The Credit Crisis of 2008: How Did We Get Here?

The credit crisis began earlier this year first with defaults on mortgages that were packaged into securities and sold to institutional investors. The defaults were simple homeowner defaults on mortgage payments that had adjusted upward and became too expensive for the homeowner to pay. When greater numbers of defaults occurred, it became clear that the securities into which these mortgages were packaged – known generally as structured investment vehicles, collateralized mortgage obligations, or collateralized debt obligations – were of a poorer credit quality than anticipated at the time the securities were originally sold.

With the recognition that the default rates were outside the predicted ranges when the packaged mortgages were sold large investment institutions did not want to purchase new securitized mortgage securities, and therefore banks found it increasingly difficult to sell their mortgages to investment banks that would package them into securities. Banks had to reduce their lending because they could not easily sell their mortgages. Since banks could not sell as many mortgages, the banks’ supply of capital for new loans was significantly reduced. The reduction in lending reduced the demand for homes, causing declines in home values, for the first time in decades.

Meanwhile payments on older adjustable rate mortgages were adjusting upward. As payments rose and home values fell, it created an incentive for homeowners to default on their mortgages, putting more homes into foreclosure and more homes on the market for sale by banks that foreclosed on homes. These foreclosed home sales further depressed home values. Soon, even homeowners with fixed rate mortgages were questioning whether to continue paying their mortgages on their homes with falling values. Many such homeowners began to default on their loans, including an increasing number of “prime” borrowers – those who were not considered at risk of default.

Meanwhile, as defaults rose in the packages of mortgages held by banks, insurance companies, and Fannie Mae and Freddie Mac, the value of those securities began to decline, reducing the value of such assets on the books these firms. Furthermore, these institutions were required to “mark the securities to market” meaning carry the mortgage securities at fair market value. With so many sellers of these securities, the market value was significantly below the original cost to purchase these securities, and in some cases there was no market price – there were simply no buyers. Accordingly, those securities had a zero value on the balance sheet of the institutions.