The 2008 Financial Crisis

Why this matters

The recession that began in December 2007 was the deepest and longest in the United States since World War II.¹ It started in housing, a market most people thought they understood, and spread through financial products few people did. Today's bank capital rules, stress tests, and much of the Federal Reserve's crisis toolkit were built in response to it.

The housing boom

Average US home prices more than doubled between 1998 and 2006, the sharpest increase recorded in US history. Homeownership rose from 64% in 1994 to 69% in 2005, and household mortgage debt rose from 61% of GDP in 1998 to 97% in 2006.¹

Much of the new lending went to borrowers who once would have struggled to get a mortgage. In the early and mid-2000s, lenders made high-risk, or "subprime," loans and funded them by pooling them into securities sold to investors. The safer slices of those securities were seen as low-risk, because they were insured or because other slices would absorb losses first. Rising prices encouraged expectations of further gains, which pushed demand and prices higher still, and as long as prices rose, struggling borrowers could sell at a gain or borrow more against their homes.²

Economists still debate the causes. Some argued that the Fed's low interest rates after the 2001 recession fed the boom; others concluded that rates could explain only a small part of it, pointing instead to a global glut of savings that held rates down and to the growth of mortgage securities.¹

Losses on a $100 pool	Junior slice ($5)	Middle slice ($15)	Senior slice ($80)
$3, as in a normal year	−60%	0%	0%
$10	−100%	−33%	0%
$25, a severe nationwide fall	−100%	−100%	−6%

The senior slice is protected by the $20 of slices beneath it, so it looks almost riskless as long as losses stay modest. That protection depends on mortgages not all going bad at once. A nationwide fall in home prices made defaults rise everywhere together, and slices that had looked safe were downgraded and fell in value.

The turn

By the Federal Housing Finance Agency's index, home prices peaked at the beginning of 2007. Large nationwide declines had been rare in US history, but so had a run-up of that scale.¹ In April 2007 New Century Financial, a leading subprime lender, filed for bankruptcy. Large numbers of mortgage securities were soon downgraded, funding for subprime loans collapsed, and falling prices fed expectations of further falls.² In August 2007, strains appeared in the market for asset-backed commercial paper as money market investors grew wary of anything exposed to subprime mortgages.¹ At commercial banks, the share of single-family mortgages behind on payments rose from about 1.6% in early 2006 to 11.5% at the start of 2010.³

2008

Federal Reserve History and the US Treasury.⁴²⁵⁶ Several of these firms weren't commercial banks, the kind of institution the Fed normally supports. It stepped in anyway to avoid disorderly failures that could harm the wider economy.⁴

The rest of this lesson is for members

Still to come in this lesson: The response, The damage, What changed, the key takeaways, and 2 quiz questions with explanations.

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