A recent liquidity crisis at the second-largest property developer in China has investors drawing parallels to the infamous 2008 financial crisis. This issues has raised investors’ concerns; that its effects may trickle down to the global economy. Evergrande, the infamous company, has fueled an economic spur in the country since 1996, but most of the growth sat atop unsustainable and ever-increasing debt. Today, the company has liabilities of over $305 billion, the largest debt of any business worldwide. Moreover, its real estate properties have low occupancy rates, which is reminiscent of the 2008 financial crisis.
The Chinese government says they’ve got things under control. At the same time, strategists recommend that Beijing acts promptly because Evergrande’s decline is hurting market sentiment, even spreading to crypto by causing Bitcoin to drop over 5% before rebounding.
In this guide, we discuss what caused the 2008 financial crisis and how savvy crypto investors can learn from the economic uncertainty in the market.
What Caused the 2008 Financial Crisis?
The 2008 financial crisis was mainly caused by the collapse of the U.S. housing bubble. Deregulation in the finance industry allowed banks to trade hedge funds with derivatives and bundle subprime mortgages, ultimately causing real estate assets’ values to plunge.
The roots of the Great Recession began to form in 2007. At that time, it was clear that the long-practiced binging on cheap credit would have imminent consequences. Preliminary events had already begun to expose cracks in the system, such as the collapse of two Bear Stearns hedge funds.
Meanwhile, Northern Rock in Britain was also going to ask the Bank of England for emergency funding. At the same time, BNP Paribas shocked investors by freezing $2.2 billion of funds under management.
However, these signs failed to prepare investors for what was to hit the next year. 2008 brought the worst financial crisis in about eighty years, engulfing the whole world.
The 2008 financial crisis cost ordinary people their life savings, homes and jobs — and sometimes all three. Today, many people wonder what caused the 2008 financial crisis. Realistically, there was more than one culprit, but if there’s a place to start, it’s mortgage-backed securities.
What Is a Mortgage and What Are Mortgage-Backed Securities?
A mortgage is a legal agreement between you and a lender that permits the lender to seize your property if you can’t repay the loan you’ve taken to buy it, along with any applicable interest. If you miss payments, the lender can take your home in a process called foreclosure.
Mortgage-backed securities (MBS) are bonds secured by real estate and home loans. The pooling of several similar loans creates mortgage-backed securities. Essentially, investors can benefit from these securities without ever buying or selling a property. An investor putting their money in MBS is essentially obtaining the right to the value of this mortgage pool.
An investor buys an MBS because monthly payments from the borrowers go to that investor, rather than to the original lenders. If the borrowers are unable to pay, the investor may lose money.
Mortgage-backed securities exist because they let the bank sell its mortgages, which frees up more funds for the bank to lend to other borrowers. Additionally, it allows non-banking institutions to invest in the mortgage business.
How Did Mortgage-Backed Securities Lead to a Rise in Housing Prices?
Before mortgage-backed securities, only banks could offer long-term loans to borrowers, since they had enough money to wait for the loans to be repaid in 10 to 30 years.
With MBS, lenders were able to retrieve their cash instantly from the investors. As a result, the number of lenders rose. In fact, some started offering unrealistically low interest rates — in some cases not even bothering to verify the borrowers’ assets or salaries.
The lax lending policies meant banks were now facing tough competition. Therefore, they also had to make their qualification standards more flexible and lenient. And to make matters worse, mortgage-backed securities weren’t regulated.The U.S. federal government’s regulations only applied to banks, as they were required to ensure the protection of their depositors. Nevertheless, the lax lending standards meant more people were buying homes, resulting in a real estate boom.
Since lenders weren’t consistently confirming whether the borrowers could repay loans, many people ended up with unaffordable mortgages. As a result, subprime mortgages started piling up.
A subprime mortgage is given to a high-risk borrower with a low credit rating. The interest rate on this type of mortgage is much higher than a standard rate in order to compensate for the higher risk.
Subprime mortgages are sometimes also adjustable-rate, which means the lender can increase the interest rate at any point in time.
The Role of Subprime Mortgages in the 2008 Financial Crisis
Subprime mortgages were a primary reason for the 2008 financial crisis, since many borrowers were issued these loans without any proof of income or down payment.
A borrower could come along and state their income to be $200,000 without any documentation to prove their claim, and they could still apply for a mortgage.
Back then, these were called Ninja Loans, (“no income, no job, and no assets”). Things began to go seriously wrong when lenders and the rest of the financial services industry began putting subprime loans in the same bundles as conventional mortgages issued to people with high credit scores.
The bundles were divided into “tranches” of collateralized mortgage obligations. These obligations have multiple security pools, with each pool having different priorities and maturities. Bear in mind that the loan repayments for the first three years of any subprime mortgage have a low interest rate. Thus, the banks pooled these payments with the low-interest payments of regular mortgages.
Then, they sold these bundles to investors.
The drop in housing prices in 2006 had already started creating problems. Unfortunately, the decline came during the third-, fourth- and fifth-year mortgage repayments, when many borrowers started to struggle with the sudden spike in interest rates.
