The Buildup

The global financial crisis of 2007-2008 had a significant impact on the world’s economy as well as millions of people for the next few years causing economic damage rivaled by the Great Depression. The reasons behind the crash are immensely complicated, but fundamentally come down to irresponsible banks looking to make money.

In the United States, house prices were increasing steadily from 1977 and were predicted to continue to rise into the foreseeable future. Much of the populace saw this as a time to become home owners and therefore took out a mortgage from a lender and bought a house. Now here’s where the banks come in; the banks bought multiple mortgages from the lender so that they were receiving the payment on the mortgage, and compiled these mortgages into a Collateralized Debt Obligation (CDO). A CDO is a collection of high yield bonds split into “safe”, “okay” and “risky” securities that are all sold to investors so that the banks essentially get rid of their debts. The “safe securities were given a triple A credit rating, meaning they were an extremely low risk investment. The investors would want to buy these securitised products as they appeared to be a safe investment while providing high returns in a time when interest rates were low. Wall street needed to insure their CDO incase some of the homeowners defaulted, so they did what is called a “credit default swap”. This was when the CDO would be covered by an insurance company such as AIG so if someone did default, the bank would still receive the money.

To increase their profits on the mortgages, the banks were using a tactic called “leveraging”. This was when the bank would borrow billions of dollars from another bank to buy thousands of mortgages; then use the profit from selling the bonds to pay the loan back. They were able to do this as federal interest rates were only at 1% and there was an abundance of cheap credit . Leverage has the ability to transform mediocre deals into extremely lucrative ones, but with the added risk of having to borrow a large sum of money.

Wall street found they were making tremendous amounts of money from this as the investors were profiting hugely and wanted more. They realized that in order to make even more money, more mortgages were needed to buy and bundle into CDOs to sell, and hence, increase profits. To increase the number of people taking out mortgages, lenders began employing a scheme called subprime lending.

Subprime lending was when lenders would give a mortgage to a “risky” borrower who is someone not usually qualified for a house mortgage. Typically, to be considered for a home loan, your credit rating needed to be above 650 and a 20% downpayment was required on the property. The subprime loan changed this so no downpayment was required and even someone with a credit rating of 500 was allowed to take out a loan. The scheme also allowed the lender to loan upwards of 90% of the houses total value, giving people a further incentive to purchase property. The interest rates on these subprime loans were variable, so for the first couple of years they were uncharacteristically low which deceived unknowing borrowers into taking the mortgage. However, what the borrower did not know was that the interest rates on the subprime loans would drastically shoot up in the future. Banks such as Lehman Brothers used this strategy and profited greatly, with their revenue increasing by 56% from 2004 to 2007.

Everyone was happy now, the banks, investors and lenders were making money and the people were proud homeowners, which would have continued if not for the fall of the housing market. The increased number of houses bought meant a lower demand for them in the future as almost anyone who wanted a house had bought one, and the number of houses for sale also increased but there was no demand to match it. The low demand coupled with high supply saw the housing bubble burst which had drastic repercussions as the worlds economy came crashing down.