The Financial Crisis for Dummies

Understanding the financial crisis doesn’t have to be hard. Here’s a short run-through of the causes and events for those who need a basic understanding or a short brush-up.

Think of the economy as a soap bubble, blown gently into by a child. Now, imagine someone giving that child a quick squeeze. The bubble bursts, naturally, and that’s what happened when the financial crisis kicked off.

The banks of the US were giving out mortgages and thus homes to everyone. People who could not make the payments on their loans were given the money anyway, because the home they were going to buy was predicted to rise in value. The basic thought: “It doesn’t matter if he can’t pay us the one million dollars right away if the property will be worth two million dollars in a little while.”

At the same time, the banks were looking for ways to make money. This, they did by reselling loans in “packets”. A variety of loans, some with secure payers and some with people who would only be able to pay back the money if the property rose in value were bundled up and cut up into pieces until you could no longer know how secure the loans in any such packet were. Then, these packets were sold to a variety of investors, many from other countries, on the premise that they would make their money back when people started paying their loans.

This was of course very risky business, something people eventually understood when the value of homes in the US started dropping, instead of rising like it had to for these loans to work. Suddenly, a lot of people/countries/governments had wasted a lot of very important money, while a lot of US residents ended up with huge mortgages on worthless homes. 

The collapse in the housing market is of course only one facet of the financial crisis. Another major factor is “shortsale” of stocks. This is when someone lends their stock to a shortseller for a small amount of money, and the shortseller sells the stock, waits for it to fall in value, buys it back and hands it back to the owner, keeping the revenue. There’s a reason why this is illegal in several countries: When someone sells a stock, it sends a message to everyone else that they perhaps should sell their stocks as well, and if enough stock owners do this, the company the stocks are in will go bankrupt. 

This is similar to what happened to several of the banks. People got insecure and wanted to get their money out of the bank, but found that the banks did not have this money. Banks don’t actually have all the money people have put in them, these funds are in fact used to generate income for the bank. Thus, when people came to get their money, and said money was gone due to packages of worthless loans and stocks going down in value, the banks went bankrupt as well.

There are a number of different conclusions one might reach about the cause of the financial crisis, and I have only covered a basic part of it. Still, I hope I have provided you with the knowledge to understand what’s going on just a little better.