A drop in the price of homes meant that the value of borrowers’ properties was less than their mortgage balance. Therefore, they couldn’t sell their homes. On the other hand, investors in mortgage-backed securities realized that borrowers were starting to default, pushing them into foreclosure, so investors tried to get insurance.
At this point, American Investment Group (AIG), the issuer of this insurance, nearly declared bankruptcy, partially contributing to the notorious 2008 financial crisis.
What Was the Chain of Events that Led to the 2008 Financial Crisis?
To fully understand what caused the 2008 financial crisis, it’s essential to look chronologically at the events leading up to it.
Home Buyers Take up Loose Credit Lines to Finance Mortgages
The Federal Reserve wanted to boost the economy and make more money available for consumers and businesses. As they say, the road to Hell is paved with good intentions.
Due to low lending rates, even people with poor credit scores could get mortgages to buy homes. Therefore, they took loose credit lines and financed mortgages. On the flip side, lenders failed to put stringent qualifying requirements in place because they were selling the loans in bundles to investors.
In keeping up with the competition, banks also dropped their standards, offering lowered interest rates. The Federal Reserve did raise the rates later, but it didn’t do much to alleviate the situation.
As a result, homeownership spiked to saturation.
Mortgage Defaults for Subprime Borrowers
Subprime mortgages, as discussed earlier, have high interest rates. Borrowers who were already subprime struggled to repay their loans in the third through fifth years of the repayment period.
Boom in Supply of Houses Causes Home Prices to Plunge
Problems had already started surfacing way before 2008. In 2004, homeownership in the U.S. had risen to 69.2%.
However, prices of homes started falling in 2006. Americans suffered widespread hardships during this time as their homes had less worth than the amount they’d paid for them. Because of this, there was no way for them to sell their homes.
Subprime Lenders and Financial Institutions Declare Bankruptcy
By 2007, subprime lenders started declaring bankruptcy. Twenty-five lenders had gone under by March of that year. New Century Financial filed for bankruptcy in April and laid off 50% of its workers. Soon after, BNP Paribas, the largest bank in France, also announced a loss worth billions of dollars, while American Home Mortgage Investment also declared bankruptcy.
Investors Lose Their Money from Financial Instruments: CDOs, CDSs and Mortgage-Backed Securities
As borrowers defaulted on their payments, investors began losing money from financial instruments, such as MBS. Likewise, investors also sustained losses from collateralized debt obligations.
Lehman Brothers Holdings suffered the most significant blow during the 2008 financial crisis: it owed $600 billion, of which credit default swaps covered $400 billion. In credit default swaps, buyers shift the financial risk to an insurance company and make periodic payments in exchange.
Think of it as an insurance policy, except it’s for buyers who predict that they may wind up in a financial pickle that could affect their investments in the future.
Credit default swaps became popular soon after their invention. By 2007, they were valued at $62.2 trillion. However, the global financial crisis hit CDSs hard, dropping the value to $26.3 trillion in just two years following the Great Recession.
Lehman Brothers faced a substantial burden as their insurer, AIG, didn’t have sufficient funds to clear Lehman Brothers’ debt. Therefore, the Federal Reserve had to step in to bail out Lehman Brothers.
Huge Banks Declare Bankruptcy, Causing Liquidation of Assets and the Stock Market Plunge
The world became aware of the initiation of a global financial crisis when major banks started declaring bankruptcy. As a result, the stock market plunged.
Here are some public companies that went bankrupt in 2008:
- Lehman Brothers Holdings Inc.
- IndyMac Bancorp
- Downey Financial Corp.
- The Tribune Company
- Franklin Bank Corp.
- Luminent Mortgage Capital Inc.
Meanwhile, these are a few banks that failed during the financial crisis of 2008:
- Downey Savings and Loan, Newport Beach, California
- Freedom Bank, Bradenton, Florida
- Meridian Bank, Eldred, Illinois
- Haven Trust Bank, Duluth, Georgia
- Franklin Bank, S.S.B., Houston, Texas
The most notable bank to collapse during the global financial crisis of 2008 was Bear Stearns, an investment bank in New York City. Ultimately, JPMorgan Chase & Co. bought Bear Stearns for just $1.2 billion, a fraction of its original value.
Federal Reserve Steps in to Make Emergency Loans to Banks and Salvage the Economy
The primary reason many other financial giants in the country didn’t fail was that the Federal Reserve intervened, pumping taxpayers’ money into the economy. Here are a few steps the government took:
The Troubled Asset Relief Program was introduced to mollify the financial crisis in the country. U.S. President George W. Bush signed TARP in 2008, allowing the Department of the Treasury to put money into the market by purchasing equity and assets.
TARP was designed to give consumers debt relief and stabilize the overall economy. Initially, TARP was authorized to inject $700 billion into the failing market. However, the amount was later lowered to $475 billion after the signing of the Dodd-Frank Act.
Dodd–Frank Wall Street Reform and Consumer Protection Act
President Obama signed the Dodd-Frank Act in 2010 to tackle the aftereffects of the financial crisis of 2008. The law put in place regulations to prevent the predatory behavior of lenders and mortgage companies. Here are some of its other provisions:
- Banks have to formulate a shutdown plan if they’re out of money or nearing bankruptcy.
