Alright. So now let's spend some time talking about the financial crisis that occurred between 2007 and 2009. Some professors like to spend a lot of time on this, especially since it's current events. They love to talk about the recent financial crises and apply what we've learned in macroeconomics to it. I want to add this video to give you a lot more depth into why things occurred in this crisis. But just so you know, not all professors are going to dive into this that much. So let's go ahead and go through this information and see what caused the financial crisis and what were some of the responses.
The financial crisis of 2007 to 2009 was generally caused by risky home lending and a crash of the real estate market. There were a lot of bad loans out there. And then when the market crashed, those loans all defaulted. They stopped making their payments and a lot of problems ensued from that. But it wasn't just regular home loans. Let's go ahead and see how this special situation arose. There are two types of banks. There's your traditional commercial bank, which is a depository bank that accepts deposits, and they're FDIC insured. That means deposits up to approximately $250,000 are insured. So if you have money in the bank, what they're trying to avoid is you going to the bank and saying, "Hey, give me my money." And there'd be some sort of bank panic where everyone is trying to withdraw their money. They don't have enough in reserves and the bank fails, right? They become insolvent. They don't have the money to pay everyone out. So what they say is: "Don't worry. The government will pay you your money if the bank doesn't have the money. So don't rush to the bank to get the deposit. You'll get that money no matter what." And the second type of bank is an investment bank, and they trade financial assets such as stocks and bonds, and they're not insured. They play a huge role in this financial crisis.
Let's think about the real estate market and see the effects of the investment banks in this market. We generally have a traditional home loan. And these home loans are basically the bank loans money to the home buyer. Bank loans money, and then the bank collects money with interest over time. Just a standard loan. They loan you money to buy a house, and then over time, you'll make the payments. But what happened during this period, there was the securitization of these home loans. This created a secondary market for home loans. Instead of the banks just holding on to those mortgages and waiting to get the payments, they sold them off as securities. A key term here is this mortgage-backed security. What this means is that the bank gets all these mortgages. Different mortgages here, here, and here. They all have different risks. Maybe some of them are less risky, they have good credit, and they generally always pay on time. So they have some low interest rate. Let's say their interest rate is 4%. And then they have riskier mortgages. Maybe one that's 8%. And someone who's very risky with like a 16% variable mortgage, that they got the loan, which is part of the problem that they were giving out these bad loans. So what they did is they took these loans, all of these different mortgages, and they bundled them together into one security called the mortgage-backed security. And they sold the shares of these securities to their investors. Generally, investment banks bought these mortgage-backed securities to show returns to their investors. So, how it worked is whenever these mortgages paid money on their mortgage, they made a payment. Well, that money was a cash flow of this mortgage-backed security. So people who own the mortgage-backed security saw a return on their investment. At first, this looked really good. The economy was booming. Everyone was making their payments. Even these risky people were making their payments. So these mortgage-backed securities were making tons of money. But what ended up happening is that, these mortgage-backed securities only did well because the homeowners were making their payments like I got here. Oh, the suspense is building.
The real estate market was booming in the early 2000s. Because of this booming real estate market, banks started being a lot looser with their credit. They started making what we call subprime mortgage loans. And these are high interest rate loans. So this would be something like what we saw in this mortgage-backed security, the 16% loan to riskier homebuyers. So risky people are taking loans now that are more likely to default. And a lot of times, there was required little to no down payment. So you could literally buy a house, maybe buy a $300,000 house with like $5,000 to $10,000 and get this huge loan from the bank with literally no risk. So a lot of these home buyers, these risky home buyers are just saying why not? The economy is booming. I can take out this loan. The market will go up, and I'll make some more money, right? And these loans, these risky loans were bundled with lower risk loans in these MBS, these mortgage-backed securities so that the investment seems safe. There are these safe cash flows coming from these less risky homeowners. And then, these very risky cash flows that when those cash flows came in, they played a huge return. But what ended up happening is some of these risky loans began to default. And as the market started to crash, well, these people had taken out huge loans on these houses, and they didn't want to pay them back. So when some of the loans began to default, the entire mortgage-backed security market suffered again. Oh, the suspense is building.
What happened next is that the biggest holders of these mortgage-backed securities were large investment banks. They were trying to show big profits to their investors and they were going. For a few years, they were showing really high profits because of these mortgage-backed securities. But once they started to tumble, once the real estate market started to fall, some of these risky homeowners started to default. Well, they didn't want to make their payments anymore. Now, they have a $300,000 house that's gone down in value to $200,000 but they still owe $290,000 on their mortgage. They have a huge loan still for a house that's lost tons of its value. So they're like, "You know what? I'm just going to walk away from this." And as everyone started to walk away, the mortgage-backed securities stopped seeing their income coming in. And there was a huge decrease in profits. A lot of these banks were uninsured. They had all of these risky investments with no insurance. And we had what was called this shadow banking system that was loosening the credit. Basically, banks were able to give all of these bad loans, these subprime loans, and they were selling them off as mortgage-backed securities and these unregulated financial activities. There wasn't much regulation around this at the time, but it also helped loosen the credit. There was a lot of activity in the market, and that's why it was soaring during that time. But as the housing prices fell, the homeowners learned that their mortgage was higher than the value of the home like I just said. They owed like $250,000 on a $100,000 home or something like that, and they just backed away. They just left. Many mortgages defaulted. The mortgages defaulted, and the mortgage-backed securities failed. And these investment banks suffered huge losses. Right? So a lot of these banks were failing. They were completely insolvent. They lost tons of their money like they had so much of their money invested in these mortgage-backed securities because they had been so profitable for so long. But when they failed, they lost tons of money. So what happened? This is that huge bailout. The bailout that's been very controversial since the recession was called the Troubled Asset Relief Program. And this was basically the government buying the really bad mortgage-backed securities that these investment banks were holding. They were holding all of these really bad investments, and the government bailed them out. They just bought them from them and absorbed all of that. All of those bad investments which totaled over $700,000,000. That's a lot of money that they bailed them out. These were emergency loans that happened to these investment banks. By saving the reason they did this was they thought that if they didn't save these banks, it was going to have a domino effect. And just everything would keep getting worse, and we would slide into a great depression again, like we saw in the 1930s. So the government considered these investment banks too big to fail. This is one of those key topics that always comes up, they were too big to fail. And that's the idea of if they failed, well, the whole financial system would have collapsed on top of it. But this created a problem called moral hazard. Because if these banks now have the idea in their head, "Well, if I take these risky investments, and I do all of this crazy manipulation in the market, well, the government's going to bail me out. I can take riskier positions because I have insurance now." But in this situation, they didn't even pay for the insurance, right? The government just bailed them out. They didn't insure themselves. They literally got bailed out afterward. It's as if they were insured without paying any premiums, right? The government provided them insurance, and they never even paid premiums for that insurance. They lost all their money, but the government paid for it. So that gives them the idea in their head that, "Hey, if I do this again, maybe it won't matter again. Hey, they'll bail me out." So it kind of puts a very tricky situation when they bail out these banks for these bad decisions that basically they made. Cool? So that's a synopsis of what happened there during the 2007 to 2009 crisis. Let's go ahead and move on to the next topic.
