The crisis started with mortgages that banks knew borrowers could not afford to repay

Between 2003 and 2006, banks and mortgage brokers stopped checking whether people could actually pay back home loans. A borrower with no job, no savings, and no down payment could get a mortgage for $400,000. Banks did this deliberately because they made money upfront on the loan itself, then when ready sold that loan to someone else—so they had no reason to care if the borrower defaulted later.

These were called subprime mortgages: loans to people with poor credit or unstable income, often at interest rates that started low and jumped sharply after two or three years. When the jump came, many borrowers could not pay. They stopped making payments, and the houses went into foreclosure. By 2007, the default rate on subprime mortgages was climbing fast.

Key Takeaways

  • Banks issued mortgages to borrowers they knew could not afford them, then sold those mortgages to other financial institutions so they bore no risk if the borrower defaulted.
  • Investment banks bundled thousands of these bad mortgages into complex securities and sold them to pension funds, insurance companies, and other banks around the world.
  • When borrowers stopped paying, the value of these securities collapsed, and nobody knew which banks held the toxic assets or how much they had lost.
  • Banks stopped lending to each other because they did not trust each other's balance sheets, and the entire financial system froze.
  • The government had to inject hundreds of billions of dollars into banks to prevent a complete collapse of credit and the economy.

How bad mortgages became Wall Street securities

A mortgage broker in Ohio sold a subprime mortgage to a bank. That bank sold it to an investment bank. The investment bank bundled it with thousands of other mortgages—good ones and bad ones mixed together—and created a security called a mortgage-backed security (MBS). This security was then sliced into layers, with the safest layer sold first and the riskiest layer sold last.

Investment banks sold these securities to pension funds, insurance companies, foreign banks, and other large institutions. The buyers thought they were getting a safe investment backed by real estate. Rating agencies like Moody's and Standard & Poor's stamped these securities with AAA ratings—the same rating given to U.S. Treasury bonds. This was false. The agencies were paid by the banks creating the securities, so they had a financial incentive to rate them highly.

By 2006, subprime mortgages made up about 20 percent of all new mortgages. Wall Street had created roughly $2 trillion in mortgage-backed securities. Almost nobody understood what was actually inside them.

The moment the system realized the mortgages were worthless

In 2006, housing prices stopped rising. Borrowers who had been counting on refinancing or selling at a profit suddenly could not. When interest rates jumped on their adjustable-rate mortgages, many straightforward walked away. Foreclosures accelerated through 2007 and into 2008.

As defaults climbed, the mortgage-backed securities lost value. But nobody knew how much they had lost, because the securities were so complex and opaque that even the banks holding them could not calculate their actual worth. A pension fund in Norway might own a piece of a security that contained mortgages from five different states, bundled with mortgages from three other securities, and sliced into tranches that were themselves repackaged into new securities.

By September 2008, the market for these securities straightforward stopped. No one would buy them at any price. Banks that held large amounts of these assets suddenly could not say what they were worth. Other banks did not know whether their counterparties were solvent.

Why banks stopped lending to each other

Banks lend to each other constantly—overnight loans to cover daily cash needs, longer-term loans to fund operations. This is called the interbank lending market, and it is the plumbing of the entire financial system. When one bank does not trust another bank's balance sheet, it stops lending.

In September 2008, trust evaporated. Lehman Brothers, a major investment bank, announced it was bankrupt. AIG, an insurance company that had sold protection on mortgage-backed securities, needed a government rescue. Washington Mutual, a large bank, failed. Suddenly, no bank knew which other banks were about to collapse.

Banks stopped lending to each other. The interbank lending market froze. Without access to short-term credit, banks could not pay their employees, could not fund their operations, and could not lend to businesses and consumers. The entire financial system was on the edge of seizing up completely.

How the government stepped in

The Federal Reserve and the U.S. Treasury moved to prevent a total collapse. The Fed lent directly to banks at emergency rates. The Treasury created the Troubled Asset Relief Program (TARP), which injected $700 billion into banks to shore up their capital and restore confidence.

The government also may provide deposits above the normal $100,000 limit, so people would not rush to withdraw their money from banks. The Fed dropped interest rates to near zero and began buying mortgage-backed securities and Treasury bonds directly—a policy called quantitative easing—to inject money into the economy and lower borrowing costs.

These actions stopped the when ready panic, but the damage was already done. The economy entered a severe recession. Unemployment climbed above 10 percent. Millions of people lost their homes to foreclosure. The stock market fell nearly 60 percent from its peak.

Why the regulations that followed did not prevent future crises

Congress passed the Dodd-Frank Act in 2010, which created new rules for banks: higher capital requirements, stress tests to may support they could survive a downturn, and restrictions on proprietary trading (banks betting with their own money). The law also created the Consumer Financial Protection Bureau to oversee mortgage lending and other consumer financial products.

These rules made the banking system safer than it was in 2008, but they did not eliminate the underlying incentive that caused the crisis: the ability to originate a loan, when ready sell it to someone else, and pocket the profit without bearing any risk if the borrower defaults. That structure still exists in mortgage lending today.

Regulators also cannot predict which new financial instruments will become toxic or how interconnected the system has become. The 2008 crisis showed that when enough bad debt is hidden inside complex securities and spread across the entire financial system, the system itself becomes fragile. No set of rules has yet solved that problem.

Frequently Asked Questions

Did the banks that caused the crisis go to jail?

Very few individuals faced criminal charges. The Department of Justice prosecuted some mortgage brokers and lower-level employees, but no major bank executives were convicted of crimes related to the crisis. The government argued that proving criminal intent was difficult because the banks' actions, while reckless, were often technically legal under the rules at the time.

Did the banks that got government money pay it back?

Most of the major banks repaid their TARP loans within a few years, and the government ultimately recovered most of the $700 billion it spent. However, the government also lost money on some investments, and the broader cost to the economy—lost jobs, lost homes, lost retirement savings—was far larger than the direct cost to taxpayers.

Could the 2008 crisis happen again?

The specific chain of events that caused the 2008 crisis is less likely now because of Dodd-Frank regulations. However, financial crises are a recurring feature of market economies. The next crisis will probably involve different assets and different mechanisms, which is why regulators focus on making the system more resilient rather than trying to prevent all risk.

Why did housing prices fall if mortgages were backed by real estate?

Housing prices had risen far above what people could actually afford to pay. When borrowers stopped making payments and lenders began foreclosing, the supply of homes for sale increased sharply. With more homes on the market and fewer buyers able to get mortgages, prices fell. Real estate is only as valuable as what someone is willing to pay for it.