The Stock Market Crash Of 2008

CNN Money

CNN Money

The Economy

How Did We Get Here?

By now you likely know that the crisis in the financial markets is the culmination of years of reckless mortgage lending and Wall Street dealmaking. It’s the final gasp of the burst housing bubble. But how exactly did this happen?

To find the root cause of Wall Street’s woes, you have to go back to the collapse of a different bubble – tech. In 2001, after the dotcom craze ended and the bear market began, the Federal Reserve started aggressively slashing short-term interest rates to stave off recession. By eventually reducing rates to a historically low 1%, the Fed reinflated the economy. But this cheap money sparked a new wave of risk taking.

Homeowners, armed with easy credit, snapped up properties as if they were playing Monopoly. As prices soared, buyers were able to afford ever-larger properties only by taking out risky mortgages that lenders were happily approving with little documentation or money down.

At the same time, Wall Street investment banks got a brilliant idea: bundle the riskiest of these mortgages, then slice and dice these portfolios into tradable bonds to be sold to other banks and investors. Amazingly, bond-rating agencies slapped their highest ratings on the “best” of this debt.

This house of cards came down when subprime borrowers began defaulting on their mortgages. That sent housing prices tumbling, unleashing a domino effect on mortgage-backed securities. Banks and brokerages that had borrowed money to boost the impact of those investments had to race to raise capital.

Some, like Merrill Lynch, were forced to sell. Others, like Lehman Brothers, weren’t so lucky. “What we always tell investors is beware of too much leverage in a company,” says Brian Rogers, chairman and portfolio manager for T. Rowe Price. “Leverage is the enemy of the investor.”

Sure, everyone from former Fed chairman Alan Greenspan to your friends and neighbors played a role in stoking this casino culture. But troubled banks and brokerages can’t pass the blame. “These firms closed their eyes and made very bad bets on risky securities that they didn’t truly understand,” says Jeremy Siegel, finance professor at the University of Pennsylvania’s Wharton business school. “Investments that they did not have to make led to their demise.”

One Response

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