Subprime mortgage crisis
Based on Wikipedia: Subprime mortgage crisis
The House of Cards
In September 2008, Lehman Brothers—a 158-year-old financial institution that had survived the Civil War, two World Wars, and the Great Depression—filed for bankruptcy. It was the largest bankruptcy filing in American history. Within weeks, the global financial system teetered on the edge of complete collapse, and governments around the world scrambled to prevent an economic catastrophe not seen since the 1930s.
How did we get here?
The answer involves a toxic cocktail of easy money, creative financial engineering, and the universal human tendency to believe that good times will last forever. At its heart was something deceptively simple: mortgages. Loans that helped ordinary Americans buy homes had been transformed into complex financial instruments that few people truly understood—and when those instruments failed, they brought down the entire global economy.
The American Dream, Turbocharged
To understand the subprime mortgage crisis, you first need to understand what a subprime mortgage is. A "prime" borrower is someone with a good credit history—they pay their bills on time, have stable income, and present low risk to lenders. Banks love lending to these people.
A "subprime" borrower is everyone else.
For most of American history, subprime borrowers had limited access to mortgage credit. Banks considered them too risky. But in the early 2000s, this changed dramatically. Lenders began offering mortgages to people who would have been turned away just a few years earlier. The terms of these loans were often unusual—low initial payments that would suddenly jump higher after a few years, or interest rates that could adjust upward without warning.
Why would anyone take such a loan? Because house prices were going up. If your home increased in value, you could simply refinance before the higher payments kicked in, using your new equity to get better terms. It was like musical chairs where everyone assumed the music would never stop.
Financial Alchemy
Here's where it gets complicated—and where the real trouble began.
Banks that made these mortgages didn't want to hold onto them. A mortgage is just a promise that someone will pay you back over thirty years, and that's a long time to wait for your money. So Wall Street invented a way to turn these promises into something you could sell immediately.
The solution was called a mortgage-backed security, or MBS. The concept is straightforward: bundle together thousands of individual mortgages, then sell shares in that bundle to investors. The homeowners make their monthly payments, and those payments flow through to whoever bought shares in the bundle. It's like creating a mutual fund, except instead of owning pieces of companies, you own pieces of mortgages.
In theory, this was brilliant. It spread risk around—if one homeowner defaulted, it barely affected the overall bundle. It also freed up bank capital to make more loans, which meant more people could buy homes. Everyone won.
But Wall Street didn't stop there.
Investment banks created something called collateralized debt obligations, or CDOs. A CDO took the riskiest pieces of multiple mortgage-backed securities and combined them into a new product. Then they sliced that product into different levels of risk, with the safest pieces paying lower returns and the riskiest pieces paying higher returns.
Through mathematical models that turned out to be deeply flawed, the ratings agencies—firms like Moody's and Standard & Poor's—gave many of these products their highest rating: AAA. This was the same rating given to U.S. Treasury bonds, supposedly the safest investment in the world. Pension funds, insurance companies, and banks around the globe bought these securities, believing they were purchasing rock-solid investments.
They weren't.
The Shadow Banking System
Traditional banks are heavily regulated for good reason. They take deposits from ordinary people and lend that money out. If too many loans go bad, depositors could lose their savings. To prevent this, banks must hold reserves, maintain certain capital ratios, and submit to regular examinations.
But much of the activity that fueled the housing boom happened outside traditional banks, in what economists call the "shadow banking system." Investment banks, hedge funds, and special purpose vehicles operated under lighter regulation. They could take bigger risks with more borrowed money.
Think of leverage like this: if you have $10 and borrow $90, you can make a $100 investment. If that investment goes up 10%, you've made $10—doubling your original money. But if it goes down 10%, you've lost everything. Many shadow banks were operating at leverage ratios of 30-to-1 or higher, meaning a small drop in asset values could wipe them out entirely.
These institutions also relied heavily on short-term borrowing. Every day, they would borrow billions of dollars overnight to fund their positions, repaying and re-borrowing the next day. This worked fine as long as lenders were confident. But confidence can evaporate overnight—literally.
The Trigger
By 2006, house prices had stopped rising in many parts of America. They weren't crashing yet—just leveling off. But for the subprime mortgage market, that was enough.
Remember those mortgages with low initial rates that jumped higher after a few years? When borrowers tried to refinance, they discovered their homes were no longer worth more than what they owed. They couldn't get new loans to escape the old ones. Default rates began climbing.
At first, this seemed like a manageable problem. In February 2007, the Federal Reserve chairman said he expected the subprime market issues to be "contained." They weren't.
In July 2007, two hedge funds run by Bear Stearns—one of Wall Street's oldest and most prestigious investment banks—collapsed. These funds had invested heavily in subprime mortgage securities, using enormous amounts of borrowed money. When the value of their holdings dropped, lenders demanded more collateral. The funds had to sell securities to raise cash, but their selling pushed prices down further, triggering more demands for collateral. It was a death spiral.
Economist Mark Zandi later called this event "arguably the proximate catalyst" for the broader financial crisis. The hedge fund collapse revealed that securities once thought to be safe were actually quite risky—and nobody knew exactly who was holding how much of this toxic debt.
Trust Evaporates
Financial systems run on trust. Banks lend to each other every day, confident they'll be repaid tomorrow. Investors buy securities, trusting that the ratings agencies have done their homework. This trust allows money to flow smoothly through the economy, funding everything from home purchases to business expansion.
