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  • Jacob: Welcome to Crash Course Economics. My name is Jacob Clifford.

  • Adrienne: And I'm Adrienne Hill. And today we're going to do something a little different.

  • We're going to explore one moment in history in depth. We're going to talk about how the

  • 2008 Financial Crisis happened and the government response to it in the United States.

  • Jacob: So let's get started.

  • [Theme Music]

  • Jacob: The 2008 Financial Crisis was a big deal. Ben Bernanke said it could have resulted

  • in a 1930s style global financial and economic meltdown with catastrophic implications. But

  • what happened? Why did it happen? And why aren't we all huddled around burning trash

  • cans forming a raiding party to go steal gas from other tribes in the wasteland?

  • By the way, if you're actually doing that, you probably didn't hear we survived the financial

  • crisis. Things got better. Seriously. Put down your crossbows.

  • Adrienne: To explain what happened, first we have to do a quick explainer about mortgages.

  • And you might already know this, but basically someone that wants to buy a house will often

  • borrow hundreds of thousands of dollars from a bank. In return, the bank gets a piece of

  • paper, called a mortgage.

  • Every month, the homeowner has to pay back a portion of the principal, plus interest,

  • to whomever holds the piece of paper. If they stop paying, that's called a default. And

  • whomever holds that piece of paper gets the house.

  • The reason I'm saying whomever holds the paper, rather than the bank, is because the bank,

  • the original lender, often sells that mortgage to some third party. And the reason I say

  • often is because this happens all the time. I've had my house for nine months, and three

  • different banks have had the mortgage.

  • Traditionally, it was pretty hard to get a mortgage if you had bad credit or didn't have

  • a steady job. Lenders just didn't want to take the risk that you might "default" on

  • your loan, but all that started to change in the 2000s.

  • And before we go further, a quick aside here. The story gets complicated fast, and it's

  • a fascinating story. But we're trying to keep it relatively simple. So, I've asked Stan if

  • we could put some additional resources in the YouTube description. And Stan said "Yes." Thanks Stan!

  • Anyway, back to our story. In the 2000s, investors in the U.S. and abroad looking for a low risk,

  • high return investment started throwing their money at the U.S. housing market. The thinking

  • was they could get a better return from the interest rates home owners paid on mortgages,

  • than they could by investing in things like Treasury Bonds, which were paying very, very low interest.

  • But big money, global investors didn't want to just buy up my mortgage, and Stan's mortgage.

  • It's too much hassle to deal with us as individuals. I mean, we're pains. Instead, they bought

  • investments called mortgage backed-securities. Mortgage backed-securities are created when

  • large financial institutions securitize mortgages. Basically, they buy up thousands of individual

  • mortgages, bundle them together, and sell shares of that pool to investors.

  • Investors gobbled these mortgage backed-securities up. Again, they paid a higher rate of return

  • than investors could get in other places and they looked like really safe bets. For one,

  • home prices were going up and up. So lenders thought, worse case scenario, the borrower

  • defaults on the mortgage, we can just sell the house for more money.

  • At the same time, credit ratings agencies were telling investors these mortgage backed-securities

  • were safe investments. They gave a lot of these mortgage backed-securities AAA Ratings--the

  • best of the best. And back when mortgages were only for borrowers with good credit,

  • mortgage debt was a good investment.

  • Anyway, investors were desperate to buy more and more and more of these securities. So,

  • lenders did their best to help create more of them. But to create more of them, they

  • needed more mortgages. So lenders loosened their standards and made loans to people with

  • low income and poor credit. You'll hear these called sub-prime mortgages.

  • Eventually, some institutions even started using what are called predatory lending practices

  • to generate mortgages. They made loans without verifying income and offered absurd, adjustable

  • rate mortgages with payments people could afford at first, but quickly ballooned beyond their means.

  • But these new sub-prime lending practices were brand new. That meant credit agencies

  • could still point to historical data that indicated mortgage debt was a safe bet. But

  • it wasn't. These investments were becoming less and less safe all the time. But investors

  • trusted the ratings, and kept pouring in their money.

  • Traders also started selling an even riskier product, called collateralized debt obligations,

  • or CDOs. And again, some of these investments were given the highest credit ratings from

  • the ratings agencies, even though many of them were made up of these incredibly risky loans.

  • While, the investors and traders and bankers were throwing money into the U.S. housing

  • market, the U.S. price of homes was going up and up and up. The new lax lending requirements

  • and low interest rates drove housing prices higher, which only made the mortgage backed

  • securities and CDOs seem like an even better investment. If the borrowers defaulted, the

  • bank would still have this super valuable house, right? No. Wrong. Let's go to the Thought Bubble.

  • Actually, let's go to the Housing Bubble. You remember bubbles, right? Rapid price increases,

  • driven by irrational decisions. Well, this was a bubble, and bubbles have an annoying

  • tendency to burst. And this one did. People just couldn't pay for their incredibly expensive

  • houses, or keep up with their ballooning mortgage payments.

  • Borrowers started defaulting, which put more houses back on the market for sale. But there

  • weren't buyers. So supply was up, demand was down, and home prices started collapsing.

  • As prices fell, some borrowers suddenly had a mortgage for way more than their home was

  • currently worth. Some stopped paying. That led to more defaults, pushing prices down further.

