How it Happened - The 2008 Financial Crisis: Crash Course Economics #12

CrashCourse

21 Oct 201511:24

EducationalLearning

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TLDRThe 2008 financial crisis was triggered by the bursting of the U.S. housing bubble, fueled by risky subprime mortgages and complex financial instruments. As home prices fell and borrowers defaulted, major financial institutions collapsed or needed bailouts. The government responded with stimulus spending, bank bailouts, and later, financial reform. The crisis revealed lack of regulation and oversight, as well as perverse incentives and moral hazard in the financial system. No one party was solely to blame - many contributed to the systemic failure through ignorance, willful disregard, or unethical behavior motivated by profits.

Takeaways

😲 The 2008 financial crisis started with the bursting of the US housing bubble and nearly caused an economic depression globally.
👨‍👩‍👧‍👦 It was caused by loose lending standards, predatory lending practices, overly complex and risky financial products, and lack of regulation and oversight.
💸 Banks and investors poured money into the booming housing market via mortgage-backed securities, CDOs, and derivatives.
📉 When the housing bubble burst, borrowers defaulted, home prices fell, and financial institutions started losing money, causing panic.
💥 Major banks and lenders filed for bankruptcy or needed government bailouts, stock markets crashed, lending froze up, leading to a recession.
�$$ The US government responded with bank bailouts, stimulus spending, emergency Federal Reserve loans, and stress tests for banks.
🤝 Moral hazard and perverse incentives encouraged excessive risk-taking that was passed on through the complex financial system.
😡 The crisis revealed failures in government regulation and oversight as well as reckless behavior and lack of ethics in finance.
✅ Post-crisis reforms like Dodd-Frank aimed to increase regulation, transparency, and stability in banking and lending.
🙏 But more change may still be needed to prevent future crises, as roots of the problem lie in human nature itself.

Q & A

What were some key factors that led to the 2008 financial crisis?
-Key factors included perverse incentives like mortgage brokers getting bonuses for risky loans, moral hazard where banks took risks knowing they'd get bailed out, lack of regulation and oversight, banks and lenders taking on too much debt and risk, and individual borrowers taking out mortgages they couldn't afford.
How did the housing bubble bursting contribute to the crisis?
-As housing prices fell, borrowers defaulted on their mortgages, putting more houses on the market and further reducing prices. This led to more defaults as people owed more than their homes were worth, creating a downward spiral.
What role did mortgage-backed securities and derivatives play?
-They exponentially increased risk in the system. Mortgage-backed securities bundled risky loans that still got high ratings. Complex derivatives like credit default swaps provided insurance without adequate backing.
Why were regulators unable to prevent the crisis?
-Regulators failed to properly oversee the financial system. There was widespread belief markets could self-correct and banks could self-police. Years of deregulation also reduced oversight.
What was the government's initial response?
-The Fed provided emergency loans to banks to prevent their collapse. The $700 billion TARP program bailed out banks and was later expanded to other institutions. Stress tests and transparency helped stabilize banks.
How did the Dodd-Frank legislation aim to prevent future crises?
-It increased transparency, reduced risky practices, created consumer protections, required trading of derivatives on open exchanges, and established processes for large banks to fail safely.
What is meant by 'perverse incentives'?
-When a policy has unintended negative consequences, opposite of the desired effect. Like mortgage brokers getting bonuses for risky loans that ultimately hurt profits.
What is moral hazard?
-When one party takes more risks because someone else bears the burden of those risks. Banks took risks knowing they'd likely be bailed out.
What was the role of 'too big to fail' banks?
-It led to moral hazard. Big banks knew they'd likely be bailed out if they failed, giving them incentive to take unwise risks.
Who does the report blame for the crisis?
-The report blames the lack of regulation, oversight and unethical practices in the financial system itself, not external factors beyond human control.

Outlines

00:00

😊 Introducing the 2008 Financial Crisis

Jacob and Adrienne introduce themselves and state that they will explore the 2008 Financial Crisis in depth. They note the crisis could have caused an economic meltdown globally but things improved after governments intervened. They aim to explain what happened in a simple way.

05:03

🏠 Understanding the Role of Mortgages

Adrienne explains that people borrowing money from banks to buy houses are given mortgages. The borrowers must pay back the loan amount plus interest every month to whoever holds the mortgage. If they stop paying, it's a default. Banks often sell mortgages to third parties who bundle and sell them to investors.

10:08

💸 Loosening Lending Standards

Jacob explains lending standards were loosened in the 2000s to create more mortgages to bundle and sell as securities. Subprime mortgages with risky terms were given to those with poor credit. Loan terms eventually became predatory. But ratings agencies still labeled the securities as safe.