In the second half of 2007, trust began to collapse.
Banks became afraid to lend to each other. What if the bank across the table was holding billions in worthless mortgage securities? What if they went bankrupt tomorrow and couldn't repay? Better to hold onto your cash and wait.
This freeze in lending spread throughout the financial system. Businesses that relied on short-term borrowing to finance their operations suddenly couldn't get credit. The commercial paper market—a crucial mechanism for corporate short-term financing—seized up. Companies that had nothing to do with housing found themselves unable to borrow.
The Fall of 2008
The crisis reached its climax in September 2008.
First, the government took over Fannie Mae and Freddie Mac, two enormous government-sponsored enterprises that guaranteed trillions of dollars in mortgages. Then Lehman Brothers, unable to find a buyer or secure government support, filed for bankruptcy. The next day, the Federal Reserve lent $85 billion to AIG, the world's largest insurance company, to prevent its collapse—AIG had sold vast amounts of credit default swaps, essentially insurance policies on mortgage-backed securities, and couldn't pay its claims.
The stock market plunged. Between January 1 and October 11, 2008, American stock holdings lost roughly $8 trillion in value—falling from $20 trillion to $12 trillion. Markets around the world suffered similar collapses.
Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke went to Congress with a stark warning: without immediate action, the financial system would collapse, taking the broader economy with it. Congress passed the Troubled Asset Relief Program, or TARP, authorizing $700 billion to stabilize the financial system.
The Human Cost
The statistics are staggering, but they represent real human suffering.
Nearly nine million Americans lost their jobs during 2008 and 2009—roughly six percent of the entire workforce. The unemployment rate wouldn't return to pre-crisis levels until May 2014, more than six years after the recession began.
Housing prices fell approximately thirty percent on average. For millions of Americans, their home—often their largest asset—was suddenly worth less than what they owed on it. They were "underwater," trapped in properties they couldn't sell without writing a large check to their bank.
American household wealth declined by nearly $13 trillion, a twenty percent drop. Retirement accounts were decimated. College savings evaporated. The American dream of each generation doing better than the last suddenly seemed like a cruel joke.
Europe suffered its own parallel crisis, with unemployment soaring and banking systems requiring hundreds of billions in support. The effects rippled through developing economies as trade contracted and investment dried up.
Who Was to Blame?
Assigning blame for the crisis became a cottage industry. There were plenty of culprits to choose from.
Wall Street firms created and sold securities they didn't fully understand, using mathematical models that assumed housing prices would keep rising. They earned enormous fees packaging and selling these products, with little concern for what would happen when the music stopped.
Rating agencies gave their blessing to securities that turned out to be toxic. They were paid by the same firms whose products they were rating—an obvious conflict of interest that compromised their independence.
Mortgage lenders made loans to borrowers who couldn't afford them, sometimes using predatory practices that obscured the true costs. They earned their fees when the loan closed and passed the risk on to investors.
Regulators failed to recognize the systemic risks building in the system. They didn't adequately supervise the shadow banking sector or require financial institutions to hold sufficient capital.
And yes, some borrowers took on mortgages they couldn't realistically afford, speculating that rising prices would bail them out.
The truth is that the crisis emerged from a system-wide failure. Each actor behaved rationally according to the incentives they faced, but the collective result was catastrophic. As Warren Buffett and former Federal Reserve Chairman Paul Volcker later observed, the entire system was built on flawed assumptions: that housing prices would never fall dramatically, that sophisticated financial engineering had tamed risk, and that free markets would naturally regulate themselves.
The Aftermath
In the years following the crisis, significant reforms were enacted. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 created new regulatory agencies, imposed stricter capital requirements on banks, and attempted to bring the shadow banking system under greater oversight. The Consumer Financial Protection Bureau was established to protect borrowers from predatory lending.
Perhaps surprisingly, the government bailouts ultimately made money. By January 2021, the Treasury had recovered all the funds it invested, plus an additional $109 billion in profit from interest on bailout loans. The financial system had been stabilized, and the direct cost to taxpayers turned out to be negative.
But the broader costs were immense and enduring. A generation of workers lost years of career advancement during the recession. Homeowners who lost their houses through foreclosure saw their credit destroyed. Trust in financial institutions plummeted. The political consequences—including rising populism and anger at economic elites—continue to shape American politics today.
The Lesson
The subprime mortgage crisis offers a sobering lesson about the fragility of complex financial systems. Innovation in finance can create genuine benefits—mortgage-backed securities did make homeownership more accessible for millions of Americans. But financial innovation can also create hidden risks that compound until they threaten the entire system.
The crisis also revealed the profound interconnection of the modern economy. A homeowner in Nevada missing a mortgage payment might seem like a small event. But multiply that by millions, package those mortgages into complex securities, distribute those securities around the world, leverage those holdings thirty-to-one, and suddenly a housing downturn becomes a global catastrophe.
Most fundamentally, the crisis was a reminder that market prices don't always reflect reality. For years, housing prices climbed higher and higher, and millions of people made decisions based on the assumption that this would continue forever. When the assumption proved false, the consequences were devastating.
The question isn't whether financial crises will happen again—they will. The question is whether we'll remember the lessons of 2008 when the next bubble inflates, or whether, as so often happens, we'll convince ourselves that this time is different.