The Great Recession: How it Happened and Why it Matters

We’ve all heard of the 2008 financial crisis, the so-called “Great Recession” that rocked the US. It was the largest financial collapse since the Great Depression, wiping out almost $9 Trillion in US wealth in just over 2 years. Retirement accounts vaporized overnight, millions of people evicted, and millions of houses foreclosed by the very same banks that sold them the American Dream. Unemployment spiked to its highest since the 1980s, with the rate peaking at over 10% in 2010. We all know what it caused, but do we know how it happened? I’d say confidently that most people reading this right now don’t know what a CDO or a subprime mortgage is. That in itself is a problem. 

Let’s start with mortgages. A mortgage is a loan that a person takes out to purchase a house. Usually, people don’t have enough money in cash to buy a house, so they take out a loan from the bank. The bank offers them the loan on the condition that they will pay it back in full by a certain date, plus interest. Usual mortgages have maturity dates (due date) of 30 years. A lot of things go into whether you qualify to receive a loan from a bank as they don’t want to loan someone money who has a track record of not paying the money back. This is where credit scores come in. A credit score, sometimes also called a FICO score, is basically a score based on your track record/ability of paying back loans. It can range from paying back your credit card, to paying off your car loan etc. Using the same reasoning, when loaning to a person with a lower credit score, you have a higher chance of not getting the money back, causing the risk. Banks devised a way to lessen the possible risk, making people with lower credit scores have to pay higher interests on their mortgages and agree to less favorable terms to receive their loan to compensate for the higher risk they present to the banks. Any credit score under what the bank considers “prime” or a good credit score, is referred to as “subprime” or a bad score. Therefore, subprime mortgages are mortgages that are riskier.

Moving on to a bit more complex idea, bonds. You can think of bonds as a reverse loan. Instead of you borrowing money, you’re loaning to someone else. The most common form of bonds are government bonds, because unless you’re counting on the government collapsing, you’ll get your money back plus interest. A mortgage bond is basically you becoming the bank. You take on the debt that the bank had for giving a pool of people money to buy their houses, but in return, you will earn the interest that the people pay if they keep paying. The collateral in a mortgage bond are the houses; even if the mortgages go belly up and the people can no longer pay, you can evict them and foreclose on the property, and then sell the property to try and recoup your losses. Most people don’t own mortgage bonds as the majority of ownership is investment groups or hedge funds. 401ks, other retirement savings and savings accounts, are invested in a wide variety of hedge funds and investment groups to try and make you more money in the long run. When most people say they have X amount saved in their 401k, it’s not in the form of cash; rather it’s the worth of the assets/stakes that they have, whether that be stock in a company, or stake in a hedge fund. So technically they don’t have X amount. They have assets that CAN be worth X amount.

Mortgage bonds are divided up into groups, commonly referred to as tranches. These tranches go as followed: AAA, AA, A, BBB, BB, B. The rating is to signify how likely a loanee is to pay back the loan, plus interest. As you go further down in rating, all the way down to B, it becomes more risky. Obviously, everybody wants to buy the AAA mortgages as they are the safe bet,  however, with more risk comes more reward. Banks will sell you the B rated mortgages at a much cheaper rate then they will the AAA mortgages. This means you can earn a lot more money if the B mortgage bond succeeds, but if it doesn’t, and that’s a fairly high chance, you stand to lose the money, and often with poorer quality collateral (the houses) than for a AAA rated bond. However, the banks are not allowed to rate their own mortgage bonds. There are 3 major rating agencies who rate these mortgage bonds; Moody's Investors Service, Standard & Poor's, and Fitch Ratings. These are the so-called “watchmen” of the mortgage bonds. All three being private companies, they make sure that the bonds are rated accurately so investors know what they’re buying. 

