3 Theories about how the Financial Crisis got started

The financial crises that occurred at the end of the 2000's is one of the most serious to strike the United States. The reasons behind the crisis are complicated and involve a number of different factors but there are three theories that explain how it got started.

One theory about how the financial crisis got started was that interest rates were too low, something I've heard support on multiple occasions. For nearly a decade following the burst of the dot com bubble in the late nineties the Federal Reserve had been lowering interest rates in order to stimulate the economy. By the mid nineties the prime rate was at one percent. This led to a great increase in the amount of money that was being borrowed. This had two effects; it drove up the price of assets like houses since there was increased demand for them since it was so cheap to borrow money to buy them. The other effect was that it greatly increased the value of the US dollar making it harder for exporters. In order to help exporters by lowering the value of the dollar the Fed had to raise interest rates. This caused a huge problem for the people who had borrowed more than they could afford, it also caused the housing bubble to burst since there was now less demand.

The second theory about how the financial crisis got started is that lenders gave mortgages to people who really couldn't afford them. These were the so called sub-prime mortgages. The reason that these were given out is that the banks were running out of people to loan money to. In order to keep their profits rising to keep investors happy the banks had to keep writing mortgages. The problem is that once everybody who had good credit had a house the only people left to lend money to was the people who didn't have good credit. When interest rates rose most of these people were unable to make their mortgage payments and the banks had for foreclose. This contributed heavily to the decline in housing prices.

The third theory as to what caused the financial crisis is what is known as securitization of the loans. This is part of the reason that the banks were so willing to give out sub-prime loans. What they did was they bundled a whole bunch of loans together and then sold them to investors. They did this to hide the bad loans by mixing them with the good ones. The result was that when the housing bubble burst and people were unable to pay their mortgages nobody knew who was holding the bad debt. Since nobody could be sure if anybody else would end up going bankrupt because of the bad debt they were holding everybody just stopped lending money. This was a disaster for the economy which depends heavily on credit to run properly.