📉 The Housing Bubble Bursts

Adrienne explains a housing bubble formed as prices rapidly increased. People eventually couldn't pay their mortgages. Defaults rose, housing supply increased, and prices collapsed. Financial institutions declared bankruptcy as subprime mortgages lost money. The crisis spread through complex financial instruments like derivatives.

🏦 Government Intervention and Reforms

Jacob outlines the government responses. The Fed offered loans to fundamentally sound banks. TARP bailed out banks and other institutions to approximately $250 billion. Stress tests and stimulus packages also helped. Reform laws aimed to increase transparency and prevent excessive risk taking by banks.

😞 Spreading Blame for the Crisis

Adrienne notes blame lies throughout the system. The bi-partisan crisis report blamed inadequate regulation and supervision, years of industry deregulation, and regulators not doing enough. The financial industry was overleveraged and took excessive risks. The faults lie in human failings to understand, willful ignorance, and unethical behavior.

Mindmap

Keywords

💡mortgage

A mortgage is a loan used to purchase a home, where the home serves as collateral for the loan. Mortgages are a key part of the 2008 financial crisis, as lenders provided mortgages to high-risk borrowers and then bundled and sold these mortgages as securities. This led to a housing bubble and then crisis when people defaulted on subprime mortgages.

💡subprime mortgage

Subprime mortgages refer to mortgages given to borrowers with poor credit history or other higher risk factors. As demand grew for mortgage-backed securities, lenders loosened lending standards and offered more subprime mortgages, contributing to the crisis.

💡housing bubble

A housing bubble refers to rapidly rising housing prices driven by speculative demand rather than real economic factors. The easy credit and subprime mortgages lead to a housing bubble in the 2000s, which eventually burst and led to falling prices and foreclosures.

💡bailout

A bailout refers to government intervention to rescue a failing key institution or industry, as was done for banks and auto companies during the financial crisis through programs like TARP.

💡securitization

Securitization refers to the process of taking individual assets like mortgages and bundling them into tradable securities, as was done with mortgage-backed securities that were then sold to investors.

💡credit default swap

A credit default swap is a form of insurance against default on a security, which AIG sold in large quantities against mortgage-backed securities, contributing to its failure in the crisis.

💡collateralized debt obligation (CDO)

CDOs are complex securities created by bundling riskier assets like subprime mortgages and slicing them into tranches to sell to investors, contributing to market instability.

💡moral hazard

Moral hazard refers to more risky behavior due to someone else bearing the risk, for example lenders lowering standards as they planned to sell off mortgages.

💡perverse incentive

A perverse incentive is one that has unintended negative consequences, like mortgage brokers being rewarded for making more loans leading to riskier loans.

💡financial regulation

Financial regulation refers to government policies to regulate banking and markets to prevent instability and crises. Lack of regulation was seen as a factor in the 2008 crisis, leading to reforms.

Highlights

The 2008 Financial Crisis was a big deal. Ben Bernanke said it could have resulted in a 1930s style global financial and economic meltdown.

Mortgage backed-securities are created when large financial institutions securitize mortgages by bundling thousands of them together and selling shares to investors.

Credit ratings agencies were telling investors these mortgage backed-securities were safe, giving many AAA ratings - the best of the best.

Lenders loosened standards and made loans to people with low income and poor credit, called sub-prime mortgages.

Eventually some lenders even used predatory lending practices to generate mortgages, making loans without verifying income.

Housing prices were rapidly increasing, driven by irrational decisions - marking a bubble that eventually burst.

As housing prices fell, borrowers had mortgages for more than their homes were worth, causing more defaults and pushing prices down further.

Major financial institutions declared bankruptcy or needed government bailouts. Trading and credit markets froze. The stock market crashed.

The government provided emergency loans to banks, enacted the $700 billion bank bailout program, and passed an $800 billion economic stimulus package.

In 2010 Congress passed the Dodd-Frank financial reform law aiming to increase transparency and prevent banks from taking excessive risks.

A key factor was perverse incentives, where policies had unintended negative effects. Mortgage brokers got bonuses for risky loans that later hurt profits.

"Too big to fail" exemplifies moral hazard - when entities take more risks because someone else bears the burden.

Blame lies with inadequate government regulation and supervision of the financial system.

Blame also lies with the financial industry itself - institutions borrowing too much and taking too much risk.

The faults lie not in happenstance, but in human failing - some didn't understand, some ignored problems, and some were motivated by greed.

Transcripts

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