The Financial Crisis of 2008 Analysis

1. What caused the financial crisis of 2008?

In 1998, hosing in major cities along the pacific coast began to enjoy double-digit annual appreciation price. Because of that, in the following seven years, more and more people invest in real estate which initiates the boom of home sales. As a result, in 2014, the U.S. homeownership rate reached an all-time high of 69.2% in 2004.

But during the boom of housing market, “easy money policy” began to increase the risk in the housing market. The U.S. fell into a short-term recession in 2001 due to the terror attacks of September 11. So the Federal Reserve sharply reduced interest rate to 1%, which is the lowest level in 45 years, which significantly affected and lowered rates on home loans.

Meanwhile, a trick on mortgage finance became popular - there are more and more subprime loans.

On the one hand, the brokers rush to extend home loans during boom and some of them were thought to have committed fraud. It was believed that people with low credit scores will pay off their loans using the capital gain earned from soaring housing price. So the subprime issuers progressively lowered their lending standard, and even waived the down-payment in the mortgages for the high-risk borrowers without verifying their incomes. By 2006, one out of every four newly issued home loans was subprime.

On the other hand, the low credit borrowers were lack of appropriate financial knowledge to identify the lies about the overstated value of the home, steep hidden fees, and registration of refinancing included in their mortgage contracts. They were convinced that the soaring house price will make them money and help achieve their “American Dream” of having a nice house. Though it sounds funny now, it did attract a lot of people who were affected by the irrational actions which were normally seen among the whole society at that time.

The obviously frenzied home purchasing and hidden bubble in home price was not identified by the influential analysts. So the bust of housing market was get more and more severe until the implosion of the subprime sector in 2016. At that time, housing prices began a steady retreat and the home sales declined at their sharpest annual rate.

The subprime lending companies were unable to sell their risky loans to Wall Street. Due to the large percent of subprime issued by the lenders, they collapsed in late 2006. And this was just the start of a wave of failures that would destroy the subprime lending industry within months.

Since Wall Street purchased a lot of mortgages from lenders, divided them into tranches and sold them to institutional investors in the form of mortgage-backed securities. The payments from the borrowers would fill the tranches in the order of their level of risk. With the nosedive house market, more and more borrowers miss their payments and cause the widespread fears of future defaults even for those with the highest rating AAA.  The hedge funds that invested in the mortgage securities suffered from it and “a loss of trust” was felt in European financial markets and quickly swept around the globe.