The Perfect Storm of Deregulation and Greed
The 2008 financial crisis, often referred to as the Global Financial Crisis (GFC), was the most severe worldwide economic disaster since the Great Depression of the 1930s. It resulted in the collapse of massive financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. At the heart of this catastrophe was the United States housing market and a toxic financial innovation known as the Mortgage-Backed Security (MBS).
The Subprime Mortgage Boom
In the years following the Dot-Com bubble crash of 2000, the Federal Reserve lowered interest rates to stimulate the economy. This made borrowing extremely cheap. Simultaneously, banks and lending institutions began offering mortgages to individuals with poor credit histories—these were known as subprime mortgages. Because these borrowers were high-risk, the loans carried higher interest rates.
Traditionally, a bank would issue a mortgage and hold it for 30 years, collecting the interest. But Wall Street found a way to package these loans together and sell them to global investors, transferring the risk away from the original lender. This process is called securitization.
CDOs and the Illusion of Safety
Wall Street investment banks purchased thousands of these subprime mortgages, bundled them together, and created Collateralized Debt Obligations (CDOs). These complex financial derivatives were then evaluated by credit rating agencies like Standard & Poor's and Moody's. Shockingly, many of these CDOs—despite being filled with high-risk, subprime loans—were given AAA ratings, making them appear as safe as U.S. Treasury bonds.
Because they were rated AAA, pension funds, foreign governments, and institutional investors worldwide poured trillions of dollars into these products, seeking higher yields.
The Bubble Bursts
The entire system was predicated on housing prices continuing to rise. By 2006, the Federal Reserve began raising interest rates to combat inflation. Adjustable-rate mortgages (ARMs) reset to much higher monthly payments, and simultaneously, housing prices began to fall. Borrowers could no longer afford their homes, nor could they refinance or sell them without taking a loss.
Defaults skyrocketed. The CDOs that held these mortgages plummeted in value, becoming toxic assets. Major financial institutions like Bear Stearns and Lehman Brothers, which held massive amounts of these worthless securities, faced catastrophic insolvency.