1. The Olden Days
Dave needed a place to live, had a job with a steady income, a good history of paying back any money he borrowed, and a little bit of money saved up. Unfortunately, he didn’t have enough money to buy a piece of property outright. So, Dave went to his bank and said “let’s make a deal. You lend me the rest of the money to buy this property, and I’ll pay you back in monthly instalments over the next 20 years, plus some extra money every month (interest). If I don’t pay you back, you can take my property and sell it, pay yourself whatever I still owe you and I’ll get the rest” The bank agreed, knowing that Dave was a good guy and would pay them back. Plus, if he didn’t, they could just take the property, sell it, and get their money back. The bank got their money from cash they were holding on to, and borrowed the rest from a bigger bank or the country’s central bank. Dave got his house, and was happy. The bank was paid back over 20 years, and made a nice profit.
Alice had no money saved up, a crappy job, and didn’t pay back money she borrowed. Alice wanted her own place too. She went to the bank, but was denied because they didn’t think she would pay them back.
2. Mortgage Backed Securities
One day, a bunch of investment bankers had a great idea. Instead of getting the money to give Dave to buy his property from money already in the bank’s hands, they would get a bunch of Investors together to put money into a pot. Dave would get his loan from the pot of investor money. Then, whenever Dave made his payments, the bank would take a chunk for themselves, and the investors would get the rest. These investments would be called “mortgage backed securities” because the investments were backed by mortgages.
This worked great for a while, except eventually the investors started to get angry because they weren’t making enough money. The bank had a great idea. They would give a loan to Alice so she could buy her property too. Because they were worried that Alice wouldn’t pay them back, they charged her a lot of extra money in interest on top of what she owed. If Alice couldn’t pay the full amount, they would just add what she couldn’t pay to the total amount she owed. If she stopped paying, they would sell the house, and hopefully it would be worth more. The bank then bundled a whole bunch of loans to people like Alice and made the bundles into an investment that investors could invest in.
The bank took their investments to a rating agency, and asked the agency to tell them how risky the investments were. The rating agency looked at the bundles of mortgages to people like Dave, and said they were not risky, and gave them a good rating. They looked at the investments to people like Alice and said they were very, very risky, and gave them a bad rating.
The banks needed more money. They decided to take a bundle of loans to people like Dave, and a bundle of loans to people like Alice, and put them together into an even bigger bundle. They then went back to the rating agency, and asked how risky these loans were. The rating agency thought that this big bundle would really spread out the risk, since there were so many little bundles in it, and gave the bundles a good rating.
The rating companies screwed up, because the risky investments were still risky, they were just in a bigger bundle. Investors flocked to these big bundles, thinking they were not risky, when they really were, and bought them in large quantities.
3. Credit Default Swaps
The investors were worried though. What if they lost money on their bundles? Insurers like AIG came along and had a great idea. The investors would pay money to AIG. In return, if the investors lost any money on their bundles, AIG would pay them back whatever they lost. This was called a credit default swap. AIG was confident that people could only lose a little bit of money on these investments, since they were all backed by hard, tangible, real estate. Historically, real estate prices had never gone down very much, and had a steady increasing price trend.
Banks all over the world bought billions of dollars of these big bundles of mortgages. They invested all of their money in them, and were so happy that they were getting so rich. Plus, if they lost money, they had insurance.
4. The Beginning of the Collapse
Dave started making more money, and decided that he was going to buy a nicer house. He sold his house and went to buy a bigger one. He found a house he really liked, and put an offer on it. But, it turned out that Alice made an offer on the same house that was $100,000 higher, and got the house. The investors gave the bank money to give to Alice so that she could buy the house.
One month later, Alice didn’t make her payment on the house, and the bank took it back. They put it up for sale again at the amount that Alice had bought it for to get their money back. But, no one would pay that amount. Dave came back in with his offer that was $100,000 lower. The bank did not get any other offers and had to give Dave the house.
Now, the bank had lost $100,000 that it owed to investors!
