Module 4, Section 3: Crisis Precursors

Overview of Module 4, Section 3: Crisis Precursors, which focuses on the events and conditions that led to the 2008 Financial Crisis.

Main Themes

The Rise and Proliferation of Asset-Backed Securities (ABS) The securitization of debt, particularly mortgages, played a central role in the lead-up to the crisis. ABS transformed illiquid loans into tradable assets, offering benefits like liquidity and risk transference for issuers and access to diversified assets for investors. However, this also obscured and amplified underlying risks.

The Expansion of Subprime and Affordability Mortgages The growth of subprime mortgages (loans to borrowers with higher default risk) and affordability products (loans with features like low initial rates and flexible qualification criteria) increased the volume of risky debt in the system. It was not uncommon to see aggressive sales tactics and the focus on immediate affordability over long-term sustainability.

Adjustable Rate Mortgages (ARMs) as a Catalyst for Payment Increases ARMs, with their initial lower fixed-rate periods followed by upward adjustments based on market rates, created a ticking time bomb. When these initial periods ended and interest rates rose, many borrowers, particularly subprime borrowers, could not afford the increased payments, leading to defaults.

Lax Underwriting Standards and Lack of Due Diligence The process of originating and securitizing mortgages led to a decline in underwriting standards. Originators, knowing they would quickly sell the loans, had less incentive to thoroughly assess borrower creditworthiness.

The Role of Non-Bank Lenders ("Shadow Banks") The rise of non-bank financial institutions in mortgage lending significantly altered the financial landscape. These less regulated entities issued a large portion of the new credit, bypassing traditional banking regulations. This reduced the effectiveness of Federal Reserve interest rate policies on mortgage rates.

The Housing Bubble and its Burst A significant and rapid increase in home prices between 2000 and 2006 fueled the mortgage boom. This created a bubble where prices were driven by speculation and the expectation of continued appreciation. When this bubble burst, starting in the summer of 2006, many borrowers found themselves underwater (owing more than their homes were worth), further exacerbating defaults.

Falling Long-Term Interest Rates For decades leading up to the crisis, long-term interest rates had been falling due to global factors, making borrowing cheaper. However, while the Federal Funds Rate increased, mortgage rates did not rise proportionally due to the influx of lending from the non-bank sector.

Increased Household Debt Aggregate household debt as a share of disposable personal income rose dramatically, indicating that a larger portion of income was being used to service debt, leaving less buffer for economic shocks.

Systemic Risk and Contagion The interconnectedness of the financial system through ABS meant that defaults in one part of the mortgage market could quickly spread throughout the system, leading to widespread losses and a credit crunch. When homeowners began to default, the value of ABS declined, impacting the balance sheets of financial institutions holding these securities.

Regulatory Capital and Funding Risks Large financial institutions significantly increased their leverage by borrowing heavily on short-term markets to purchase ABS. This created a situation of high capital inadequacy risk and reliance on unstable funding.

Hindsight Bias and the Gradual Nature of the Crisis Looking back, the causes of the crisis seem obvious. However, at