The financial crisis of 2007 to 2009 was primarily driven by risky home lending practices and a subsequent crash in the real estate market. A significant factor was the prevalence of bad loans, which defaulted when the market collapsed. This crisis was exacerbated by the actions of two types of banks: traditional commercial banks, which are insured by the FDIC, and investment banks, which trade financial assets but lack such insurance.

In a typical scenario, a traditional home loan involves a bank lending money to a homebuyer, who then repays the loan with interest over time. However, during the early 2000s, banks began to engage in the securitization of these home loans, creating a secondary market for them. This process involved bundling various mortgages into a financial product known as a mortgage-backed security (MBS). An MBS consists of a collection of mortgages, which can vary in risk. For instance, some mortgages might have lower interest rates due to the borrower's good credit, while others might carry much higher rates due to the borrower's riskier profile.

As the real estate market boomed, banks loosened their lending standards, leading to the rise of subprime mortgage loans—high-interest loans offered to borrowers with poor credit histories. These loans often required little to no down payment, enticing many risky homebuyers to take on large mortgages. Initially, the MBS market thrived as homeowners made their payments, generating cash flow for investors. However, as the housing market began to decline, many of these risky loans started to default. Homeowners found themselves owing more on their mortgages than their homes were worth, leading to widespread defaults.

The fallout from these defaults severely impacted investment banks, which had heavily invested in MBS. As defaults increased, the income from these securities plummeted, resulting in significant financial losses for the banks. Many of these institutions became insolvent, prompting a government intervention known as the Troubled Asset Relief Program (TARP). This program involved the government purchasing the toxic assets held by these banks, totaling over $700 billion, to prevent a complete collapse of the financial system.

The rationale behind the bailout was the belief that the failure of these large banks would trigger a domino effect, potentially leading to another Great Depression. This situation raised concerns about moral hazard, as banks might feel encouraged to take on excessive risks, believing they would be bailed out in the future without facing the consequences of their actions. The crisis highlighted the need for better regulation in the financial sector to prevent similar occurrences in the future.

Struggling with Macroeconomics?