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Causes of the Crisis

So, from everything we have learned thus far, we can categorize the causes into 4 core issues that were determined to have most greatly contributed to collapse. It is important to note that causes 1) and 2) are highly correlated with one another, and causes 3) and 4) are highly correlated with one another. As you go through, it will become clear that many of the causes are highly dependent on one another, showing how this crisis was truly caused by a financial system riddled with problems. 

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The above graph demonstrates how risky Washington Mutual's lending practices became over time leading up to the crash. The more "subprimes" they issued, the more risk that was associated with their total asset value. 

1) High-risk lending practices by some of the largest financial institutions.  

  • Large thrift banks began to issue low quality mortgages and increasing subprime loan securitization because there were no longer any more "prime mortgages." 
    • Example: Washington Mutual was the largest thrift bank in the US and one of the biggest FI's in the US. It increased its subprime loaning from $4.5 billion in total asset value to $29 billion between 2004 and 2006, which is very concerning.
  • Also, issued more Option Adjustable Rate Mortgages, which were much more risky because the rates could be adjusted if the market rates were to drop sharply (which they did). The safer option here would be a fixed rate mortgage because if the rates are fixed, if IRs drop, the issuer cannot change the interest payments, rather they are fixed at what is in the contract.  

2) Regulatory failures by the financial overseers of the markets, such as the Office of Thrift Supervision and the Federal Deposit Insurance Corporation.   

  • OTS failed to regulate institutions such as Washington Mutual even though their risk assessment tests showed there were a massive amount of "deficiencies."  
    • Ex: In the case of Washington Mutual, the OTS learned of over 500 of these "deficiencies" and did absolutely nothing over the three years leading up to the crisis. 
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The above chart shows the different levels of credit ratings in which a financial security can be given. Check the chart and look at what a AAA rating really meant. In reality, these AAA rated "subprime" mortgages should have been rated as "junk," which is towards the bottom of the ratings scale. 

3) Greatly inflated credit ratings that were issued by the largest rating agencies. 

  • It was revealed that there were multiple conflicts of interest surrounding many of the rating agencies.  
    • focused more on market share and profits than properly rating financial securities and products. 
    • Part of the reason for this is that they would rate the products of the investment banks, but if banks received a bad rating at one agency, they would simply move on to another one for a better rating. 
    • So when banks went to a rating agency, such as Moody's, with their new mortgage securities, they were given AAA ratings even though they shouldn't have.  
    • For reference, nearly all of the "subprime" mortgages being issued were given a AAA rating. Today, with new adjustments to financial regulations (which will be discussed later), there are only two or three stocks that can achieve this high of a rating today. 
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This graph demonstrates Goldman Sachs' Net Short Position in the Real Estate Market up to the 2007 collapse. 

4) High risk, low quality financial instruments issued by some of the largest investment banks.  

  • As we already are aware by now, investment banks were creating these new mortgage financial securities that allowed for investors to essentially bet on how how well the mortgage market would do. 
  • Because in the early 2000s, it was going so well, there was high excitement and many investors were buying the new securities sold to them by the investment banks, such as mortgage-backed securities and collateralized debt obligations. 
  • Many of these investment banks, such as Goldman Sachs, understood the mortgage market was overvalued, and took a "net short" position. This essentially means that they bet against the market going up, even though they were selling these products to investors. Can you see the problem here yet? 
    • This shows how the investment banks created these instruments partly in order to profit off of the average investor consulting them for investment services. They knew the market might collapse, they just set themselves up to make money both before it did, and leveraged their profits when it did. 

If you're still having trouble understanding the core causes of the crisis, please follow the link below for a useful video!

https://www.youtube.com/watch?v=GPOv72Awo68