What Caused the 2008 Global Financial Crisis?

4 Underlying Causes

Causes of 2008 financial crisis
A trader works on the floor of the New York Stock Exchange (NYSE) June 30, 2005 in New York City. As expected, the Federal Reserve Thursday raised its federal funds rate target by a quarter-percentage-point to 3.25 percent from 3 percent. This is its ninth increase in a row. Photo: Spencer Platt/Getty Images

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 were affordable to subprime borrowers. The Fed raised the Fed funds rate just as the interest rates on these new mortgages reset.

Housing prices started falling as supply outpaced demand.That trapped homeowners who couldn't afford the payments, but couldn't sell their house. The values of the derivatives crumbled, and banks stopped lending to each other. That created the financial crisis that led to the Great Recession.


First, the 1999 repeal of Glass-Steagall by the Gramm-Leach-Bliley Act. This allowed banks to use deposits to invest in derivatives. Banking lobbyists said they couldn’t compete with foreign firms, and that they would only go into low risk securities, reducing risk for their customers.

The following year, the Commodity Futures Modernization Act allowed the unregulated trading of credit default swaps and other derivatives. This federal legislation overruled the state laws that had formerly prohibited this as gambling.

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 was heavily lobbied by Enron where his wife, who had formerly held the post of Chairwoman of the Commodities Future Trading Commission, was a board member. Enron was a major contributor to Senator Gramm’s campaigns. Federal Reserve Chairman Alan Greenspan and the former Treasury Secretary Larry Summers also lobbied for the bill’s passage.

Enron and the others lobbied for the Act to allow it to legally engage in derivatives trading using its online futures exchanges. Enron argued that legal overseas exchanges of this type was giving foreign firms a competitive advantage.  (Source: Eric Lipton, “Gramm and the ‘Enron Loophole,”New York Times, November 14, 2008.)

Big ban had the resources to become very sophisticated at the use of these complicated derivatives. As banking became more competitive, the banks that had the most complicated financial products made the most money, and bought out smaller, stodgier banks. That’s how 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, it sells it to a hedge fund 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 the monthly payments, total amount owed, the likelihood you will repay, what home prices and interest rates will do, and other factors.

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. They weren’t worried about the risk because they had insurance, called credit default swaps.  They were sold by solid insurance companies liked AIG. 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.

The combination of a derivative backed by real estate, and insurance, was a very profitable hit! However, it required more and more mortgages to back the securities. This drove up demand formortgages. 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, not the loans.

The Growth of Subprime Mortgages

In 1989, the Financial Institutions Reform Recovery and Enforcement Act increased enforcement of the Community Reinvestment Act. This Act sought to eliminate bank “redlining” of poor neighborhoods, which had contributed to the growth of ghettos in the 70s. 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. It was the “pull” factor that complimented the “push” factor of the CRA.  (Source: John Carney, “The Phony Time-Gap Alibi for the Community Reinvestment Act,” Business Insider, June 26, 2009)

The Fed Raised Rates on Subprime Borrowers

Banks really needed this new product, thanks to the 2001 recession (March-November 2001).  In December, Federal Reserve Chairman Alan Greenspan lowered the Fed funds rate to 1.75%. The Fed lowered it again in November 2002, to 1.24%. 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. 

Many homeowners who couldn't afford conventional mortgages were delighted to be approved for these interest-only loans. As a result, the percent of subprime mortgages doubled, from 10% to 20%, of all mortgages between 2001 and 2006.  By 2007, it had grown into a $1.3 trillion industry. The creation of mortgage-backed securities and the secondary market was what got us out of the 2001 recession. (Source: Mara Der Hovanesian and Matthew Goldstein, "The Mortgage Mess Spreads,"BusinessWeek, March 7, 2007.)

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, not to live in them or even rent them, but just 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%, and went to 5.25% by June 2006. Homeowners were hit with payments they couldn't afford. For more, see Past Fed Funds Rate.

Housing prices started falling after they reached a peak in October 2005. By July 2007, they were down 4%. That was enough to prevent mortgage-holders from selling homes they could no longer make payments on. The Fed's rate increase couldn't have come at a worse time for these new homeowners. The housing market bubble turned to a bust. That created the banking crisis in 2007, and to Wall Street in 2008.

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