the 1990’s that more folks needed to own their homes, even if they were not financially ready. The government created no-money down initiatives and threatened banks who refused to give credit to these people. As a result, home ownership rates rose 6% to record levels. On top of that, many legislators were bought and sold by money from Fannie Mae and Freddie Mac which were backing these crazy loans.
TML,
That’s a good point, and to be honest, I’ve probably left out several factors - an entire book could be written to cover this financial crisis and I’m sure there are several books already in the making. These problems have been well over a decade in the making.
Ron from The Wisdom Journal recently wrote about the legislators were bought and sold by money from Fannie Mae and Freddie Mac: How Much Did Your Senator or Congressman Take From Fannie Mae or Freddie Mac?. This list also points out how much money each Presidential Candidate received over their tenure in the Senate. It is worth noting.
Patrick,
Thanks for the nice overview. I hope that as a result of the crisis we don’t make the process of purchasing a home too complicated and burdensome.
The main problem is not legislature, its greed. You can’t outlaw it no matter what.
What do you think is the next step in the crisis?
DGI: You’re right, the problem isn’t legislation, although it could be written to simplify the mortgage and lending rules and outlaw some of the forms of loans that are either predatory or irresponsible on the part of the lender (for example, giving mortgages without verifying income).
The next step in the crisis is the bailout which was just agreed upon. We will still see some volatility in the markets, and a few more banks and financial institutions will likely be bought and sold, and possibly even crash. Hopefully the markets will stabilize soon.
I made some poor financial decisions in the past why isn’t the government bailing out the little guy and not corporate America.
I think the problems are much deeper and more troubling. One of the reasons credit was loosened up was to address the growing divide between haves and have-nots. Some people saw injustice in the inability of people of lesser means not being able to access credit. In and of itself, that’s not a problem (loosening credit) - microfinance works incredibly well for the bottom billion, for example. And we also know that how much you make doesn’t say much for how responsible you are with money.
I think the more troubling issue is not greed, but entitlement. Our entire societal perspective on what we are entitled to is all wrong. And I think we see this rebounded in all aspects of our life, not just with credit.
I don’t have a solution, though.
Good Post.
Too many people got sucked in by the promise of an easy life built on rising home values and easy access to credit. It was like a giant ponzi scheme.
Unfortunately the chickens are now coming home to roost.
The teaser rates and HELOC really impacted some of our friends and made it easy to buy a large house with no money down. When any little setback occurs, it can devastate a family and get them late on home payments. I think we might not see 100% or 110% home financing for a very long time. It’s hard to believe people bought homes and also were able to take more money out and buy new cars, boats, and shop for furniture. Kind of like being a kid in a candy store with a free credit card.
Scott, I don’t think we should have seen 100% or 110% loans in the first place. That is irresponsible on the lender’s part and wishful thinking on the borrower’s part.
It looks like the Senate just passed a revised version of the bill. Hopefully it includes some provisions to prevent these mistakes from happening in the future. The next few days will be interesting.
These are very good points. And yes, Greed was the main issue in this financial crisis we are now going through, BUT the banks AND the government are to blame for. Because the gov’t should control this economy issue AND the banks should not be lending out money when they see that people are not going to be able to pay them back.
Your analysis of the current crisis reflects that of most commentators. It is missing three elements.
First, an understatement of real inflation rates (see “core inflation,” the BLS measurement formulae, the “chained” CPI), enabled the Fed to offer credit at terribly low rates, while saying that inflation was contained. (It did not account for the inflation in housing (15-20% per year), fuels (30-50% per year), and used distorted measures for other inflation rates.
Second, this made bankers wildly successful, as banks could take Fed loans at 1% interest and loan those funds to mortgagors at 6%; promptly thereafter selling the loans, and lend to credit card debtors at up to 18% interest (that’s why there was a new credit card in the mail every week).
Third, it created the hedge fund industry, where 10:1 borrowed leveraged was used for commodity investments. As inflation was truly raging, and loans were available at below these inflation rates, hedge fund profits were enormous and almost guaranteed.
These events drove the economy to an explosion of credit.
