What caused the 2008 financial crisis? In plain words

The 2008 financial crisis was caused by a housing bubble in the United States, fed by risky mortgages that were bundled into securities and sold around the world, and by financial firms that had borrowed so heavily that small losses could wipe them out. When house prices fell, nobody knew who held the bad loans, lenders pulled their money, and the failure of Lehman Brothers in September 2008 turned the strain into a global panic.

In short

• Easy mortgages and rising prices fed each other until 2006, when house prices began to fall and borrowers began to default.
• The losses landed in mortgage-backed securities held by banks that were heavily leveraged and funded with short-term loans that could vanish overnight.
• Governments and central banks stopped the panic with bailouts and emergency lending, then rewrote the rules, most of all in the Dodd-Frank Act of 2010.

How did a housing boom become a crisis?

Between 1998 and 2006, average American home prices more than doubled, according to the Federal Reserve's history of the period. Rising prices made lending look safe: if a borrower couldn't pay, the house could be sold for more than the loan. Lenders extended credit to people with weak credit records, called subprime borrowers, often with low starting "teaser" rates that reset higher after two or three years, and sometimes with little check on income. Household mortgage debt rose from 61% of GDP in 1998 to 97% in 2006.

Housing activity peaked in 2006 and prices turned down. Borrowers whose rates reset found they couldn't pay and couldn't sell for enough to clear the loan. Defaults rose, which pushed more houses onto the market and prices lower still. In April 2007, New Century Financial, one of the largest subprime lenders, went bankrupt. Prices kept sliding for years, and housing markets did not stabilize until about 2012, according to the Federal Reserve's history.

Where did the bad loans go?

Most of the mortgages didn't stay with the lenders who made them. They were sold and pooled, thousands at a time, into mortgage-backed securities: bonds whose payments came from homeowners' monthly payments. The pools were sliced into layers, called tranches. The bottom layers took the first losses, which let the top layers be rated AAA, the safest grade, even when the loans underneath were risky. Some of the riskier layers were pooled again into collateralized debt obligations and sliced again.

Each link in the chain was paid at the time of the sale, so each had less reason to care whether the loan would be repaid years later. The rating agencies' models assumed that house prices across the whole country would not fall together, and they did. And because the securities were spread across banks, insurers and funds worldwide, when losses came, no one could tell which firms were holding them.

Why did losses on mortgages break the banks?

Losses alone don't cause a panic. Leverage and short-term funding do. Leverage means running a business mostly on borrowed money. The Financial Crisis Inquiry Commission found that, by one measure, the five big investment banks had leverage ratios as high as 40 to 1 in 2007: for every $40 of assets, only $1 of their own capital.

Here is what that means in numbers. Take a firm with $100 of assets, funded by $97.50 of borrowing and $2.50 of its own money, which is 40 to 1. If its assets lose 2.5% of their value, falling to $97.50, its capital is gone. A homeowner with a 20% deposit can survive a 15% fall in the house price; a firm at 40 to 1 cannot survive a fall of 3%.

Much of the borrowing was also very short-term, through repurchase agreements, or repos, and commercial paper, renewed every night or every few weeks. When lenders began to doubt a firm, they simply stopped renewing, which forced it to sell assets in a falling market and made the doubts come true. This was a bank run, but by professional lenders instead of depositors, and outside the deposit insurance built after the Great Depression.

The crisis, step by step

When	What happened
2006	US housing activity peaks and prices begin to turn down
April 2007	Subprime lender New Century Financial files for bankruptcy
August 2007	Short-term funding markets seize up as investors flee mortgage-linked paper
December 2007	The US recession begins
March 2008	JPMorgan Chase buys the investment bank Bear Stearns with Federal Reserve help
7 September 2008	The government takes over Fannie Mae and Freddie Mac, the giant mortgage firms
15 September 2008	Lehman Brothers files for bankruptcy, the largest in US history
16 September 2008	The Fed rescues the insurer AIG; a large money market fund "breaks the buck"
3 October 2008	Congress authorizes $700 billion for the Troubled Asset Relief Program, TARP
December 2008	The Fed cuts its policy rate to between 0 and 0.25%
June 2009	The recession ends, after 18 months
October 2009	US unemployment peaks at 10.0%
21 July 2010	The Dodd-Frank Act becomes law

Lehman was the turning point. The government had helped arrange a rescue of Bear Stearns but let Lehman fail, and markets suddenly had to ask which large firm was next. Lending between banks nearly stopped, and the panic spread to Europe and beyond. In the United States, the economy shrank 4.3% from peak to trough, and employment fell from 138 million in January 2008 to 129 million in February 2010.

How did governments respond?

The response had three parts. The Federal Reserve cut interest rates to nearly zero, lent to banks and other firms on a scale never seen before, and from November 2008 bought large amounts of mortgage-backed securities and Treasury bonds, a policy known as quantitative easing. The Treasury used TARP to put capital into banks, rescue AIG and the carmakers, and help homeowners; Congress later cut the program's authority to $475 billion. Governments also guaranteed bank debts and money market funds to stop the runs.

Then came new rules. The Dodd-Frank Act of 2010 created a Consumer Financial Protection Bureau to police mortgages and other loans, a council to watch for risks across the whole system, annual stress tests for big banks, and a process for winding down a failing giant without a Lehman-style collapse. International rules known as Basel III required banks to hold more and better capital and more cash-like assets.

Who was to blame?

Still argued

The official inquiry split. The Financial Crisis Inquiry Commission's majority concluded in 2011 that "this financial crisis was avoidable", blaming failures of regulation, notably the Federal Reserve's failure to set mortgage-lending standards, along with reckless risk-taking, excessive borrowing and breakdowns in ethics and accountability at financial firms. Three Republican commissioners dissented, arguing the crisis had many causes, including a global credit bubble and weak management of risk, and that regulation alone would not have prevented it. A fourth, Peter Wallison, put the main blame on government housing policy that pushed Fannie Mae, Freddie Mac and others toward riskier loans. The bailouts are argued too: supporters say they stopped a second Great Depression, and most TARP money was paid back; critics say they rescued the firms that caused the crisis and taught big banks that they would be saved, a problem called moral hazard. The evidence points to many causes acting together rather than one villain.

The crisis left a deep mark beyond economics. In January 2009, the first block of Bitcoin carried a newspaper headline about a second bank bailout, and its anonymous creator presented it as money that needed no bank. The downturn that followed is the standard example of a severe recession, and the response to it is the clearest case of policymakers applying the lessons of the 1930s, as economics had come to understand them.

Check yourself

• Without looking back: how could a loan to a risky borrower end up inside a bond rated AAA?
• Why does leverage of 40 to 1 make a firm fragile, in numbers?
• Why did the failure of Lehman Brothers do more damage than the losses on subprime mortgages themselves?

Sources

• The Financial Crisis Inquiry Report — Financial Crisis Inquiry Commission, U.S. Government Publishing Office, 2011
• The Great Recession and Its Aftermath — Federal Reserve History
• Subprime Mortgage Crisis, 2007–2010 — Federal Reserve History
• Troubled Asset Relief Program — U.S. Department of the Treasury
• The Recession of 2007–2009 — U.S. Bureau of Labor Statistics, 2012