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Overview

In 2004, the economy was booming. There were jobs everywhere and houses were increasing in value every day.

As we know, the economy changed drastically in 2007 and 2008. What exactly happened to cause this?

The US government helped the economy by saving it from a complete collapse. If they hadn’t done this, we would have been worse off than ever before.

In this article, we’ll examine the housing bubble and bust of 2005-2008. We’ll look at why people thought their houses would quadruple in value in seven years. We’ll also see how a 150-year old prestigious Wall Street firm fell apart due to greed and corruption. Finally, we’ll learn what links banks with Wile E Coyote (the cartoon character who runs off cliffs).

Let’s look at the causes of the financial crisis.

Big Idea #1: After the year 2000, enormous price bubbles developed in the housing and mortgage-bond markets.

Before the financial crisis became evident in 2007, buying a house or investing in bonds seemed like a very profitable investment. However, both markets were actually in trouble. First of all, there was an unsustainable price bubble in the housing market (which is when prices have risen to levels that are too high), and second of all, there was a lot of debt involved with these investments.

Despite the rise in prices, people kept investing in houses because they believed that prices would keep rising.

A survey of Los Angeles homeowners revealed that many believed their house values would increase by approximately 22 percent each year. Therefore, if they bought a $500,000 home now, it would be worth over $3.6 million in ten years.

While the bond market was also experiencing a price bubble.

After the 2001 economic slump, the US Federal Reserve cut interest rates to 1%. The idea was that banks would lower their interest rates on bank accounts and people would spend more money. At the same time, investors were getting less from government bonds, so they looked for other investments.

When the housing market was booming, banks and investment companies were buying mortgage-backed securities. Banks would pool mortgages together to create a bond that investors could buy. This drove up the price of MBSs, which made them more popular among investors.

Big Idea #2: Poor regulation by banks and the government was partially responsible for the housing and bond market bubbles.

The housing and bond market bubbles happened because of poor regulation by the government and banks.

For example, banks were approving people for mortgages even when they didn’t qualify. These subprime mortgages were issued to borrowers with bad credit and low income levels. The main thing was to sell lots of them to fuel the housing boom.

For example, one couple in California made $27,000 a year picking strawberries. They were given a mortgage of $720,000! It was clear that they and others like them would eventually default on their loans.

As for the bond market bubble, it was partially due to a new financial instrument called Credit Default Swaps (CDS). These are basically insurance policies that investors can buy against bonds defaulting. For example, if they bought a mortgage bond and homeowners defaulted on their mortgages, then the bond would also default.

So, if you buy a bond and the company goes bankrupt, then there’s nothing left for you to collect. However, if you bought a CDS (Credit Default Swap) on that bond before it went bankrupt, then your CDS provider will pay out to you instead of the original owner of the bond. This is similar to car insurance: You pay an annual fee for coverage in case something bad happens with your car. Then when something bad does happen with your car—say it gets totaled by another driver—then the insurance company pays off whoever has been hurt from that accident instead of just paying yourself because they have already paid their yearly fee.