But it also destroyed savings. No one was going to forego consumption if the rates paid on savings accounts were below the rate of inflation.
As a consequence, other than as a consequence of the inflated assets purchased on credit (e.g., houses), the balance sheets of the citizens quickly deteriorated.
Today we do not have a crisis of liquidity…we’ve had a flood of liquidity. We have a crisis of solvency. People cannot afford to borrow, and banks cannot afford to lend.
There will need to be fewer banks…there’s an easy way to accomplish that…don’t bail them out. There will need to be increased savings, with decreasing consumption. That will be recessionary, and that’s the cost of having gone so far into debt.
You cannot blame greed. People did exactly what government (Fed and fiscal policies) caused them to do. Now, dispite the cost of the cure, government will be unable to fix the problem otherwise. Regrettably it will try. The Paulson plan is a typical mistake. It will weaken citizens’ balance sheets by $700B, and will put this money in places where it actually has no benefit.
Regardless of the heresy involved, the unsuccessful banks need to die. We do not need them, they could not manage themselves, and they will not help us to recover from this.
John B. Goodrich
I totally agree with the article above. My article is very similar but far more detailed. Have a read at my site. Furthermore, as for there being less banks - well I dont think that is the answer, unless they ‘cant make it on their own’. I do believe the people - the home loan writers need better training and should be given more stringent lending guidleines. After all - we’ve been here before in the 1980s to a lesser degree with regards to copious amounts of debt.
Hi, I agree! I was really hoping that the economy will start its recovery soon as my investments in stocks were all losing big.
Furthermore, I would like to add about the issue of inflation and leveraging or hedging.
Companies before hedge against the price of oil when it was reaching its peak price thinking that they can profit from it since they expect a lot more increase in price. Unfortunately, as a result of the financial crisis, the oil price fell because of the slow demand and their hedge against oil price led them to huge losses.
All i wanted to say is that this economy needs to stop doing so bad and get the people who are bring us down out of the chair. Also neoptism needs to stop. And i would like to give a special shoutout
i have read the article but non of the replies,
i agree with all what have been addressed but i think one factors was left behind,,
Globalization,open market ,which lead to wealth reallocation over nations.
when US companies start to produce in Asia markets like china,India etc due to the low cost, and export-import agreement among countries,less shipping cost,free customs imposed on the imported goods. cause transforming of job opportunities to these economies which left more unemployed and less quality jobs in US.
Alaa: I agree, there is more to the economic crisis than is listed in this article. What I have written is a very simple explanation of how the debt market in the US grew exponentially over the previous few years. There is, of course, much more to the equation. Reallocation of wealth to other nations is definitely part of the situation. In the coming years I think we will see an even greater distribution of wealth throughout the world.
Greed is a constant. Saying greed is to blame for the crisis is perhaps as void of meaning as a statement can be. Might as well say “humans are to blame” - yes, indeed, if there were no people, there would certainly be no crisis. “Carelessness” could be a more reasonable claim.
Elithrion: Isn’t carelessness as abstract as greed? Carelessness also implies that what happened was an accident, which in a large sense, it is - certainly no one intended for the economy to crash. But many of the actions leading up to the crash were wanton examples of greed and fraud. I’ll stand by my answer.
I agree with all what you have said, this crisis has been due to greed and now we suffer the consequences. Now what I think is, that credit is good, it is money supply chain that keeps the economy working so thus if more money is lent to people with a reasonable interest rate then this would keep the economy stable, moreover people should now know that it is not advisable to get into buying houses and selling them to make money, because for example i do agree that there should be legislation that stops bankers lending big sums of money to people on certain annual salary for instance England has been very bad when coming to give mortgages of 9 or 10 times your annual salary, it is this that has mainly caused the problem. How can a person that’s annual salary of £25,000 pay back £250,000 back in their life time they would still be paying it at the age of 70 or still unpaid after death. Banks therefore have to limit what they give out and this would lead to stability. in conclusion government should create laws that limit banks on their loans, banks should still lend money to keep the economy flowing at a set and reasonable interest rate, and government should also cut down on vat o most things as well as create a savings plan for when situations as such occur.