All of the sudden, the prices of houses everywhere started going down. Alices all over America stopped paying, and banks lost billions of investor dollars. Real estate prices started tanking. In the past prices had never gone down much because they never got too high. They never got too high because loans were always made to low-risk people like Dave. But prices got too high because anyone, including people like Alice, could get a loan for however much they wanted.
The investors asked for their money back from the banks, but the banks didn’t have it. The investors then went to AIG and said “I want my insurance money”. AIG started paying out insurance money.
By the end of 2007, this caused the American economy to stop growing. It slowly started to decline, but the problem got worse. Eventually AIG had no more money to compensate investors and banks, and the banks were losing billions of dollars.
5. Lehman Brothers
One of these banks was Lehman Brothers. Lehman had been in business for a long time, and lots of people put their money in Lehman thinking it was safe. Lehman realized that they had no more money because they had too many investors trying to get money back. Lehman owed billions of dollars to these investors, but didn’t have it . Lehman asked the government for help, but the government at the time (Republican) did not want to interfere with the free market, and decided to let Lehman fend for itself. Lehman realized that it couldn’t pay money back, and went bankrupt.
6. The Catastrophe
Banks and investors all over the world were terrified. If investments in a secure bank like Lehman were unsafe, then any investment could be unsafe. Investors decided that they wanted all their money in cash, and really safe investments, because they didn’t want to lose it. So they all started selling all their shares and bundles of mortgages. But, no one wanted to buy their investments at a regular price, so they had to sell them at a really low price.
These lower prices caused the stock market to start crashing. People started selling stocks in regular companies that had nothing to do with investments because they were worried about their money. This sent share prices crashing. People who were just regular investors saw their share prices crashing, and decided to sell before prices got too low. This sent prices even lower.
This could have spiralled into another great depression. If more banks went bankrupt, and more investors lost more and more money, then all sorts of companies would go bankrupt. Banks owed hundreds of billions of dollars and had no way to get that money. It appeared that civilization as we know it could come to an end.
7. How the world was saved
The federal government saw this problem happening and realized that something had to be done. They knew that if the banks kept making loans like they did in the olden days they would surely make money again. So, Treasury Secretary Paulson decided to loan money to all the big banks and to AIG to compensate them for all the money they lost in the crisis. Paulson convinced president Bush, and a majority of congress that this was a good idea. The media called this a bailout, but it was really necessary to prevent another great depression.
With the billions of government dollars in hand, the banks could pay their investors back, and pay for all the losses that were occurring. Countries all over the world undertook similar bailout plans to keep their banks from going out of business.
8. Why there was still a recession
Unfortunately, the damage done was already severe. The banks had lost so much money that they didn’t want to make loans to companies and lose more money. Companies were losing money, and realized that the only way they could save money would be to cut costs. They started laying off workers and shutting down operations.
People who lost their jobs stopped spending money, and lived off of unemployment insurance. People who did have jobs got paranoid, especially after losing so much of their investments when the market crashed, and started putting away any last penny they could. This meant that stores and companies were selling less stuff and making less money. Stores had to shut down and lay off more workers.
9. The Aftermath
Although the recession is/was the worst since the great depression, the new Obama government and the Federal Reserve have fought to end it. The reserve made it very easy for banks to borrow money to lend out to good customers like Dave, charging really low rates of interest to banks, and making lots of money available.
The federal government’s stimulus package was designed to give the economy a boost at the other end, by creating actual jobs, extending unemployment benefits, and spending money on government programs.
In the end, this recession will be looked at as a wakeup call in the history of modern human civilization. The free market works brilliantly when it is monitored and regulated. But, it has the capacity to spiral out of control when people make the wrong decisions. If it was not for secretary Paulson and the TARP bailout, the free market would have self destructed, and would have taken years to correct itself.
This recession has been horrible, and has negatively affected the lives of millions. However, it would have been much worse if it were not for the bold and swift actions of the responsible bodies, guided by hundreds of years of economic thought. Hopefully, we can learn from these mistakes, and try to make sure something like this never happens again.