Subprime mortgage bubble
The precipitating factor for the Financial Crisis of 2007–2008 was a high default rate in the United States subprime home mortgage sector – the bursting of the "subprime bubble". While the causes of the bubble are disputed, some or all of the following factors must have contributed.
- Low interest rates encouraged mortgage lending.
- Securitization. Many mortgages were bundled together and formed into new financial instruments called mortgage-backed securities, in a process known as securitization. These bundles could be sold as (ostensibly) low-risk securities partly because they were often backed by credit default swaps insurance. Because mortgage lenders could pass these mortgages (and the associated risks) on in this way, they could and did adopt loose underwriting criteria (due in part to outdated and lax regulation).
- Lax regulation allowed predatory lending in the private sector, especially after the federal government overrode anti-predatory state laws in 2004.
- The (CRA), a US federal law designed to help low- and moderate-income Americans get mortgage loans encouraged banks to grant mortgages to higher risk families.
- Mortgage guarantees. Many of the subprime (high risk) loans were bundled and sold, finally accruing to quasi-government agencies (Fannie Mae and Freddie Mac). The implicit guarantee by the US federal government created a moral hazard and contributed to a glut of risky lending.
The accumulation and subsequent high default rate of these subprime mortgages led to the financial crisis and the consequent damage to the world economy.
High mortgage approval rates led to a large pool of homebuyers, which drove up housing prices. This appreciation in value led large numbers of homeowners (subprime or not) to borrow against their homes as an apparent windfall. This "bubble" would be burst by a rising single-family residential mortgages delinquency rate beginning in August 2006 and peaking in the first quarter, 2010.
The high delinquency rates led to a rapid devaluation of financial instruments (mortgage-backed securities including bundled loan portfolios, derivatives and credit default swaps). As the value of these assets plummeted, the market (buyers) for these securities evaporated and banks who were heavily invested in these assets began to experience a liquidity crisis. Freddie Mac and Fannie Mae were taken over by the federal government on September 7, 2008. Lehman Brothers filed for bankruptcy on September 15, 2008. Merrill Lynch, AIG, HBOS, Royal Bank of Scotland, Bradford & Bingley, Fortis, Hypo Real Estate, and Alliance & Leicester were all expected to follow—with a US federal bailout announced the following day beginning with $85 billion to AIG. In spite of trillions paid out by the US federal government, it became much more difficult to borrow money. The resulting decrease in buyers caused housing prices to plummet.
While the collapse of large financial institutions was prevented by the bailout of banks by national governments, stock markets still dropped worldwide. In many areas, the housing market also suffered, resulting in evictions, foreclosures, and prolonged unemployment. The crisis played a significant role in the failure of key businesses, declines in consumer wealth estimated in trillions of US dollars, and a downturn in economic activity leading to the Great Recession of 2008–2012 and contributing to the European sovereign-debt crisis. The active phase of the crisis, which manifested as a liquidity crisis, can be dated from August 9, 2007, when BNP Paribas terminated withdrawals from three hedge funds citing "a complete evaporation of liquidity".
The bursting of the US housing bubble, which peaked at the end of 2006, caused the values of securities tied to US real estate pricing to plummet, damaging financial institutions globally. The financial crisis was triggered by a complex interplay of policies that encouraged home ownership, providing easier access to loans for subprime borrowers; overvaluation of bundled subprime mortgages based on the theory that housing prices would continue to escalate; questionable trading practices on behalf of both buyers and sellers; compensation structures that prioritize short-term deal flow over long-term value creation; and a lack of adequate capital holdings from banks and insurance companies to back the financial commitments they were making. Questions regarding bank solvency, declines in credit availability, and damaged investor confidence affected global stock markets, where securities suffered large losses during 2008 and early 2009. Economies worldwide slowed during this period, as credit tightened and international trade declined. Governments and central banks responded with unprecedented fiscal stimulus, monetary policy expansion and institutional bailouts. In the US, Congress passed the American Recovery and Reinvestment Act of 2009.
Many causes for the financial crisis have been suggested, with varying weight assigned by experts.
- The US Senate's Levin–Coburn Report concluded that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street."
- The Financial Crisis Inquiry Commission concluded that the financial crisis was avoidable and was caused by "widespread failures in financial regulation and supervision", "dramatic failures of corporate governance and risk management at many systemically important financial institutions", "a combination of excessive borrowing, risky investments, and lack of transparency" by financial institutions, ill preparation and inconsistent action by government that "added to the uncertainty and panic", a "systemic breakdown in accountability and ethics", "collapsing mortgage-lending standards and the mortgage securitization pipeline", deregulation of over-the-counter derivatives, especially credit default swaps, and "the failures of credit rating agencies" to correctly price risk.
- The 1999 repeal of the Glass-Steagall Act effectively removed the separation between investment banks and depository banks in the United States.
- Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products, and that governments did not adjust their regulatory practices to address 21st-century financial markets.
- Research into the causes of the financial crisis has also focused on the role of interest rate spreads.
- Fair value accounting was issued as US accounting standard SFAS 157 in 2006 by the privately run Financial Accounting Standards Board (FASB)—delegated by the SEC with the task of establishing financial reporting standards. This required that tradable assets such as mortgage securities be valued according to their current market value rather than their historic cost or some future expected value. When the market for such securities became volatile and collapsed, the resulting loss of value had a major financial effect upon the institutions holding them even if they had no immediate plans to sell them.