Alaa :I think that was really selfish of you to mention. the truth is globalization hasn’t caused any havoc in USA as it has in many countries particularly African countries. US net capital inflow has been on the rise in a geometric progression. for instance from 100bil (usd)in 1994 to about 700bill(usd) in 2004. In a nut shell, its true outflow of capital may cause financial crisis in a country but for us current situation, its not a factor. unfortunately developing countries will bare the most of this crunch. not to mention the damages done by brain-drain and negative net capital inflow.
Since we are spreading the blame around here (and there is plenty to spread), I would like to add that the entertainment industry has certainly played their part. Just look at all the shows on television (from reality shows to moronic sitcoms); how many are set in main street America? Very, very few. In movies, and on TV, everyone drives big cars, lives in big houses, wears flashy clothes, etc, etc. We quickly became a culture chasing bigger and better. Average home sizes have nearly doubled in thirty years. Nothing is ever enough
Prakash: You’re spot on. The American economy is built on consumption and consumerism. The problem is that the bill came due and many people simply can’t afford to pay. We, as a country and as taxpayers, will be paying for this for a long time.
YES I AGREE WITH YOU,MANY PEOPLE ARE FACING IT’S EFFECTS ALL OVER THE WORLD.
ISAAC
The financial crisis will continue well into 2010. I hope it won’t go beyond that year.
Excellent post! All very true, and all very sad. Deepali - you are also very right about entitlement. I believe the root of this problem lies in the idea that people are entitled to certain things (such as home ownership) even if it’s beyond their financial capabilities. Honestly, if individuals learned to live within their means, and use credit for large purchases like houses (when financially ready) and cars, we’d be in much better shape. Therefore, I believe we’re in this financial crunch because people want more than they can afford, and firms are too focused on short term gains.
Meleah: I think you hit the nail on the head. I hope this economic crisis causes more people to live within their means. It may slow down economic growth due to less consumption, but we will all be better off in the long run.
Great point ! Every coin has two sides.
From this, we could have an overall view that little thing make big difference. All of us should hang together and change something to some extent.
I agree with all what you said, this crisis is due to greed and we all now suffer from it is consequences. There is no doubt that credit is very important to the economic growth,
so more money supply that lent to people with reasonably interest rate then these could
lead to stabilizing the economic. But this shoud be followed with very closed control,
monitoring and legislations by governments to all banks and also the banks should be
more regirous in the loans’ oblegations and mortgages insurances, also the people
should bear resposibility of not taking loans over their financial ability, but the more
important thing is to fight GREED. How Do You See The Future?
One positive effect of the crisis is more people became interested in economics and finance.
We hope that our Big Bosses will find the right way to resolve the crisis that further will remain on historical book!
I think current global crises has bad effects on highly industrialized countries. Through these countries, agricultural coumtries
i don’t have anough to say just to thank everybody for his or her comment.i realy benefited from it.djakna chad
i do think that economic crisis will spread all over the world because of well strengthed globalization
financial crisi is a leverage “effect” to the global insdustralizationin the and period where the cheif operating officer of most company resigned their appointment, staff lay off,defoulting in share prises,bankrutcy of firm, and in increase in debt and where criditors gain.
I’ve paid off 80% of the mortgage I took out 20 years ago, but lost my job in the recession; so even those who used credit responsibly are very vulnerable in the current economic crisis. Other family members who had AIG and BOA stock also lost disproportionally - and none of us are particularly ‘greedy’ - we worked hard for our money and just ended up being unfortunate victims of circumstance.
Hopefully we can stick together and find our way through this mess, but it’s going to take some time. The S&L crisis of the early 1990’s cost over $160 billion, it’s dwarfed by what this will end up costing…
can someone tell me whether if the solution for the current economic crisis of the WORLD (which resulted from the economic crisis of the US) is IMPORT CONTROL???
im having a hard time understanding the whole economic crisis-thing…and i really would appreciate some help…………
uhm, did anybody mention the role of credit default swaps?
good stuff made its real easy to understand a little bit more about this problem
I like to know that what are the main causes of this global finincial crisis and what are the main effects of crisis , point wise . I will be very happy if sombody give me solution.