What caused the 2008 financial crisis?

The crisis followed a boom and bust in the housing market, which had been fed by loose credit and speculation. The downturn began as a housing problem concentrated in subprime mortgages, then spread because the financial system was deeply exposed to housing and was fragile in other ways. According to the Reserve Bank of Australia, a range of factors explains the crisis and its severity, and people are still debating how important each one was. [1] [2]

In the years before the crisis, growth was strong and stable, and inflation, unemployment and interest rates were relatively low. House prices rose strongly. Expecting them to keep rising, households, especially in the United States, borrowed imprudently, often for amounts close to or above the purchase price of a home. Property developers and households in several European countries borrowed heavily too. Much of the risky borrowing came from investors who were flipping houses and from subprime borrowers, who have higher default risk. [2]

Lenders competed to make ever larger volumes of loans, and many did not closely assess whether borrowers could repay. They had little incentive for care because they sold loans on to investors instead of expecting to bear the losses. The RBA also notes that fraud became more common, such as overstating a borrower's income. [2]

Loans were packaged into mortgage-backed securities that grew complex and opaque, yet outside agencies kept rating them as very safe. Investors, including large US banks and European banks seeking higher returns, mistakenly believed they were buying low-risk assets. Banks and investors also borrowed more to buy these products. This leverage magnifies profits but also losses, so falling house prices caused large losses. Many institutions also relied on very short-term loans, even overnight, to fund assets that could not be sold quickly. [2]

The FDIC adds that complexity masked risk, high leverage left little capital to absorb losses, and institutions had underpriced risk after a long period of economic stability. When defaults rose, the interconnectedness of the system worsened the effects. [1]

Ben Bernanke, then chair of the Federal Reserve, distinguished between triggers and vulnerabilities. The most prominent trigger was the prospect of large losses on subprime mortgages once house prices began to fall. But with a little over $1 trillion in subprime mortgages outstanding, he argued, those losses were not large enough relative to global financial markets to explain the crisis on their own. In his account, structural weaknesses in the financial system and regulation, plus gaps in the government's crisis-response tools, were the main reasons it was so severe. [3]

He described a run-like pullback in short-term funding markets. In July 2007 the German bank IKB needed rescue support because its off-balance-sheet vehicle could no longer roll over asset-backed commercial paper. Lenders then withdrew even from vehicles with no subprime exposure, and outstanding US asset-backed commercial paper fell almost $200 billion in August 2007. Bernanke concluded that the disruption to financial markets proved far more damaging than the subprime losses themselves. [3]

The RBA says regulation of subprime lending and of the institutions that created and sold mortgage-backed securities was too lax, and that central banks and governments were slow to see how far bad loans had spread. Other accounts stress different emphasis. Brookings points to an asset price bubble interacting with financial innovations that masked risk, and to companies that failed to follow their own risk standards. A Berkeley policy brief argues that financial institutions actively sought out risky mortgage loans in pursuit of profit. The search results do not settle how the factors rank against each other, and the RBA states that this relative importance is still debated. [2] [4] [5]