The Financial Crisis of 2008

The financial crisis happened because banks were able to create too much money, too quickly, and used
it to push up house prices and speculate on financial markets.

What happened in simple terms

The driving force behind the mortgage and financial market excesses that led to the current credit crisis
was the sustained rise in house prices and the perception that they could go nowhere but up.

Most analysts link the current credit crisis to the sub-prime mortgage business, in which US banks give
high-risk loans to people with poor credit histories.

These and other loans, bonds or assets are bundled into portfolios - or Collateralised Debt Obligations
(CDOs) - and sold on to investors globally.

The US Housing Market

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.

CDO's ( Collateralized Debt Obligations )

- These are structured financial product backed by a pool of loans

- Banks approves loans such as mortgages. Loans were repackaged by investment banks and sold to
other investors

- The loans were also rated in accordance to the risk level

→ Senior rating (AAA) - least risk

- The popularity of CDOs exploded

→ 2003: $30 billion; 2006: $225 billion

Loans were given to borrowers who effectively had no chance of paying them back. This was done so
because as mortgages are secured to the asset (housing), thus the house could compensate for the
borrower's’ inability to repay

When the housing market crashed in 2008, the CDO's was worth much less than what was expected

This heightened the risk of interbank lending as banks did not know which ones were credit-worthy

Interbank lending thus collapsed

Regulators asleep at the wheel

Failures in finance were at the heart of the crash. But bankers were not the only people to blame.
Central bankers and other regulators bear responsibility too, for mishandling the crisis, for failing to
keep economic imbalances in check and for failing to exercise proper oversight of financial institutions.

The regulators’ most dramatic error was to let Lehman Brothers go bankrupt. This multiplied the panic
in markets. Suddenly, nobody trusted anybody, so nobody would lend. Non-financial companies, unable
to rely on being able to borrow to pay suppliers or workers, froze spending in order to hoard cash,
causing a seizure in the real economy. Ironically, the decision to stand back and allow Lehman to go
bankrupt resulted in more government intervention, not less. To stem the consequent panic, regulators
had to rescue scores of other companies.

But the regulators made mistakes long before the Lehman bankruptcy, most notably by tolerating global
current-account imbalances and the housing bubbles that they helped to inflate.