How the credit crisis came about
A mountain of debt with a foundation of shaky mortgages began to crumble in the summer of 2007. A little over a year later, Wall Street was in the grip of the biggest financial crisis since the Great Depression.
The investment banks that had been its rulers for decades either went under, were bought for a fraction of their worth or scrambled to reinvent themselves as banks. The nation's largest insurance company and largest savings and loan both were seized by the government to prevent failures that would have caused further casualties.
The crisis had its roots in a previous boom and bust: the tech bubble of the late 1990's. When the stock market collapsed in 2000 and the nation slipped into recession the next year, the Federal Reserve cut interest rates sharply to limit the economic damage.
Lower interest rates make mortgage payments cheaper, and demand for homes began to rise, sending prices up. In addition, millions of homeowners took advantage of the rate drop to refinance their existing mortgages.
As the industry ramped up, the quality of the mortgages went down. The people making mortgages no longer held onto them, but sold them to banks that bundled thousands of loans together.
Shares of those bundles were resold as mortgage-backed securities – in effect, bonds backed by the monthly mortgage payments of thousands of homeowners. This process made money for mortgages plentiful, but it also meant that there was little consequence for the company making the mortgage if it eventually went sour.
And turn sour they did, when home buyers had to leverage themselves to the hilt to make a purchase. Default and delinquency rates began to rise in 2006, but the pace of lending did not slow.
Banks and other investors had devised a plethora of complex financial instruments to slice up and resell the mortgage-backed securities and to hedge against any risks -- or so they thought.
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