The Financial Meltdown of 2008

By Matt Hughes

  • Interest Rates Begin to Fall

    The Fed lowers interest rates quickly in response to the dot com boom and bust. This makes money cheaper and pushes down long term interest rates. This means people are willing to borrow more and take on more debt.

  • Banks 'bundle' debt

    Large investment banks 'bundle' debt by packaging it together and selling it to investors. Often times these investors are foreign banks and hedge funds. Just as often they are municipal retirement funds.

  • Risky loans increase

    Because of the loan bundles, investment banks begin making more risky investnments. They do not take on much risk, because this debt is packaged and resold. They often prompted people to take out mortgages with little to no money down, or proof of income. This is risky, unless you're going to package the debt and sell it, which they do...

  • Home prices rise

    If the demand for houses goes up, and there's lots of cheap money going around, houses become worth much more money! This period saw a huge (yet artificial) increase in home equity, meaning people's homes went up in price.

  • Now let's leverage our debt!

    Ok, now banks and hedge funds are using all of this extra money to make investments. They are buying low, and investments are rising rapidly. There is cheap money everywhere!

  • Interest rates start to rise

    The Fed catches on, but only slowly. They raise rates because to de-incentivize spending. Basically, when credit is more expensive, people will buy it less (it's the law of supply - woot!)

  • Home prices fall

    Now that interest rates are rising and homeownership is shooting through the roof (record levels in 2006), the prices start to slide.

  • Mortgage defaults increase

    So now, all those people who bought homes with little or no money down begin to lose money in equity. Their homes become worth much less that they owe - that means if you bought a house for 300,000 with no money down, it is now worth around 200,000 - but you still owe 3. Now you're in trouble. Mortgage defaults increase when people can't pay their mortgage (sub prime morgages actually go up in price over time, making this worse)

  • The Credit Crisis

    Now that people are defaulting on their home loans, remember all that debt? It had been bundled, repackaged, and sold on to hedge funds and investment firms. Now those debt bundles aren't looking so good with so many people defaulting on their loans (there were actually financial firms BETTING on them to fail. In some cases, they were the same folks who were slapping credit ratings on the bundles and, knowing they were lousy, betting on them to fail).

  • The downward spiral into financial crisis

    Very large banks are heavily invested in this bad, faulty debt that won't ever get repaid. That means they lose money. It turns out that banks have very little money in reserve (remember repealing the Glass-Seagal act?) and so huge financial firms begin to go under. When this happens, we lose the core of our financial system and spending stops. Thus, the financial crisis.