When the Federal Reserve raised the federal funds rate, it sent adjustable mortgage interest rates skyrocketing. As a result, home prices plummeted, and borrowers defaulted. Derivatives spread the risk into every corner of the globe. That caused the 2007 banking crisis, the 2008 financial crisis, and the Great Recession. It created the worst recession since the Great Depression. The subprime mortgage crisis was also caused by deregulation. In 1999, the banks were allowed to act like hedge funds. They also invested depositors’ funds in outside hedge funds. That’s what caused the Savings and Loan Crisis in 1989. Many lenders spent millions of dollars to lobby state legislatures to relax laws. Those laws would have protected borrowers from taking on mortgages they really couldn’t afford. Mortgage-backed securities allow lenders to bundle loans into a package and resell them. In the days of conventional loans, this practice allowed banks to have more funds to lend. With the advent of interest-only loans, this also transferred the risk of the lender defaulting when interest rates reset. As long as the housing market continued to rise, the risk was small. The advent of interest-only loans combined with mortgage-backed securities created another problem. They added so much liquidity in the market that it created a housing boom. The advent of interest-only loans helped to lower monthly payments so subprime borrowers could afford them. But, it increased the risk to lenders because the initial rates usually reset after one, three, or five years. But the rising housing market comforted lenders, who assumed the borrower could resell the house at the higher price rather than default. Another myth is that the Community Reinvestment Act created the crisis. That’s because it pushed banks to lend more to poor neighborhoods. That was its mandate when it was created in 1977. In 1989, Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) strengthened the CRA by publicizing banks’ lending records. It prohibited them from expanding if they didn’t comply with CRA standards. In 1995, President Clinton called on regulators to strengthen the CRA even more. But, the law did not require banks to make subprime loans. It didn’t ask them to lower their lending standards. They did that to create additional profitable derivatives. The real problem with CDOs was that buyers did not know how to price them. One reason was they were so complicated and so new. Another was that the stock market was booming. Everyone was under so much pressure to make money that they often bought these products based on nothing more than word of mouth. When asset prices fell, the banks had to write down the value of their subprime securities. Now banks needed to lend less to make sure their liabilities weren’t greater than their assets. Mark to market inflated the housing bubble and deflated home values during the decline. In 2009, the U.S. Financial Accounting Standards Board eased the mark to market accounting rule. This suspension allowed banks to keep the value of the MBS on their books. In reality, the values had plummeted. If the banks were forced to mark their value down, it would have triggered the default clauses of their derivatives contracts. The contracts required coverage from credit default swaps insurance when the MBS value reached a certain level. It would have wiped out all the largest banking institutions in the world. Banks lent, even to those who couldn’t afford loans. People borrowed to buy houses even if they couldn’t really afford them. Investors created a demand for low premium MBS, which in turn increased demand for subprime mortgages. These were bundled in derivatives and sold as insured investments among financial traders and institutions. When the housing market became saturated and interest rates started to rise, people defaulted on their loans which were bundled in derivatives. This was how the housing market crisis brought down the financial sector and caused the 2008 Great Recession.
