The financial crisis was primarily caused by deregulation in the financial industry. That permitted banks to engage in hedge fund trading with derivatives. Banks then demanded more mortgages to support the profitable sale of these derivatives. They created interest-only loans that became affordable to subprime borrowers.
In 2004, the Federal Reserve raised the fed funds rate just as the interest rates on these new mortgages reset. Housing prices started falling in 2007 as supply outpaced demand. That trapped homeowners who couldn't afford the payments, but couldn't sell their house. When the values of the derivatives crumbled, banks stopped lending to each other. That created the financial crisis that led to the Great Recession.
- A change in bank investing regulations allowed banks to invest customer’s money in derivatives.
- Derivatives were created from subprime residential mortgages, and demand for homes skyrocketed.
- When the Federal Reserve raised interest rates, subprime mortgage borrowers could no longer afford their mortgages.
- The supply of houses outran demand, borrowers defaulted on their mortgages, and the derivatives and all other investments tied to them lost value.
- The financial crisis was caused by unscrupulous investment banking and insurance practices that passed all the risk to investors.
In 1999, the Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act, repealed the Glass-Steagall Act of 1933. The repeal allowed banks to use deposits to invest in derivatives. Bank lobbyists said they needed this change to compete with foreign firms. They promised to only invest in low-risk securities to protect their customers.
The following year, the Commodity Futures Modernization Act exempted credit default swaps and other derivatives from regulations. This federal legislation overruled the state laws that had formerly prohibited this form of gambling. It specifically exempted trading in energy derivatives.
Who wrote and advocated for passage of both bills? Texas Senator Phil Gramm, Chairman of the Senate Committee on Banking, Housing, and Urban Affairs. He listened to lobbyists from the energy company Enron.
Senator Gramm's wife, who had formerly held the post of Chairwoman of the Commodities Future Trading Commission, was an Enron board member. Enron was a major contributor to Senator Gramm’s campaigns. Federal Reserve Chairman Alan Greenspan and former Treasury Secretary Larry Summers also lobbied for the bill’s passage.
Enron wanted to engage in derivatives trading using its online futures exchanges. Enron argued that foreign derivatives exchanges were giving overseas firms an unfair competitive advantage.
Big banks had the resources to become sophisticated at the use of these complicated derivatives. The banks with the most complicated financial products made the most money. That enabled them to buy out smaller, safer banks. By 2008, many of these major banks became "too big to fail."
How did securitization work? First, hedge funds and others sold mortgage-backed securities, collateralized debt obligations, and other derivatives. A mortgage-backed security is a financial product whose price is based on the value of the mortgages that are used for collateral. Once you get a mortgage from a bank, the bank sells the loan on the secondary market.
The hedge fund then bundles your mortgage with a lot of other similar mortgages. They used computer models to figure out what the bundle is worth based on several factors. These included the monthly payments, the total amount owed, the likelihood you will repay, and future home prices. The hedge fund then sells the mortgage-backed security to investors.
Since the bank sold your mortgage, it can make new loans with the money it received. It may still collect your payments, but it sends them along to the hedge fund, who sends it to their investors. Of course, everyone takes a cut along the way, which is one reason they were so popular. It was basically risk-free for the bank and the hedge fund.
The investors took all the risk of default, but they didn't worry about the risk because they had insurance, called credit default swaps. These were sold by solid insurance companies like the American International Group. Thanks to this insurance, investors snapped up the derivatives. In time, everyone owned them, including pension funds, large banks, hedge funds, and even individual investors. Some of the biggest owners were Bear Stearns, Citibank, and Lehman Brothers.
A derivative backed by the combination of both real estate and insurance was very profitable. As the demand for these derivatives grew, so did the banks' demand for more and more mortgages to back the securities. To meet this demand, banks and mortgage brokers offered home loans to just about anyone.
Banks offered subprime mortgages because they made so much money from the derivatives, rather than the loans themselves.
The Growth of Subprime Mortgages
In 1989, the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) increased enforcement of the Community Reinvestment Act. This Act sought to eliminate bank “redlining” of poor neighborhoods. That practice had contributed to the growth of ghettos in the 1970s. Regulators now publicly ranked banks as to how well they “greenlined” neighborhoods. Fannie Mae and Freddie Mac reassured banks that they would securitize these subprime loans. That was the “pull” factor complementing the “push” factor of the CRA.
The Fed Raised Rates on Subprime Borrowers
Banks hit hard by the 2001 recession welcomed the new derivative products. In December 2001, Federal Reserve Chairman Alan Greenspan lowered the fed funds rate to 1.75%. The Fed lowered it again in November 2002 to 1.25%.
That also lowered interest rates on adjustable-rate mortgages. The payments were cheaper because their interest rates were based on short-term Treasury bill yields, which are based on the fed funds rate. But, that lowered banks' incomes, which are based on loan interest rates.
Many homeowners who couldn't afford conventional mortgages were delighted to be approved for these interest-only loans. As a result, the percentage of subprime mortgages more than doubled, from 6% to 14%, of all mortgages between 2001 and 2007. The creation of mortgage-backed securities and the secondary market helped end the 2001 recession.
It also created an asset bubble in real estate in 2005. The demand for mortgages drove up demand for housing, which homebuilders tried to meet. With such cheap loans, many people bought homes as investments to sell as prices kept rising.
Many of those with adjustable-rate loans didn't realize the rates would reset in three to five years. In 2004, the Fed started raising rates. By the end of the year, the fed funds rate was 2.25%. By the end of 2005, it was 4.25%. By June 2006, the rate was 5.25%. Homeowners were hit with payments they couldn't afford. These rates rose much faster than past fed funds rates.
In 2005, homebuilders finally caught up with demand. When supply outpaced demand, housing prices started to fall. New home prices fell 22% from their peak of $262,600 in March 2007 to $204,200 in October 2010. Falling home prices meant mortgage-holders could not sell their homes for enough to cover their outstanding loan. The Fed's rate increase couldn't have come at a worse time for these new homeowners. They couldn't afford the rising mortgage payments. The housing market bubble burst. That created the banking crisis in 2007, which spread to Wall Street in 2008.
The Bottom Line
Deregulation in the financial industry was the primary cause of the 2008 financial crash. It allowed speculation on derivatives backed by cheap, wantonly-issued mortgages, available to even those with questionable creditworthiness.
Rising property values and easy mortgages attracted a lot of people to avail of home loans. This created the housing market bubble. When the Fed raised interest rates in 2004, the consequential increased mortgage payments squeezed home borrowers’ abilities to pay. This burst the bubble in 2007.
Since home loans were intimately tied to hedge funds, derivatives, and credit default swaps, the resounding crash in the housing industry drove the U.S. financial industry to its knees as well. With its global reach, the U.S. banking industry almost pushed most of the world’s financial systems to near collapse as well. To prevent this, the U.S. government was forced to implement enormous bail-out programs for financial institutions previously billed as “too big to fail.”
The 2008 financial crisis has similarities to the 1929 stock market crash. Both involved reckless speculation, loose credit, and too much debt in asset markets, namely, the housing market in 2008 and the stock market in 1929.