The banks then sold those loans on to Wall Street banks, which packaged them into what were billed as low-risk financial instruments such as mortgage-backed securities and collateralized debt obligations CDOs. Soon a big secondary market for originating and distributing subprime loans developed. That freed them to leverage their initial investments by up to 30 times or even 40 times.
Eventually, interest rates started to rise and homeownership reached a saturation point. The Fed started raising rates in June , and two years later the Federal funds rate had reached 5. There were early signs of distress. By , U. This caused real hardship to many Americans. Their homes were worth less than they paid for them. They couldn't sell their houses without owing money to their lenders. If they had adjustable-rate mortgages, their costs were going up as their homes' values were going down.
The most vulnerable subprime borrowers were stuck with mortgages they couldn't afford in the first place. In , it filed for bankruptcy protection. As got underway, one subprime lender after another filed for bankruptcy.
During February and March, more than 25 subprime lenders went under. In April, New Century Financial, which specialized in sub-prime lending, filed for bankruptcy and laid off half of its workforce. Even these were small matters compared to what was to happen in the months ahead. It became apparent by August that the financial markets could not solve the subprime crisis and that the problems were reverberating well beyond the U.
The interbank market that keeps money moving around the globe froze completely, largely due to fear of the unknown. Northern Rock had to approach the Bank of England for emergency funding due to a liquidity problem. In the coming months, the Federal Reserve and other central banks would take coordinated action to provide billions of dollars in loans to the global credit markets, which were grinding to a halt as asset prices fell.
Meanwhile, financial institutions struggled to assess the value of the trillions of dollars worth of now-toxic mortgage-backed securities that were sitting on their books.
By the winter of , the U. In January , the Fed cut its benchmark rate by three-quarters of a percentage point—its biggest cut in a quarter-century, as it sought to slow the economic slide.
The bad news continued to pour in from all sides. In February, the British government was forced to nationalize Northern Rock. By the summer of , the carnage was spreading across the financial sector. IndyMac Bank became one of the largest banks ever to fail in the U.
That same month, financial markets were in free fall, with the major U. The Fed, the Treasury Department, the White House, and Congress struggled to put forward a comprehensive plan to stop the bleeding and restore confidence in the economy. The Wall Street bailout package was approved in the first week of October The package included many measures , such as a huge government purchase of "toxic assets," an enormous investment in bank stock shares, and financial lifelines to Fannie Mae and Freddie Mac.
The public indignation was widespread. It appeared that bankers were being rewarded for recklessly tanking the economy. But it got the economy moving again. It also should be noted that the investments in the banks were fully recouped by the government, with interest. The passage of the bailout package stabilized the stock markets, which hit bottom in March and then embarked on the longest bull market in its history.
Still, the economic damage and human suffering were immense. About 3. A number of factors appear to have contributed to the growth in home mortgage debt. However, other analysts have suggested that such factors can only account for a small portion of the increase in housing activity Bernanke Moreover, the historically low level of interest rates may have been due, in part, to large accumulations of savings in some emerging market economies, which acted to depress interest rates globally Bernanke Others point to the growth of the market for mortgage-backed securities as contributing to the increase in borrowing.
Historically, it was difficult for borrowers to obtain mortgages if they were perceived as a poor credit risk, perhaps because of a below-average credit history or the inability to provide a large down payment. The result was a large expansion in access to housing credit , helping to fuel the subsequent increase in demand that bid up home prices nationwide. After home prices peaked in the beginning of , according to the Federal Housing Finance Agency House Price Index, the extent to which prices might eventually fall became a significant question for the pricing of mortgage-related securities because large declines in home prices were viewed as likely to lead to an increase in mortgage defaults and higher losses to holders of such securities.
Large, nationwide declines in home prices had been relatively rare in the US historical data, but the run-up in home prices also had been unprecedented in its scale and scope.
Ultimately, home prices fell by over a fifth on average across the nation from the first quarter of to the second quarter of This decline in home prices helped to spark the financial crisis of , as financial market participants faced considerable uncertainty about the incidence of losses on mortgage-related assets. In August , pressures emerged in certain financial markets, particularly the market for asset-backed commercial paper, as money market investors became wary of exposures to subprime mortgages Covitz, Liang, and Suarez In September, Lehman Brothers filed for bankruptcy, and the next day the Federal Reserve provided support to AIG , a large insurance and financial services company.
The Fed also introduced a number of new lending programs that provided liquidity to support a range of financial institutions and markets. But in October , the Federal Reserve gained the authority to pay banks interest on their excess reserves.
