In a sentence, causes of the 2008-2009 economic crisis include subprime mortgages gone bad that were packaged into risky securities gone bad compounded by lax regulatory oversight, a credit crunch (i.e., reduced lending by financial institutions), and lack of consumer confidence. The financial crisis started to unfold in 2006-2007 when large numbers of homeowners started to fall behind on their monthly mortgage payments.
Many subprime mortgages with artificially low initial payments had been made to people who couldn’t really afford them. Some of these loans had features that quickly bumped up payments substantially to a point where people could not afford to pay the higher payments that were required of them to keep their homes. Refinancing these loans wasn’t an option because borrowers couldn’t afford it and/or local real estate values had started to decline, thereby reducing distressed homeowners’ equity (home value minus mortgage balance), which often became a negative number.
By the fall of 2008, about 17% of homeowners had a mortgage that exceeded the value of their home. In addition, these mortgages were packaged together by the quasi-government agencies Fannie Mae and Freddie Mac, as well as by Wall Street investment banks. This process of packaging mortgages, called securitization, is not inherently bad and had, in fact, been done for decades. Where things went wrong was when Wall Street firms bundled prime and subprime mortgages together in an investment called “credit default swaps (CDS),” which were touted as being “low risk” because of the way that the underlying mortgages were pooled together.
To make matters worse, “credit default swaps” sales were leveraged (i.e., sold with the use of borrowed money). Of course, these mortgage-backed securities were extremely risky, which became readily apparent when homeowners started to default on the mortgages that were underlying “credit default swaps” portfolios. The value of these assets plummeted, causing billions of dollars of losses. Things then got progressively worse. As increasing numbers of homeowners could not make their mortgage payments, foreclosure rates increased and home values decreased due to an oversupply of homes available for sale. A credit crunch occurred as banks that had suffered massive losses pulled back on their lending, making financing difficult for consumers and businesses alike.
In the financial services sector, government bailouts and corporate mergers (e.g., Bank of America taking over Merrill Lynch) ensued due to the “toxic loans” on the balance sheets of many financial institutions. Stock prices and, in fact, the values of most securities plummeted in response to uncertainty in the financial markets. Many people experienced big losses in their 401(k) plans and other investments and, feeling the sting of these losses and nervousness about the stock market, reduced their spending. This caused a big reduction in consumer spending, particularly during the fourth quarter of 2008. The gross domestic product (GDP) of the U.S. contracted sharply.
As companies sold fewer products and services, their income (profit) was reduced, and many had to lay off or furlough (i.e., require unpaid time off) workers to stay afloat. With decreased income and sales tax revenue, and rising costs for unemployment benefits, layoffs and/or furloughs of government workers in the public sector also occurred. Many families and communities have been adversely affected by these economic changes.
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