  • As this was happening, the big financial institutions stopped buying sub-prime mortgages and sub-prime

  • lenders were getting stuck with bad loans. By 2007, some really big lenders had declared

  • bankruptcy. The problems spread to the big investors, who'd poured money into these mortgage

  • backed securities and CDOs. And they started losing money on their investments. A bunch

  • of money. But wait. There's more.

  • There was another financial instrument that financial institutions had on their books

  • that exacerbated all of these problems--unregulated, over-the-counter derivatives, including something

  • called credit default swaps, that were basically sold as insurance against mortgage backed securities.

  • Does AIG ring a bell? It sold tens of millions of dollars of these insurance policies, without

  • money to back them up when things went wrong. And as we mentioned, things went terribly

  • wrong. These credit default swaps were also turned into other securities -- that essentially allowed

  • traders to bet huge amounts of money on whether the values of mortgage securities would go up or down.

  • All these bets, these financial instruments, resulted in an incredibly complicated web

  • of assets, liabilities, and risks. So that when things went bad, they went bad for the

  • entire financial system. Thanks Thought Bubble.

  • Some major financial players declared bankruptcy, like Lehman Brothers. Others were forced into

  • mergers, or needed to be bailed out by the government. No one knew exactly how bad the

  • balance sheets at some of these financial institutions really were--these complicated,

  • unregulated assets made it hard to tell.

  • Panic set in. Trading and the credit markets froze. The stock market crashed. And the U.S.

  • economy suddenly found itself in a disastrous recession.

  • Jacob: So what did the government do? Well, it did a lot. The Federal Reserve stepped

  • in and offered to make emergency loans to banks. The idea was to prevent fundamentally

  • sound banks from collapsing just because their lenders were panicking. The government enacted

  • a program called TARP, the troubled assets relief program, and which the rest of us call

  • the bank bailout. This initially earmarked $700 billion to shore up the banks. It actually

  • ended up spending $250 billion bailing out the banks, and was later expanded to help

  • auto makers, AIG, and homeowners.

  • In combination with lending by The Fed, this helped stop the cascade of panic in the financial

  • system. The treasury also conducted stress tests on the largest Wall Street banks. Government

  • accountants swarmed over bank balance sheets and publicly announced which ones were sound

  • and which ones needed to raise more money. This eliminated some of the uncertainties

  • that had paralyzed lending among institutions.

  • Congress also passed a huge stimulus package in January 2009. This pumped over $800 billion

  • into the economy, through new spending and tax cuts. This helped slow the free fall of

  • spending, output and employment.

  • Adrienne: In 2010, Congress passed a financial reform, called the Dodd-Frank law. It took

  • steps to increase transparency and prevent banks from taking on so much risk. Dodd-Frank

  • did a lot of things. It set up a consumer protection bureau to reduce predatory lending.

  • It required that financial derivatives be traded in exchanges that all market participants

  • can observe. And it put mechanisms in place for large banks to fail in a controlled predictable manor.

  • But, there's no consensus on whether this regulation is enough to prevent future crises.

  • Jacob: So, what have we learned from all this? Well, one key factor that led to the 2008

  • financial crisis was perverse incentives. A perverse incentive is when a policy ends

  • up having a negative effect, opposite of what was intended. Like, mortgages brokers got bonuses

  • for lending out more money, but that encouraged them to make risky loans, which hurt profits in the end.

  • That leads us to moral hazard. This is when one person takes on more risk, because someone

  • else bears the burden of that risk. Banks and lenders were willing to lend to sub-prime borrowers because

  • they planned to sell mortgages to somebody else. Everyone thought they could pass the risk up the line.

  • The phrase "too big to fail" is a perfect example of moral hazard. If banks know that they're

  • going to be bailed out by the government, they have incentive to make risky, or perhaps unwise bets.

  • Former Fed Chairman, Alan Greenspan summed it up really nicely when he said,

  • "If they're too big to fail, they're too big."

  • Adrienne: When something terrible happens, people naturally look for someone to blame.

  • In the case of the 2008 financial crisis, no one had to look very far because the blame

  • and the pain was spread throughout the U.S. economy.

  • The government failed to regulate and supervise the financial system. To quote the bi-partisan,

  • financial crisis inquiry commission report, "the sentries were not at their posts, in

  • no small part due to the widely accepted faith in the self-correcting nature of the markets,

  • and the ability of financial institutions to effectively police themselves."

  • The report placed some of the blame on the years of deregulation in the financial industry.

  • And blamed regulators themselves for not doing more. The financial industry failed. Everyone

  • in the system was borrowing too much money and taking too much risk, from the big financial

  • institutions to individual borrowers. The institutions were taking on huge debt loads

  • to invest in risky assets. And huge numbers of home owners were taking on mortgages they couldn't afford.

  • But the thing to remember about this massive systemic failure, is that it happened in a

  • system made up of humans, with human failing. Some didn't understand what was happening.

  • Some willfully ignored the problems. And some were simply unethical, motivated by the massive

  • amounts of money involved.

  • I think we should give the last word today to the financial crisis inquiry commission

  • report. To paraphrase Shakespeare, they wrote, "The fault lies not in the stars, but in us."

  • Thanks for watching.

  • Crash Course Economics is made with the help of all of these nice people. We're able to

  • stave off our own financial crisis each month, thanks to your support at Patreon. You can

  • help keep Crash Course free for everyone, forever, and get great rewards at patreon.com.

  • And given today's subject, be exuberant, but keep it rational.

Jacob: Welcome to Crash Course Economics. My name is Jacob Clifford.

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