Ever wondered what caused the financial crisis which triggered the Occupy movement? Here’s a quick summary of what went wrong:

So say a person wants to buy a house.

Houses are expensive, so there’s a good chance they won’t be able to afford one on their own.

 

In that case, a person can take out a mortgage with a bank, which is basically an agreement that the bank will loan the person money, and if the person fails to pay it back, the bank will take the house instead (an event called foreclosure).

 

The person pays their debt plus interest back to the owner of the mortgage in regular instalments. This gives the bank a source of income over time. But the bank might not want to wait for the mortgage to be repaid.

 

If the bank wants money now, they can sell the mortgage to someone else, who will then start receiving payments from the home owner.

 

 

At the time, house prices had been rising steadily for years. Since the mortgage owner gets the house if the owners fails to pay them, mortgages seemed like a pretty safe investment at the time. If the home owner pays, the mortgage holder gets money. If the homeowner doesn’t pay, the mortgage holder gets the house, which they can resell for even more money since housing prices just kept going up.

 

As housing prices continued to climb, mortgages were sold and re-sold; all sorts of payments and purchases were made using mortgages. Essentially, the financial institutions were trading mortgages in place of actual money.

 

 

Foreign investors also got involved in the trade, and starting accepting mortgages in place of immediate payment. This is how the international market became dependant on the survival of the US housing market. Instead of getting paid in actual money, they were paid in the promise of future money, which depended on US houses remaining valuable.

Now since the banks were making such huge profits trading mortgages, they wanted to keep doing it. However, the supply of new mortgages was in danger of drying up; all the people who qualified for loans had already taken them out. So the banks decided to loosen the requirements people needed to meet in order to get a loan. These restrictions were meant to make sure people who got loans were likely to be able to pay them back; without them, people started buying property they couldn’t afford and taking out loans they wouldn’t be able to pay back. These are called “subprime mortgages”.

 

Eventually, these people started failing to make their payments, and the mortgage holders foreclosed on their homes.

 

 

At first this wasn’t a problem, since the mortgage holder could just resell the house, and houses were valuable.

 

But as more and more people started failing to make their payments, more and more houses went up for sale.

 

Soon the available supply of houses was greater than the demand for them…

 

The mortgage holders couldn’t find anyone to buy the houses…

 

 

And as a result their value started to drop.

 

With the value of houses dropping, that meant that mortgage holders’ who foreclosed on a house and tried to resell it would make much less of their money back. This made mortgages a much riskier investment, and financial institutions stopped buying them.

 

Meanwhile, as the value of houses continued to drop, some homeowners found themselves paying mortgage’s based on the original value of their home, which was much higher than what the property was now worth. This didn’t make much financial sense for them; it was actually cheaper for them to let the banks foreclose on their homes and buy a new one than to finish paying off their mortgage.

 

And that’s exactly what many of them did, leaving the banks with even more houses they couldn’t sell.

Now the banks and financial institutions who had been trading in mortgages found themselves stuck with unsellable houses that were now worth much less than they had paid for them. They had lost huge amounts of money on the deals, and with no buyers for the houses, they had no way of making any of the money back.

 

The financial institutions were in bad shape, and as a result became much more wary of risky investments, and became much more selective about who they would lend money to.

 

Foreign investors were caught in the same trap. Instead of money, they now had a bunch of houses in the US that no one wanted to buy.

 

This led to the slowing of economic growth, and ultimately to the global financial crisis.

 

Fancy Words Economists Like to Use

Certain words and phrases are often brought up in connection with the financial crisis. Here are what a few of them mean.

 

Housing Bubble: An economic “bubble”occurs when something increases in worth until it has reached a level of value that can’t be sustained. The housing bubble refers to the constantly increasing value of houses in the US. The bubble “burst” when the housing values finally started to drop.

 

Liquidity Crisis: “Liquidity” is an economic term for how easy it is for a particular type of good to be exchanged for something of equal worth. For example, buying a one dollar pen is easy when you have one dollar. Buying the same pen with one dollar’s worth of paper clips would be harder. Perhaps the pen’s owner doesn’t want paper clips and won’t accept them in exchange. Perhaps you even have two dollars worth of paper clips, and do find someone with a one dollar pen willing to trade. However, paper clips come in two dollar packets, so to trade for the one dollar pen, you have to give up two dollars worth of paper clips. If you just had two dollars, you could swap one dollar for the pen without having to give up the other dollar. Since dollars are easier to trade for items of equal worth than paper clips, dollars are considered to be a more “liquid” item than paper clips.

A liquidity crisis is a situation where much of a person’s wealth is stuck in a form with low liquidity. This is what happened to the banks when they were stuck with lots of houses instead of actual money.

 

Mortgage Backed Securities: A “security” is a representation of something of value. Whoever owns the security can exchange it for this valuable item, a bit like an IOU note. Mortgage backed securities are securities where the item of value is the mortgage on a house. These were the things that banks and other financial institutions began trading and paying each other with instead of money.

 

Irresponsible Lending: Making a loan is always a bit of a risk, since there will always be a chance that the person borrowing the money can’t pay you pack. Normally, banks won’t give out a loan unless they have enough money to survive and meet their other financial obligations even if the loan is never repaid. Irresponsible lending occurs when banks give out so many loans that that would go bankrupt if too many people failed to pay them back. This is part of what made the financial crisis so bad, since the banks had given out so many loans and mortgages that they didn’t have enough money left to support themselves, and instead had to turn to the government for bailouts to keep them functioning.

  One Response to “The Global Financial Crisis Explained”

  1. […] institutions which have drawn the ire of the Occupy movement (for more on this topic, read “The Global Financial Crisis Explained”), there have been very few groups to offer alternatives that are more equitable and sustainable.  […]