The economy is unavoidably cyclical. As time goes on, prices will rise and fall across every asset class, and the other components of the economy, almost mechanically, will adjust themselves accordingly. The economy’s cyclical nature is something that most banks, financial institutions, and investors actively think about. And many components of our broader financial system are designed to withstand at least a little bit of cyclical stress.
But sometimes, these regular changes become far too much for the financial system to handle. And when it becomes clear that the system has become too stressed to function, a sort of domino effect can occur, and the negative economic consequences will continue to pile up. The two most notable examples of systematic economic collapse in American history are the Great Depression (1929) and the Housing Crisis (2008).
So, what exactly happened in 2008?
The Most Severe Economic Crisis Since the Great Depression
The 2008 Financial Crisis, also known as the Housing Crisis or Global Financial Crisis, has been described by many economists as the “perfect storm” of multiple damaging economic events all occurring at once. The crisis was primarily related to (and triggered by) changes in the American mortgage industry, but the effects of this crisis were felt across every asset class in almost every country around the world.
In the years leading up to the crisis, American financial institutions, for several reasons, had begun to grossly overvalue large bundles of mortgages. Following the economic boom of the 1990s, more Americans were holding onto large mortgages that were issued to them with relatively little risk evaluation involved. Between 1990 and 2008, mortgage debt as a percentage of GDP grew from 46 to 73 percent, reaching an all-time high and indicating that the population as a whole was holding onto more debt than it could afford.
Due to neglectful risk evaluations, predatory lending, and general economic cooling, many American families began missing payments on their unaffordable mortgages, eventually reaching a state of default. Financial institutions holding onto large bundles of mortgages—some of which were considered “junk mortgages” that had low probabilities of being paid back—began looking for ways to dump their underperforming assets onto someone.
These collections of mortgages, packaged together as mortgage-backed securities (MBS), were sold on the secondary market (usually just from one investment bank to another). Due to the incredibly large size of these bundles (containing tens of thousands of mortgages), it became very easy for investment banks to misrepresent their overall risk. In short, the banks continually and knowingly ripped each other off, passing undesirable mortgage-backed securities from one to another (often through an instrument known as credit-default swaps) and allowing the misrepresentations of risk and corresponding liquidity problems to continue like a snowball.
Eventually, when it was time to pay the housing market’s “bill,” money that these financial institutions were promised simply wasn’t there. In a very short amount of time, it had become apparent that the entire mortgage market had become grossly overvalued. Banks began quickly scrambling for capital to avoid bankruptcy, but this capital became increasingly difficult to acquire. The housing bubble, which had been building for about 15 years (even outlasting the dot.com bubble), eventually “popped” and, in response, a roughly $1 trillion hole emerged in its place.
To plug this economic hole, the government began to bail out many of the most important investment banks, including Bear Stearns, Lehman Brothers, Merrill Lynch, Citigroup, etc. Freddie Mac and Fannie Mae were converted back to national agencies (costing taxpayers $187 billion). These institutions were considered “too big to fail,” though some of them eventually would, despite efforts at a bailout.
The peak of this entire crisis occurred on September 15, 2008, when Lehman Brothers—formerly one of the biggest banks in the world—declared bankruptcy. Shortly after, other American institutions, such as AIG, also went under, deepening the economic damages. In a short amount of time, Americans lost an estimated $2 trillion of household wealth. Housing prices dramatically plunged, businesses of all kinds began to close, the stock market dropped, and the unemployment rate jumped to 11 percent.
It was, undeniably, the worst economic event the nation had seen in nearly 80 years.
Significant Events Contributing to the Economic Crisis
The 2008 Financial Crisis didn’t just happen out of nowhere. It was the consequence of many different actions and general behaviors that accumulated over time. One of the most widely agreed-upon causes of the crisis was the repealing of the Glass-Steagall Act in 1999. Through the repealing of this Act, banks could mix their risk-tolerant investment practices with their risk-avoidant commercial practices, a likely risk-generating act they had been prohibited from doing since the Great Depression.
Banks were also engaging in a wide variety of practices that can only be described as predatory lending. Banks deliberately targeted low-income, uninformed, high-risk homebuyers through their commercial banking components and other channels, promising them mortgages the banks knew they couldn’t afford. These banks didn’t care because they knew they could usually sell the mortgage to another institution before a mortgage default occurred.
As mortgage bundles grew and continued to change hands, each additional round of swapping would make it easier for banks to misrepresent the risk attached to each bundle. The swapping caused banks to expect future rates of return that were dramatically different from what they’d actually receive. But the problem was that banks were already investing the money as if it had been received, pushing the “bubble” to expand rapidly.
The housing crisis ultimately exposed some of the deepest flaws in our broader economic system.
Responses to the 2008 Financial Crisis
The government’s initial response to the Financial Crisis was to bail out the financial institutions it deemed “too big to fail.” In the government’s view, if these financial institutions had collapsed, the entire economy would have likely collapsed, which would trigger a series of bank runs and liquidity crises even worse than what happened in the Depression.
To a certain extent, the bailouts worked as a temporary band-aid. However, it had also become obvious that further actions would need to be taken to reduce the likelihood of any system-wide crash from happening again.
The most piece of legislation that was passed was the Dodd-Frank Wall Street and Consumer Protection Act, described by then-newly elected President Barack Obama as a “sweeping overhaul of the United States financial regulatory system.”
The Act changed the tools available to and responsibilities of many institutions, including the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve, the Securities and Exchange Commission (SEC), and many more. It also created a new institution, the Consumer Financial Protection Bureau (CFPB), to combat predatory lending and other potentially harmful actions from financial institutions. Furthermore, the Act included measures to combat credit default swaps and change reporting practices. The Act also changed the amount of liquid assets (cash) that banks must keep in their reserves.
What Makes the Current Housing Boom Different from 2008?
Over the past two years, housing values in the United States have been significantly rising. 2021 was an especially lucrative year to be a homeowner. According to data reported by RealtyHop, the median home price appreciated by 14 percent—far more than the historical average of about 4 percent.
Since the housing market has been growing at such a tremendous rate—and perhaps because investors are still traumatized by 2008—some speculators have worried that we might be experiencing another housing bubble. After all, housing prices are currently close to the highest they’ve ever been.
However, several characteristics of the current housing market make it very different from what we saw in 2008. The primary driver of housing values in 2008 was that mortgage bundles were fundamentally mispriced. A combination of lazy practices, deceptive reporting, and the clustering of unrelated mortgages combined to create a price bubble that, once exposed to liquidity problems in the market, had no choice but to pop.
Today’s high housing prices, on the other hand, are caused by a much more fundamental and less “poppable” economic reality—supply and demand. There are far more people looking to buy houses than there are available. And whenever demand significantly exceeds supply in a market economy, prices start to rise. And though there are several reasons for why this housing shortage has occurred, such as global supply chain issues, increased cost of construction, increased property investment activity, etc., there is no denying that the current housing price boom is notably different from the ones we’ve seen in years past.