1. Credit Crisis: Introduction
  2. Credit Crisis: Wall Street History
  3. Credit Crisis: Historical Crises
  4. Credit Crisis: Foundations
  5. Credit Crisis: What Caused The Crisis?
  6. Credit Crisis: Bird's Eye View
  7. Credit Crisis: Government Response
  8. Credit Crisis: Market Effects
  9. Credit Crisis: Lessons Learned
  10. Credit Crisis: Conclusion
By Brian Perry

In this chapter, we'll examine the causes of the credit crisis, starting with the decline in the housing market that eventually led to increased levels of mortgage defaults. These defaults prompted drops in the value of mortgage-backed securities and, as losses in the mortgage market grew, investors gradually began avoiding all risk. As a result, global asset prices fell, liquidity dried up, and panic set in in the marketplace. (For background reading, see The Fuel That Fed The Subprime Meltdown.)

The Housing Bubble
It's a widely held belief that home prices do not decline and it is this belief that led generations of consumers to regard a home purchase as the foundation of their financial programs. More recently, speculators have used this logic as part of their rationale for purchasing homes with the intention of "flipping" them. As the rate of appreciation in home values dramatically increased during the early years of the 21st century, many people began to believe that not only would home values not decline, but that they would also continue to rise indefinitely. (For more on flipping see, Flipping Houses: Is It Better Than Buy And Hold?)

The belief that home prices would not decline was also fundamental to the structuring and sale of mortgage-backed securities. Therefore, the models that investment firms used to structure mortgage-backed securities did not adequately account for the possibility that home prices could slide. Likewise, the ratings agencies assigned their highest rating, 'AAA', to many mortgage-backed securities based partly on the assumption that home prices would not fall. Investors then purchased these securities believing they were safe and that principal and interest would be repaid in a timely fashion. (To learn more, read The Risks Of Mortgage-Backed Securities and The Debt Ratings Debate.)

Home Prices Decline
Unfortunately, in 2008, the belief that home prices do not decline turned out to be incorrect; home prices began to slide in 2006 and by 2008, they had declined at rates not seen since the Great Depression.

According to Standard & Poor's, as of 2008, home prices were down 20% from their 2006 peaks, and in some hard-hit areas, that number was even higher.

As prices began to decline, homeowners who had planned to sell for a profit found themselves unable to do so. Other homeowners found that the outstanding balance on their mortgages was greater than the market value of their homes. This condition, known as an "upside down" mortgage, reduced the incentive for homeowners to continue to make their mortgage payments.

One particular corner of the housing sector that experienced a dramatic bubble and subsequent collapse was the subprime mortgage market. Subprime mortgages are issued to households with below-average credit or income histories and are generally considered more risky than traditional "prime" mortgages. Although they constitute a minority of the overall market, subprime mortgages became increasingly important over the years. Many people who took out subprime mortgages during the real estate boom did so with the hope of "flipping" the house for a large gain; in fact, this tactic worked well when home prices were soaring. Other subprime borrowers were lured into their mortgages by the initially low payments, but when these "teaser" rates reset to current market rates, many homeowners could not afford the new, much higher payments. (To learn more about subprime mortgages read our special feature, Subprime Mortgages.)

The chart below displays home price values as measured by the S&P/Case-Shiller Home Price Index. As the chart demonstrates, following a run-up in prices from 1999-2006, prices dropped sharply.

Figure 2
Source: Standard & Poor\'s, Case-Schiller

Trouble in the Mortgage-Backed Securities Market
As the decline in home prices accelerated, an increasing number of people found themselves struggling to make their monthly mortgage payments. This situation eventually led to higher levels of mortgage defaults. Many of these mortgages had been "securitized" and resold in the marketplace. This dispersion of risk is generally a good thing, but in this instance it also meant that potential losses from defaults were spread more widely than they otherwise might have been. Defaults had an inordinate impact on certain bond issues. This is because in a typical mortgage-backed security deal, any mortgage defaults initially affect only the lowest-rated tranches. This means that even if the overall default rate for the pool of mortgages is relatively low, the loss for a particular tranche of mortgage-backed securities could be substantial. When the investors that hold these tranches employ leverage, losses can be even greater. (For more on this see, Investing In Securitized Products.)

As concerns about the housing decline grew, market participants began avoiding mortgage-related risks. Investors became even more nervous after Bear Stearns was forced to close two hedge funds that had suffered very large losses on mortgage-backed securities. As the size and frequency of mortgage-related losses began to increase, liquidity started to evaporate for many other types of securitized, fixed-income securities, leading to increasing uncertainty about their true value. (To learn more, read Dissecting The Bear Stearns Hedge Fund Collapse.)

Financial firms had previously used actual market prices in order to value their holdings, but in the absence of trading activity, firms were forced to use computerized models to approximate their holdings' value. As the market continued its decline, investors began to question the accuracy of these models. The implementation of new mark-to-market accounting rules exacerbated the situation by requiring financial firms to continually report losses on securities, even if they did not intend to sell them. This well-intentioned rule was implemented at precisely the wrong time and had the effect of adding fuel to a fire. (To learn more about this effect, read Mark-To-Market Mayhem.)

The Downward Spiral
Investors soon began to question whether financial institutions knew the true extent of the losses on their books. This uncertainty led to sharp declines in the stock prices of many financial firms, and a growing unwillingness to bid for risky assets.

As investors attempted to sell in a market with no buyers, prices fell further. Soon, most risky assets were dropping rapidly in price and panic began to creep into the marketplace.

The credit crisis had begun.

Following an extended period of relative calm, a housing market decline led to falling values for mortgage-backed securities. Losses on these and other hard-to-value securities soon spread to encompass all risky assets, prompting fear on the part of investors and an unwillingness to provide liquidity in the marketplace. As this downward spiral accelerated, fear turned to panic and the financial markets descended into crisis.

Credit Crisis: Bird's Eye View
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