Introduction To The 2008 Recession

In late 2003, the Federal Reserve chairman, Alan Greenspan, decided to lower interest rates from 6.5% in 2000 to only 1%. He hoped that in doing so, he would be able to stimulate the economy and encourage consumer spending; after all, 1% interest was a very low return on investment.

As a result, banks on Wall Street started to borrow substantial sums of money for only 1% interest. This led to an abundance of cheap credit, making borrowing money easy for banks and causing them to go crazy with leverage, or the act of borrowing money to amplify the outcome of a deal.

How does leverage work? Picture a man with only $10,000 taking out a $990,000 loan, garnering a total of one million dollars. This man then buys a house for that money and then sells it to someone else for $1,100,000 (making a 100k profit). Afterwards, this man pays back the $990,000 to the bank, plus $9,900 in interest. Ultimately, he is left with over 90k in profit. In other words, leverage makes a good deal into a great deal, and this is essentially how banks make their money.

With the 1% interest brought about by the Federal Reserve, Wall Street started to take out a ton of credit, make great deals, grow immensely rich, and easily pay back its loans.

Investors turned to banks to get in on this action as well. Wall Street came up with a lucrative idea wherein they’d connect investors to homeowners through mortgages. How did this work?

If a family wants to buy a house, it saves up money for a down payment and then contacts a mortgage broker. This broker, then, connects the family to a mortgage lender, who gives the family a mortgage. In doing so, the broker makes a nice commission. With the mortgage, the family buys the house and its members become homeowners.

Eventually, the mortgage lender gets in contact with an investment banker who wants to buy the mortgage. The lender sells it for a lofty fee. Consequently, the investment banker starts taking out millions of dollars to buy out many more mortgages. This means that every month, he will receive the payments from all the homeowners that are working to pay off their mortgages.

Soon, the investment banker begins to sell CDOs (collateralized debt obligations) to other investors. The CDOs are comprised of a pool of mortgages, or debt obligations, that serve as collateral for the CDO. In selling CDOs, the investment banker makes millions and is able to repay his loans.

Eventually, the investment banker calls the mortgage lender again, wanting more mortgages. But this time, there aren’t any mortgages available because all the homeowners who qualified for a mortgage already had one.

How was this issue resolved? Mortgage lenders turned greedy and started lending loans to unqualified families that couldn’t afford to buy houses. Such mortgages are known as subprime mortgages. They require no down payment or proof of income. The distribution of subprime mortgages enabled families to buy big houses and perpetuated the cycle wherein bank lenders sold mortgages to bank investors.

Unsurprisingly, homeowners began to default their mortgages, which were owned by the bankers. This caused the banks to start foreclosing one house after another. The crisis generated a high supply of houses but a low demand for them.

Housing prices started to depreciate. As this occurred, millions of homeowners started to realize that they owed more on their mortgages than their homes were worth. They didn’t see the point in continuing to pay their mortgage, so they walked away.

Default rates continued to sweep the nation and housing prices plummeted. The investors stopped buying mortgages from the banks, making the banks unable to pay back their loans. Simultaneously, investors who already bought thousands of mortgages also suffered huge financial losses. Ultimately, everybody started to go bankrupt, and this, precisely, was what led to the beginning of what we call today the Great Recession of 2008.

 

Here is a flowchart summarizing the above information.

 

 

 

 

This PBS documentary examines the cause of wealth inequality through the lens of the debate concerning America’s wealthiest. It portrays the wealthy as the source of an uneven playing field in terms of creating and perpetuating the gap between the rich and poor.