The causes of the 2008 financial crisis: A new perspective

Wentao Zhang

One underlying cause of 2008 financial crisis-the housing bubble-started to form in the early 2000s. After experiencing the dot-com bubble and the 9/11 attacks, U.S. economy was facing significant uncertainty marked by slowed economy growth, weakened consumer confidence, and rising unemployment rate. In response, U.S. government, through the hands of Federal Reserve, drastically lowered interest rates from 6.5% to 1% in early 2001 to early 2003, in hope to encourage borrowing, investment and spending [1], this became the direct cause the radical increase in U.S. mortgage lending as real-estate becomes easier to afford, boosting U.S. mortgage debt outstanding from 6753 in 2000 to 12070.5 billion in 2005. [2] Due to high demand, house prices soon start to inflate, by nearly 50% from 2000 to 2006. [3] Simultaneously, mortgage organizations increased sharply, particularly in the subprime market, issuing large amount of high-risk loans to low credit individuals for profit.

There are a few financial tools that played a crucial role in the burst of bubble, they facilitated the leverage of capital by enabling institutions to take on excessive risk for what seemed to be as steady and high return, amplifying the effect of the burst of housing bubble. They are–

• Mortgage-backed-securities is an instrument that allow investors to invest in bundles of different mortgages. The lack of systematic supervision allowed rating agencies to give unreasonably high ratings for their MBS bundles, even the majority mortgages in the bundle was made up of subprime mortgages.
• Collateralized debt obligations (CDOs) were created by pooling MBS and other debts, then slicing them into tranches with varying level of risks. CDOs were mainly labeled with high level of safety, drawing the attentions of large amounts of capitals, in fact they were highly complex and risky due to the underlying subprime loans in MBS as above-mentioned.
• Credit default swaps (CDS) were used as an insurance against defaults on MBS and CDOs. After the burst, CDS directly caused the fall of industry giants like AIG who sold large amounts of CDS but do not have adequate reserves to handle the potential losses.

Home prices first started to decline in year 2007, and cracks in the housing bubble started to appear. The borrowers, especially those with subprime mortgages, started defaulting on the loans, this then started a series of chain reactions. Firstly, the mortgage-backed securities’ value plummeted, then MBS drives CDOs’ value down to the ground. Investors faces lost from their investment, banks and institutions suffer from bad debt, value losses, and the claim from CDSs, causing severe liquidity issues. By 2008, the snowball effect eventually caused the collapse of Lehman Brothers, a major player in investment banking with explosive shockwave effect toward global financial markets, causing widespread panic.

The financial disaster quickly spread beyond U.S. borders, impacting economies worldwide.

The global trade slowed down sharply, and stock markets around the world tumbled. The burst of housing bubble affected banks, businesses, investors, and consumers across continents, leading to the worst global recession since the Great Depression.

[1]https://www.forbes.com/advisor/investing/fed-funds-rate-history/

[2] https://www.govinfo.gov/content/pkg/ERP-2011/pdf/ERP-2011-table76.pdf

[3] https://fred.stlouisfed.org/series/ASPUS