2007–2008 hit the US economy hard. The global financial crisis came out of nowhere for most Americans. Few people were able to predict the crash, even fewer actually managed to make money on it. It took years and trillions of dollars for the economy to recover.
The story is what some people call the ‘snowball effect’. With its roots back in the 1990s, when house prices started to rise, this was the very moment when the contagion kicked off. By 2006, the situation with the economy had become extremely aggravated. People were borrowing like never before and banks were happy to provide leverage. Investment banks, involved with mortgages, were growing tremendously rich as they owned thousands of mortgages and received large payments on a monthly basis. At the same time homeowners were also thriving. You bet! They were lending their properties and receiving fantastic profits in rental fees.
Traditional mortgages turned out to be slavery for most debt holders. They required huge down payments. Before being considered for a mortgage, a person needed to put up approximately 20 %, of the home’s original price, for a mortgage of the remaining 80% of the value. Meaning for a house valued at $100,000, a person would have to save $20,000 before getting a mortgage for the other $80,000.
Investment banks were racing to get more mortgages. But…there weren’t any! Home owners who qualified for mortgages were already part of the system. Brokers, in turn, came up with an idea. It was a revolution in the property world. A shortcut, leading to a financial fiasco.
The idea was to issue a new type of mortgage. One that was more risky. They didn't require any proof of income. In fact, they didn't require anything at all. They were available to any American family. That's how sub-prime mortgages appeared.
But, how did it work in reality? Thousands of unemployed Americans with minimal income received the possibility to buy big houses. To make those mortgages even more enticing, lenders issued them with the lowest interest rates.
The scheme was running smoothly. Lenders were selling sub-prime mortgages to the investments banks. Then the securities were successfully sold to investors as CDOs (collateralised debt obligations).
What came next? Home owners eventually started to default. This was not surprising, as due to their low income and high levels of unemployment, they were not able to pay on time or, for many, even to pay at all. The banks reaction? ‘It’s not a big deal, we have their house anyway! We’ll put it up for sale’. Easier said, than done. As more and more families appeared to be out of money and unable to pay their debt, more and more houses were put up for sale. Eventually, supply exceeded demand. As a result, prices sank dramatically.
Investment banks turned out to be holders of useless and worthless paper. As did the investors. Nobody wanted to buy ‘empty’ mortgages with zero value. That’s when the default happened. Everything and everybody went belly up – the housing bubble had exploded.
Lessons We Learned
Lesson 1: History Always Repeats Itself
As soon as the number of debt holders reached its peak and the bubble exploded, prices started to fall. Previous financial crises saw the same tendencies: it follows its course steadily, then suddenly takes the opposite direction. The subject is covered well in the ‘Great Crash’ by John Kenneth Galbraith. The author explains the link between major financial despairs and analyses how trends follow the reverse course just after they have reached the highest point.
Lesson 2: Bubbles Eventually Burst
Everything comes to an end. It takes a strong analytical thinking and innate instinct to predict when it will explode. People who were able to foresee the impending fiasco made millions on it.
Lesson 3: Regulations
The Dodd-Frank legislation became a major response to crisis. The reform oversees the stability of the largest financial institutions to prevent their failure as it can affect the overall economy. Today banks, brokers, investment firms are obliged to comply with regulations and high standards to ensure transparency.
Now, in the post-crisis era, the Federal Reserve operates in two main directions. The first is to reduce the unemployment. The second is to control inflation.
Lesson 4: No Rush
Investors also received nuggets of wisdom. The most precious lesson is not to invest in assets that gained value in almost immediately.
Years have passed. The economy recovered. Wall Street is in blossom again. Still, the market paralysis, financial despair and loose standards of 2008 are never to be forgotten.