- All financial institutions should increase the money in their reserves to deal with any slump in the future.
- The Consumer Financial Protection Bureau (CFPB) is responsible for protecting consumers against corrupt practices of financial institutions. The bureau works alongside regulators to put a stop to risky lending.
- The Financial Stability Oversight Council (FSOC) will maintain checks and balances on banks by identifying risks that could potentially impact the industry.
Emergency Economic Stabilization Act
The Emergency Economic Stabilization Act of 2008, also known as the bank bailout, was passed in 2008. Per this law, the $700 billion Troubled Asset Relief Program was created to buy toxic assets from banks.
Aftermath of the 2008 Financial Crisis
The lowered interest rates before the financial crisis were the only silver lining from the whole ordeal. Americans suffered heavily as a result of the crisis, with $8 trillion wiped from the stock market.
Also, as the housing market plummeted, Americans lost a whopping $49.8 trillion, vaporizing many of their retirement accounts. On a global scale, there was a drop of 4% in economic growth.
Overall, millions of Americans lost their jobs due to layoffs by bankrupt companies. Meanwhile, after defaulting on payments, subprime borrowers lost their homes.
What Can Crypto Investors Learn From the 2008 Financial Crisis?
The financial crisis of 2008 certainly put a lot of Americans through financial ordeals, but it also offered lessons and identified loopholes in economic policies. Here are some things crypto investors can learn from it.
Be Wary of Potential Bubbles
As a crypto investor, be wary of crashes and bubbles. We live in a world of meme coins and influential figures swaying the crypto market with their tweets. Therefore, you should have a non-sensationalist approach to crypto investing, especially when it comes to coins that seem to have rallied too quickly.
Due Diligence Is Key
Currently, there are thousands of cryptocurrencies, although not all of them are widely known since they may not have made it to price monitoring sites. Some of these currencies are in the process of seeking their niche in a saturated marketplace.
However, others are just on the hunt for unsuspecting investors — whom they can prey on to make a quick buck. Thus, perform your due diligence before investing in cryptocurrency.
Start by looking at the crypto business model. You can read the company’s white paper and judge whether there’s a scope for scalability or if the company is on its way toward expansion and development in the future.
Next, look at the team. Do a Google image search and check to see if the people mentioned even exist, or if their pictures have been taken from another website. Some developers even put fabricated team members on their white paper to make the project seem legit.
Finally, look at the company’s initial coin offering, transparency, partnerships and profits.
The blind trust of investors in credit rating agencies was one of the catalysts of the financial crisis of 2008. Don’t make the same mistake. Do your own research, rather than blindly following an online article written by someone who may simply be trying to sensationalize the content as clickbait.
Identify Promising Crypto Projects to HODL
Here’s something to etch in your mind: the bear market will not last forever.
Volatility is inevitable in the crypto market, so don’t let it cloud your judgment if you want to HODL a promising project.
After the financial crisis of 2008, internet stocks plunged. People began to regard everything containing a “dot-com” as an ill-considered, immature business strategy. However, a decade later, some of the same startups that came into existence during that bubble are ruling cyberspace: some of them include Google and Amazon.
Apply the same to cryptocurrency, and don’t let a price drop discourage you from holding projects with inherent potential. If you’ve done your research and strongly believe in the growth potential of a token, HODL on.
Be Wary of Projects that Are “Too Big to Fail”
Although the signs of an upcoming financial crisis had always been there, many investors simply didn’t believe that certain financial institutions could ever fail, due to their sheer size.
However, we all suffered the consequences of this error in judgment as some of the biggest companies and banks filed for bankruptcy in 2008. The same applies to cryptocurrency. Don’t fall prey to the idea that some tokens are simply too big to fail.
If you nonetheless choose to adhere to this ideology, you’re likely to take excessive risks that can result in a lot of monetary loss.
Diversify Your Crypto Portfolio
Instead of investing everything in a single token, diversify your portfolio. This ensures that all your eggs aren’t in the same basket, so that even when a crypto calamity strikes, your whole portfolio isn’t wiped out.
Pro tip: keep a manual record of your transactions, or use a third-party portfolio tracker to manage your diversification. Some trackers allow you to link them to personal wallets, making the process even more streamlined.
You can diversify your portfolio by crypto classification: stablecoins, value assets, payment coins, smart contracts, non-fungible tokens, privacy coins and Decentralized Finance (DeFi) takes the decentralized concept of blockchain and applies it to the world of finance. Build... tokens.
Alternatively, it’s possible to diversify your crypto portfolio by industry or geography. The major benefit of the latter is that your investments aren’t affected by regulatory uncertainties in any given country.
As unfortunate as it was, the financial crisis of 2008 taught us many lessons and led to the creation of policies that prevent a similar economic catastrophe from befalling the U.S. in the future.
By now, you should have a clear idea of what caused the 2008 financial crisis. Thus, you can use the lessons from the 2008 real estate market crash and apply them to crypto investments. To summarize: do your due diligence, be wary of market volatility, know that even the biggest cryptos can fail, hold your assets in promising projects — and diversify your portfolio.