This gave banks an incentive to hold onto their reserves rather than lending them out, thus mitigating the need for the Federal Reserve to offset its expanded lending with reductions in other assets. The housing sector led not only the financial crisis, but also the downturn in broader economic activity. In the decade leading up to , real estate and property values had been rising steadily, encouraging people to invest in property and buy homes.
By early to mids, the residential housing market was booming. To capitalize on the boom, mortgage lenders rushed to approve as many home loans as they could, including to borrowers with less-than-deal credit.
These risky loans, called subprime mortgages, would later become one of the main causes of the Great Recession. A subprime mortgage is a type of loan issued to borrowers with low credit ratings. A prospective subprime borrower might have multiple dings on their credit history or dubious streams of income. In fact, the loan verification process was so lax at the time that it drew its own nickname: NINJA loans, which stands for "no income, no job, and no assets.
Because subprime mortgages were granted to people who previously couldn't qualify for conventional mortgages , it opened the market to a flood of new homebuyers. Easy housing credit resulted in the higher demand for homes.
This contributed to the run-up in housing prices, which led to the rapid formation and eventual bursting of the s housing bubble. While interest rates at the time were low , subprime mortgages were adjustable-rate mortgages, which charged low, affordable payments initially, followed by higher payments in the years thereafter. The result? Borrowers who were already on shaky financial footing stood a good chance of not being able to make payments when the interest rate rose in the years following.
In the rush to take advantage of a hot market and low interest rates, many homebuyers took on loans without knowing the risks involved. But the common wisdom held that subprime loans were safe since real estate prices were sure to keep rising. Along with issuing mortgages, lenders found another way to make money off of the real estate industry: By packaging subprime mortgage loans and reselling them in a process called securitization.
Through securitization, subprime lenders bundled loans together and sold them to investment banks, which, in turn, sold them to investors around the world as mortgage-backed securities MBS. Eventually, investment banks started repackaging and selling mortgage-backed securities on the secondary market as collateralized debt obligations CDOs. These financial instruments combined multiple loans of varying quality into one product, divided into segments, or tranches, each with its own risk levels suitable for different types of investors.
The theory, backed by elaborate Wall Street mathematical models, was that the variety of different mortgages reduced the CDOs' risk. The reality, however, was that a lot of the tranches contained mortgages of poor quality, which would drag down returns of the entire portfolio. Investment banks and institutional investors around the world borrowed significant sums at low short-term rates to buy CDOs. And because the financial markets seemed stable on the whole, investors felt secure about taking on more debt.
To make matters even more complicated, banks used credit default swaps CDS , another financial derivative, to insure against defaults on CDOs. Banks and hedge funds started buying and selling swaps on CDOs in unregulated transactions. Also, because CDS transactions didn't show up on institutions' balance sheets, investors couldn't assess the actual risks these enterprises had assumed.
Like corporate bonds and other forms of debt, MBS and CDOs required the blessing of credit rating agencies in order to be marketed. These agencies placed AAA ratings — usually reserved for the safest investments — on many securities, even though they contained a healthy share of risky mortgages. It's worth noting that credit rating agencies are supposed to be independent.
But an inherent conflict of interest seems to have existed since the banks issuing the securities were the ones paying the agencies to rate them. Investing Investing Essentials.
Table of Contents Expand. What Is a Financial Crisis? What Causes a Financial Crisis? Financial Crisis Examples. The Global Financial Crisis. Financial Crisis FAQs. Key Takeaways Banking panics were at the genesis of several financial crises of the 19th, 20th, and 21st centuries, many of which led to recessions or depressions. Stock market crashes, credit crunches, the bursting of financial bubbles, sovereign defaults, and currency crises are all examples of financial crises.
A financial crisis may be limited to a single country or one segment of financial services, but is more likely to spread regionally or globally. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Learn About the European Sovereign Debt Crisis The European debt crisis refers to the struggle faced by Eurozone countries in paying off debts they had accumulated over decades.
It began in and peaked between and Mortgage-Backed Security MBS A mortgage-backed security MBS is an investment similar to a bond that consists of a bundle of home loans bought from the banks that issued them. Stock Market Crash Definition A stock market crash is a steep and sudden collapse in the price of a stock or the broader stock market. Contagion Definition A contagion is the spread of an economic crisis from one market or region to another and can occur at both a domestic or international level.
Bank Stress Test A bank stress test is an analysis to determine whether a bank has enough capital to withstand a negative economic shock. Partner Links. Related Articles. Economics 3 Financial Crises in the 21st Century. Macroeconomics What Causes a Recession?
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