The problem arises when the banks need to increase their revenue each year. How do you earn more from mortgages? Simple, you give out more mortgages. The problem is there’s not a massive increase in people who can afford houses each year, so what does the bank do? They give out riskier and riskier loans each year. All of a sudden, millions of people are suddenly qualified for a loan they weren’t qualified for before. This causes there to be a so-called “housing boom” in the mid-2000s were millions of people become qualified for a mortgage. This is encouraged through government actions such as the Community Reinvestment Act, which forced banks to decrease their restrictions on loans, especially when it came to minorities. During the Clinton, and Bush administration, the Dept of Housing and Urban Development pushed banks to increase their numbers of “affordable housing loanees”, who were basically just people who couldn’t afford a house.  Soon, everyone was buying a house; everything that had a pulse was qualified for a loan. This led to more BBB, BB, and B rated mortgage bonds becoming available. People didn’t want to buy these more riskier bonds, so the banks took the leftover bonds they couldn’t sell and put them into a CDO, a Collateralized Debt Obligation.

A CDO is basically all the crap that a bank couldn’t sell, bundled all together and renamed. It’s no longer a bundle of B rated subprime mortgage bonds, it’s now a “CDO”. In 2006 and 2007 alone, banks sold more than $400 billion worth of CDOs. When the banks were forced to make more people qualified for loans, they started offering an adjustable rate mortgage, where the first 5 years of the mortgage interest payments would be much lower than the next 25 years. This led to millions of people who could only afford the lower rate buying houses. People would take out mortgages on homes, pay the low-rate adjustable mortgage and then sell the house before the 5 years were up and the higher rates kicked in. Many started buying houses just to sell them and were making a profit on the backs of these adjustable rate mortgages. The can of adjustable rate mortgages was kicked down the road, leading to a massive inflation of house prices, and the housing bubble along with it. 

This was all pretty much contained within the housing market, until something happened. The rating agencies, who are in charge of rating the mortgage bonds accurately, are all private companies. Companies survive by earning money, and the only customers they had were the big banks. Now, when a big bank doesn’t like the way a rating agency is rating their mortgage bonds or CDOs, what’s to stop them from going to their competitors? Nothing. This caused the rating agencies to falsely rate mortgages that were as low as Bs, all the way up to a AAA bond. So, people who bought a CDO that is said to contain up to 95% AAA rated mortgages were actually buying 95% B rated mortgages that were likely to fail. At this point, the mortgage bond and CDO industry was worth trillions of dollars, and yet, it was all built on a lie. Banks knew that at some point it was all going to blow up, they just needed to time it correctly, so when it all hits the fan, they’re not left holding the bag.

In the spring and summer of 2007, a lot of the adjustable rates started to kick in. Suddenly, people were left not being able to pay their mortgage and lost their homes. This started a slow spiral where millions of people were left homeless after their higher rates kicked in. As these people started to default on the loans, the bonds and CDOs started to go bust. People who thought they had a safe, AAA rated CDO, were left with nothing, as they were really subprime mortgages the whole time. To recoup their losses, the owners of the failed bonds tried to sell the houses, but nobody wanted to buy, the demand rapidly decreasing as less people were able to afford houses at the increasingly inflated prices. This caused the bond owners to be left with houses they couldn’t sell. It was at this moment that the housing bubble popped, and because of the sheer scale of mortgage bonds and CDOs, it popped the American economy.

Suddenly, millions of people saw their retirement savings evaporate as the investment groups they were invested in went belly up under the debt from the failed bonds. People saw their children’s college fund dry up as trillions of dollars’ worth of bonds and CDOs were vaporized. The stock market began to crash, and companies who were seemingly unconnected to the housing market saw their stock value crash as hundreds of millions of people were trying to liquidate (sell) all their assets as fast as possible. 

The banks were left with billions of dollars’ worth of debt as the mortgage bonds that they hadn’t managed to sell yet went belly up. Ironically enough, many banks began to declare bankruptcy. Even though a lot of the mortgages defaulted, the majority of Americans still had their mortgages intact and tied to banks, along with business and car loans, so if the banks failed, there would be an innumerable amount of losses, so instead, the government bailed the banks out. The government purchased $700 billion of these failed mortgage bonds from these banks. The taxpayers who got scammed out of their homes and their savings by banks, then paid to bailout the scammers. 

This all matters to us today since all these things are still happening. Mortgage bonds and CDOs are still being sold. People who are unqualified for loans still get loans. This is all happening again and unless we do something about it as a country, which we won’t, a repeat is bound to happen at some point. So, I guess take this as more personal advice. Don’t trust so easily, don’t let people pull the wool over your eyes, do your own research and be proactive in carving out a safe life for you and your family.