Understanding the 2008 Economic Crisis
by Marc Schulman
Understanding the 2008 crisis is not easy. Some of the greatest economic minds in the United States failed to foresee these events as they were happening.
Let's starts with the basics: The economic current crisis began with the failure of sub-prime mortgages. Mortgages are loans that people often seek when they want to buy a home. Mortgage borrowers agree to pay a certain sum of money every month (for up to thirty years) and a bank or other lender, loans the borrower money to buy a home. In the past, borrowers were required to put down 20% of the purchase price before a bank would loan the borrower the remainder of the money to buy. In recent years, that was no longer always the case. This is where the sub-prime mortgages come in. Sub-prime mortgages are mortgage loans that were given to people who were at a greater risk of not being able to pay back the money they borrowed.
For the past ten years housing prices in the United States have steadily gone up. As long as prices continued to rise, there was no risk in lending money to people looking to buy a house–– despite the greater risk of their inability to pay the money back. If someone ran into trouble paying their mortgage, it was not a problem. The borrower could just sell the house at a profit and pay off the mortgage. In the worst case, the bank could repossess the property at no loss. In the past, mortgage loans were given by local banks. The bank would hold the mortgage for twenty years, making its money on the interest paid on the loan. Over the past ten years, banks and other institutions concluded they could make even more money by reselling their mortgage loans to investors. Major financial institutions developed methods to combine many mortgages into one larger loan. These loans were then sold to investors. Some of these firms even bought their loans to keep in their own portfolios. They even received special permission from the government to use additional borrowed money to buy these larger mortgages.
All of this worked fine, until last year, when the prices of homes stopped going up. In fact, housing prices started going down. The average home price in the United States went down last year by 20% (a number larger than the decrease in any year of the Great Depression.) As a result, the fancy combined loans that had been packaged by the financial intuitions were now worth a great deal less than was assumed. The losses these institutions suffered were staggering. Why were the losses so high? The exponential losses developed because the investments were made on borrowed money.
Why was this so bad? When an organization wanted to buy $1,000 in mortgage bonds, they would use $50 of their own in the purchase and borrow the remaining $950. When the value of that investment went down 20%, the original $1,000 investment becomes worth only $800 (the losses have often not been 20%, but as high as 50%). As a result, the investor not only losses his $50, but owes an additional $150 that he does not have. This is how many banks and other investment groups found themselves effectively bankrupt. Banks soon became afraid of lending money to each other or to anyone else. A number of major banks failed. This froze the world's economy. The US, and all leading world governments, decided to intervene and provide money for their nations banks. The world governments' actions attempt to provide needed capital and bolster confidence that the governments will do everything in their power to ensure the banks and economies will not be allowed to ultimately fail.